BOK "Financial Institutions' Liquidity Concerns Grow Due to Political Uncertainty... Caution Needed Against Prolongation" [Q&A]

Bank of Korea Second Half Financial Stability Report Press Briefing

On the 24th, the Bank of Korea stated, "Recently, political uncertainty has increased, raising concerns about liquidity in financial institutions," but also assessed that "considering the debt repayment capacity of households and businesses, the resilience of financial institutions, and external payment capabilities, the financial market is generally stable."

It added, "However, if political uncertainty prolongs, it could become a concern," emphasizing that "it is important to provide confidence that financial and economic policies are being implemented without disruption and that the economic system operates independently and normally."

At a press briefing held after the release of the Financial Stability Report for the second half of the year, Lee Jong-ryeol, Deputy Governor of the Bank of Korea, commented on the increased volatility in the financial market following the impeachment political situation, saying, "Compared to past experiences, the impact of political uncertainty on the economic system has been short-term and limited," and "Considering the size of net external financial assets, the ratio of short-term external debt to foreign exchange reserves, and current account outlook collectively, the soundness of our country is robust."

The following is a Q&A with Deputy Governor Lee Jong-ryeol and Director Jang Jeong-su of the Financial Stability Bureau.

- As the impeachment political situation unfolded, volatility in the financial market itself increased. Considering the Financial Vulnerability Index (FVI) and Financial Stress Index (FSI) up to November, you said it is not yet risky. How do you expect December to be?

▲(Deputy Governor Lee Jong-ryeol) It is true that recently political uncertainty has increased, leading to a contraction in economic sentiment and growing liquidity concerns among financial institutions. However, considering the debt repayment capacity of households and businesses, the resilience of financial institutions, and external payment capabilities, the financial market’s fund intermediation function is operating smoothly. Since the soundness of the financial market is also being maintained well, we continue to assess that the financial market is generally stable. Compared to past experiences, the impact of political uncertainty on the economic system has been short-term and limited. Considering the size of net external financial assets, the ratio of short-term external debt to foreign exchange reserves, and the current account outlook collectively, we view the soundness of our country as robust. However, if political uncertainty prolongs, it could become a concern, so it is important to provide confidence that financial and economic policies are implemented without disruption and that the economic system operates independently and normally. So far, the financial stability situation is not bad.

- Has the situation after the martial law been reflected in this Financial Stability Report?

▲(Jang Jeong-su, Director of Financial Stability Bureau) This report reflects recent conditions that have changed significantly, incorporating data up to December 10, two weeks before the report’s publication. The impact of recent political uncertainty will be reflected in the Financial Stress Index (FSI) for December. The FSI reflects credit spreads, stock price and exchange rate volatility, delinquency rates, CDS premiums, and more. Since the imposition of emergency martial law and the start of the impeachment political situation in December, financial market volatility has increased significantly. Specifically, stock prices showed high volatility but have somewhat decreased recently. However, exchange rate volatility remains high. On the other hand, credit spreads remain relatively stable. Since the FSI is calculated monthly, we need to observe further to see how it will develop in December.

▲(Jang Jeong-su) The Financial Vulnerability Index (FVI) uses three indicators: credit accumulation, asset prices, and financial institution resilience, so it reflects longer-term trends rather than short-term fluctuations. Therefore, it will be influenced more by subsequent changes in credit, asset price fluctuations, and the resilience of financial institutions than by immediate impacts.

- You mentioned that the impact of exchange rate increases on the financial institutions’ financial soundness is limited. How likely is it that the exchange rate level, which recently surpassed 1,450 won, will become entrenched? What impact would a sustained high exchange rate have in the medium to long term?

▲(Deputy Governor Lee Jong-ryeol) At the time of analysis, the exchange rate was around the 1,430 won level. Considering various situations during the analysis, we judge that the impact on financial institutions is not significant yet, given their capacity and response measures. Measures to improve foreign exchange supply and demand, such as raising the upper limit on forward foreign exchange positions, will also have a positive effect on the market. While it is difficult to say up to what level the exchange rate can go, considering external payment capabilities and net external financial assets, there should be no major impact on the stability of financial institutions for now. That is the current situation.

▲(Jang Jeong-su) The impact on financial institutions depends not only on the exchange rate level but also on foreign exchange market volatility, foreign currency funding investment conditions, and domestic conditions, so a comprehensive consideration is necessary. When there is excessive volatility in the foreign exchange market, that is, when the exchange rate fluctuates sharply, it can have a significant impact on financial institutions, so we are prepared to respond through smoothing operations (fine adjustments). Since the possibility of a sustained high exchange rate cannot be ruled out, the foreign exchange authorities will closely monitor and remain vigilant about its impact on the soundness of financial institutions.

▲(Yang Yang-hyun, Director of International Planning Department) It is difficult to answer easily whether the exchange rate will become entrenched at a high level in the medium to long term because of the high uncertainty in domestic and international conditions. The direction of the new U.S. administration, the slowing pace of Fed rate cuts, and domestic political uncertainty are intertwined and influencing the situation, making it hard to predict future directions. On the 20th, the government relaxed many regulations that had suppressed inflows, such as raising the forward foreign exchange position limits, as part of measures to improve foreign exchange supply and demand. Expanding the foreign exchange swap (FX Swap) with the National Pension Service is also expected to help stabilize the market. Although it is difficult to predict over a long time horizon, the government and the Bank of Korea have recently taken various measures to stabilize sentiment.

- Has the obstacle to financial stability in the interest rate cut phase disappeared?

▲(Jang Jeong-su) In monetary policy decisions, we comprehensively consider inflation, growth, and financial stability. Although conditions for interest rate cuts were established in terms of inflation and growth last August, rates were held steady due to significant increases in household debt and real estate prices. At that time, macroprudential measures were taken, which slowed the rise in household debt and real estate prices, allowing for an interest rate cut in October. The two main considerations in policy decisions regarding interest rate cuts were, first, concerns about the accumulation of financial imbalances in the household debt sector, and second, volatility in financial markets such as exchange rates. Household debt and real estate prices have recently slowed their upward trend, reflecting the effect of macroprudential measures. The Bank of Korea’s monetary policy next year will be on an interest rate cut trajectory, so additional rate cuts are possible. Meanwhile, there are concerns about housing supply shortages next year. After a certain point, housing prices, real estate prices, and household debt could increase again at any time. Therefore, monetary policy decisions will consider these changes even though the current upward trend has slowed. Exchange rates are also a major consideration because they affect not only inflation but also sentiment, which in turn impacts financial stability. Thus, exchange rates are a key factor in monetary policy decisions.

- You mentioned that caution is needed in managing risk-weighted assets during exchange rate increases. What does this mean?

▲(Jang Jeong-su) When the exchange rate rises, the won-denominated amount of risk-weighted assets increases, which causes a decline in the total capital ratio of financial institutions. When the total capital ratio falls, financial institutions decide to either increase capital or reduce risk-weighted assets to maintain a certain level of capital ratio. In the past, when the exchange rate rose significantly and had a large impact on capital ratios, financial institutions tended to reduce high-risk-weighted credit loans, small and medium enterprise loans, or household credit loans. Therefore, it is necessary to pay attention to such changes.