BOK Releases "Policy Response Analysis Considering the Depth of Financial and Foreign Exchange Markets"
Enhancing Market Depth Is Essential to Minimize Real Sector Impact from External Shocks
An analysis has suggested that it is necessary to enhance the depth of the financial and foreign exchange markets in order to minimize the negative impact of external shocks on the real sector. It was assessed that, in situations where friction factors persist in the financial and foreign exchange markets, not only monetary policy but also foreign exchange market interventions and macroprudential policies need to be combined for policy objectives to be effectively achieved. Recent efforts to improve the structure of the foreign exchange market and to be included in the World Government Bond Index (WGBI) are expected to expand the pool of investors, increase market depth, and help reduce fluctuations in the real economy.
The Bank of Korea stated this on September 22 in its "BOK Issue Note - Policy Response Analysis Considering the Depth of Financial and Foreign Exchange Markets" (by Kim Jihyun and Kim Min).
Non-reserve currency countries with a high degree of external openness, such as South Korea, tend to see their financial and foreign exchange markets respond more sensitively to external shocks-such as an increase in global risk aversion or a reduction in dollar liquidity-compared to reserve currency countries. Such responses generally manifest as depreciation of the local currency and rising market interest rates. This process can also be accompanied by tightening in the domestic financial market.
The greater the friction in the financial and foreign exchange markets, the larger the response of exchange rates and interest rates to external shocks. However, there are limitations in measuring the degree of friction in these markets using data. To address this, the report utilized the "Uncovered Interest Rate Parity (UIP) premium." The UIP premium is a variable that represents the premium a country must pay when borrowing from abroad. In other words, it refers to the additional cost that domestic economic agents must pay to global investors when borrowing externally.
Kim Min, head of the International Finance Research Team at the International Department, explained, "A significant increase in the UIP premium during a global risk shock means that the country must pay higher costs when borrowing from abroad," adding, "This is a result reflecting frictions in the market. The larger the increase in the UIP premium during a global risk shock, the lower the depth of the financial and foreign exchange markets." Kim further explained that if market depth is sufficiently high, the market can absorb external shocks, thereby limiting fluctuations in exchange rates and interest rates. However, if not, the shock cannot be absorbed, leading to significant volatility in exchange rates and interest rates, and a larger increase in the UIP premium.
The report analyzed whether the responses of exchange rates and short-term interest rate spreads to shocks differ depending on the level of market depth. To do this, panel data was constructed for 17 countries with floating exchange rate systems, including South Korea. The countries analyzed included eight advanced economies-Japan, Germany, the United Kingdom, Canada, and others-and nine emerging economies, including South Korea, Israel, South Africa, India, and Indonesia. The analysis found that the response coefficient of South Korea's UIP premium to global risk shocks was 2.11%, which was higher than the average for advanced economies (0.41 percentage points).
Kim noted, "When we classified the countries analyzed into three groups based on the depth of their financial and foreign exchange markets and compared the responses of exchange rates and interest rate spreads to global risk shocks, we found that in countries with shallow market depth, both currency depreciation and increases in short-term interest rate spreads occurred during global risk shocks. In contrast, in countries with deep market depth, there was no significant exchange rate response, and short-term interest rate spreads actually decreased." This means that in countries with shallow market depth, the negative effects of global risk shocks are amplified.
Reflecting the results of the empirical analysis, a structural model analysis was conducted. After estimating the International Monetary Fund's Integrated Policy Framework (IPF) model-which assumes friction factors in the financial and foreign exchange markets-using South Korean data, the impact of global risk shocks on South Korea's financial and foreign exchange markets and the real economy was analyzed. Kim stated, "As a result, in countries with shallow financial and foreign exchange markets, the real sector contracted more significantly during global risk shocks. This means that when global risk shocks spill over into the real sector, and when the synchronization between capital outflows and interest rate spreads increases, the negative effects are further intensified."
Based on this, the effect of policy combinations was analyzed. The results showed that a policy mix utilizing monetary policy, foreign exchange market interventions, and macroprudential policies together reduced both the GDP gap and the inflation gap, thereby increasing social welfare. Kim explained, "Foreign exchange market interventions and macroprudential policies lower exchange rates and interest rate spreads, which in turn reduce the GDP gap and inflation gap, resulting in an 18.3% reduction in welfare loss." This is because the policy mix targets frictions in the financial and foreign exchange markets, mitigating excessive fluctuations in exchange rates and interest rates caused by external shocks, and buffering the negative spillover effects on the real economy.
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