A Bank of Korea analysis found that Korea's foreign exchange market is more vulnerable to external shocks than those of advanced economies. The central bank advised actively using foreign exchange market intervention and macroprudential policies to minimize the negative impact of external shocks on the domestic economy.
On the 22nd, the Bank of Korea published a BOK Issue Note titled "Policy response analysis considering the depth of financial and foreign exchange markets." The report was written by International Finance Research Team Directors Kim Ji-hyun and Kim Min of the International Department.
Analyzing 17 countries including Korea, the researchers found that Korea's uncovered interest parity (UIP) premium response coefficient to global risk shocks was tallied at 2.11 percentage points. That is five times the average of advanced economies (0.41%).
The UIP premium refers to the additional cost that domestic economic agents must pay to global investors when borrowing from abroad. A large expense indicates that the "depth" of Korea's foreign exchange market—how well it absorbs global risk shocks—is not deep.
Given that Korea's depth is shallow, the researchers saw improvement in the financial and foreign exchange markets as important. Specifically, they viewed the use of macroprudential policies to prevent financial instability or credit crunches and foreign exchange market intervention as necessary.
According to the analysis, when responding to global risk shocks with a combination of the two policies, the output gap of gross domestic product (GDP) narrows and the welfare loss shrinks by 18.3%. The GDP gap refers to the difference between actual GDP and potential GDP, and a positive (+) GDP gap induces inflation.
The researchers said, "Improving the depth of financial and foreign exchange markets is important to minimize the negative impact of external shocks on the domestic economy," adding, "The currently promoted 'plan to improve the foreign exchange market structure' and inclusion in the World Government Bond Index (WGBI) are expected to help enhance the depth of the domestic financial and foreign exchange markets by expanding foreign capital inflows into the domestic bond market."