On the 8th, the won-dollar exchange rate opened at 1,555.2 won per $1, up 16.1 won from the previous session. After briefly topping 1,560 won in after-hours trading on the 2nd and nearing the global financial crisis level (1,597 won on Mar. 6, 2009), it has also been moving in the 1,550-won range during daytime trading on the 8th.
One of the reasons cited for the sharp rise in the exchange rate is "non-deliverable forwards (NDF) transactions." NDFs are a type of forward transaction conducted outside the Seoul foreign exchange market. They take place 24 hours a day in global financial centers such as New York, London and Singapore.
NDFs are not transactions that exchange won. Only the difference between the contracted rate and the actual rate is settled in U.S. dollars. For foreign investors, they do not have to exchange won that are hard to obtain in overseas markets, and they are not subject to Korea's foreign exchange authorities' regulations related to foreign exchange trading.
Foreign exchange authorities believe that as the size of these NDF transactions grows, it triggers a surge in the won-dollar rate in the Seoul market. According to the Bank of Korea, the average daily NDF trading volume has increased faster than spot transactions so far this year. The latest statistics show that Korea's forward transaction volume, including NDFs, is the second largest after India among emerging non-reserve currency countries.
◇ If NDF purchases betting on a higher exchange rate increase, the rate rises in the Seoul FX market
Recently, foreign exchange authorities have pointed to NDF transactions as one of the causes of the surge in the won-dollar rate. In a message sent to reporters at 11:46 a.m. the same day, the authorities said, "In the recent FX market, beyond supply-demand factors, some speculative FX transactions such as NDFs appear to have increased volatility," adding, "We will not tolerate excessive volatility and one-way herd behavior relative to fundamentals and will respond forcefully."
If foreigners investing in Korean stocks or bonds expect the won-dollar rate to rise further, they buy NDFs. Their counterparties, domestic foreign exchange banks, then buy dollars in the Seoul market to hedge exchange risk and to meet Korea's foreign exchange authorities' forward position regulations (the value of forward foreign currency assets minus forward foreign currency liabilities). This becomes a factor pushing the rate higher. This phenomenon is sometimes called "wag the dog."
According to the Bank of Korea, the average daily NDF trading volume was $15.55 billion (about 24.2 trillion won) in the first quarter of this year, up 27.7% ($3.38 billion) from the previous quarter. Over the same period, spot trading volume rose 26.2%, meaning NDF volume grew at a faster pace. Last year, the growth rate of spot trading volume (26.1%) was higher than that of NDFs (6.9%). Because NDF transactions are outside Korea's foreign exchange authorities' regulations, they can neutralize tools that would otherwise help calm sharp exchange rate swings.
◇ Korea's forward trading volume is second only to India... "As the economy and capital flows grow, the won is not internationalized"
In Korea, 70% to 80% of forward transactions are NDFs. And the size of forward transactions, including NDFs, is large even among emerging markets. According to the Bank for International Settlements (BIS) triennial Survey of foreign exchange and OTC derivatives markets, Korea's average daily forward trading volume in April last year was $87.19 billion, up 22.5% from three years earlier. Among emerging non-reserve currency countries, it is the second largest after India ($91.531 billion).
The surge in Korea's forward transactions reportedly began in earnest in 2019. In a 2023 report, the Korea Capital Market Institute analyzed, "As Korea's real and financial economies have steadily expanded, the size of residents' overseas securities investment and foreign investors' securities inflows and outflows has increased the most compared with other emerging markets, which in turn has increased both hedging demand for the won and speculative transaction demand." Recently, the growth in overseas investment by domestic investors has slowed, but foreigners' net stock sales are large.
The problem is that, because NDFs are offshore transactions, the government has no clear way to regulate them immediately. The solution cited by foreign exchange authorities is the internationalization of the won, but that is a mid- to long-term task. In a press release for an emergency market situation review meeting on the 7th, the Ministry of Economy and Finance said it "will devise ways to absorb offshore NDF transactions into our foreign exchange market."
☞ Non-deliverable forwards (NDF)
A typical spot transaction is concluded at the exchange rate on the trade date. Usually within two days of the trade date, the parties actually deliver or receive foreign currency. A forward transaction, by contrast, is a contract in which the parties agree to buy or sell foreign currency at a currently agreed rate at a specific time in the future (as short as one week to more than a year).
In an NDF, the full contract amount is not exchanged at maturity; only the difference between the contracted forward rate and the spot rate at maturity is settled in U.S. dollars. For example, on Jan. 1, a foreign bank A signs an NDF transaction with domestic bank B to sell a contract amount of $1 million in three months at an NDF rate of 1,100 won. If the actual rate on Apr. 1 is 1,000 won, bank B pays bank A only $100,000 and closes the contract.