Trade-dependent South Korean gained a powerful new arsenal of liquidity ammunition as the US Federal Reserve offered a currency swap to the Bank of Korea late on Thursday.
On Friday, Seoul’s previously bearish markets were in a bouncy mood. At lunchtime, the KOSPI stock index was up by 4.49% and the South Korean won – which had been touching 11-year lows – had gained more than 1% against the dollar.
The currency swap facility with the Fed, worth US$60 billion over a contract period of at least six months, means the BOK can borrow dollars directly from the Fed in exchange for won, avoiding dollar shortages even if local banks and firms cannot finance greenbacks in the market.
Amid the global market panic, the dollar funding market found itself squeezed at a steeper-than-expected pace this week. The Fed has traditionally maintained currency swap contracts only with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank.
However, as countries worldwide suffer collateral economic fallout from the novel coronavirus, the Fed temporarily expanded the swap contract to nine countries during the crisis, with South Korea being one of the swap partners.
Banks in a good position
The BOK said in a statement that it “plans to supply US dollars raised through currency swaps immediately and hopes dollar supply will contribute to stabilizing the local currency market, which has seen a sharp rise in the dollar/won exchange rate due to the recent mismatch in the supply and demand of dollar.”
Even so, local banks already have a high level of soundness in foreign currency liquidity.
The forex liquidity coverage ratio (LCR) of local banks is 128.3% as of the end of February – well above the ratio of 80%, which the government calls on domestic banks to maintain. This means that even if local banks run short of dollars, they have room to secure dollars by selling their own foreign currency assets. Korean banks had also secured dollars in advance.
“There is some leeway in foreign currency funding,” a top-level official at the Export-import Bank of Korea told Asia Times.” We issued (privately placed) dollar bonds last week just before the market was sharply strained. If borrowing is not feasible, we could gain some dollars selling overseas assets.”
“For the time being, foreign currency liquidity problems will not arise in South Korea, even without additional dollar borrowings or the foreign exchange authorities’ supply of dollar liquidity,” a market expert said.
Experts estimate that domestic banks can endure two to three months without additional dollar borrowing or the authorities’ liquidity supply.
However, market sentiment has been highly unstable.
In the shadow of a possible recession, policy rate cuts by the Fed and other central banks, including the BOK, as well as fiscal policy measures being enacted by major countries have failed to calm jitters.
Market changed fast
With risk-averse sentiment at its peak, those with the cash were not offering it, leading to an overall squeezing in the dollar funding.
“The market is in a different situation now,” an official at the Korea Center for International Finance said prior to Thursday’s news. “I didn’t expect the dollar funding market to go this bad so quickly.”
Dollar hoarding hammered the dollar/won spot exchange rate, driving the local currency down to 11-year lows.
In a move to provide more dollars to the market, the finance ministry and the Bank of Korea raised a cap on foreign currency forward positions for banks on Thursday. With this measure, foreign banks’ Korean branches can bring an additional $5-10 billion into Korea by borrowing from their headquarters.
And as a last resort, authorities can supply dollars from foreign reserves, which stand at $409 billion.
However, the currency swap deal is the most powerful measure to counter squeezing dollar funding. And it has a history of success. Korea’s last currency swap deal with the US, worth $30 billion, came amid the 2008 global financial crisis. Back then, the deal contributed to easing worries over the dollar liquidity condition and stabilized the dollar/won exchange rate.