Korean FX controls to have limited impact on won

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South Korea’s efforts to weaken its currency by limiting banks’ FX positions will hurt local asset managers’ abilities to buy foreign currency bonds while having a limited impact on controlling the won.

That is according to Asiamoney, a sister publication of EuromoneyFXNews.

In an effort to control its strengthening currency, South Korea’s ministry of finance announced on November 27 it will restrict foreign and local banks from growing their foreign-exchange forward positions above a specific limit.

Banks sell forward contracts to allow Korean exporters to hedge against currency fluctuations. This allows the bank to provide dollars to its customers, who can pay it back at a fixed cost. Because interest rates are higher in South Korea than in the US, the won is cheaper to buy in the forwards market than the spot market and allows investors to profit from this spread, and it has attracted carry traders to these margins.

However, a wider usage of these forward contracts increases the value of the won in the forwards and spot market. This has worried authorities, who are trying to stabilize the currency’s gains as more asset purchases in the US and Japan mobilize yield-hungry funds into South Korean assets. They are also trying to control the won because a stronger won raises the prices of goods in the country’s export markets.

South Korea’s won has strengthened by 4.5% against the dollar since the end of August, outperforming its Asian peers by a significant margin.

To prevent these forwards from boosting the value of the won, the finance ministry said it will cut the limit on banks’ FX positions to 150% from 200% of equity for foreign bank branches and 30% from 40% for domestic banks starting January 1.

However, some market players believe that the effect of repeated notices from Korean authorities about intervention in the currency has worn off. In addition, it will make it more difficult for South Koreans trying to invest in foreign-currency bonds because it reduces the ability for banks to sell these contracts to asset managers.

"I don’t think there is going to be a material impact on their ability to buy dollar bonds immediately, but the problem is that it doesn’t look like the Korean government will stop here," according to one trader. "If they keep lowering the limits, it will hurt them. It will hurt the yield on foreign currency investments, which may not make it worth the risk, especially in an environment where the European debt crisis makes things volatile."

The Financial Supervisory Service (FSS), which collaborated with the financial ministry on these rules, admitted that this can be a possible scenario for asset managers, pension funds and insurers.

"If you want to buy foreign currency-denominated bonds, you need to get into a Korean won/US dollar swap with a bank so that you can receive dollars and invest in dollar bonds," according to an official at the Seoul-based FSS’s foreign exchange markets team. "But if you do a swap, the bank’s counterparty gets into an FX forward because you need to sell and buy.

"If you reduce the [banks’] limit on these instruments, the foreign and domestic banks will be less able to do these types of transactions because of these new limits. Of course, it will have an impact [on asset managers], but I don’t think there will be a shock to the market because we should have already seen it."

South Korean mutual funds have bought W2 trillion ($1.8 billion) more in foreign-currency bonds compared with 2011, according to a global asset manager at a local securities firm. The national pension fund also plans to raise its investment in foreign currency bonds to W62.3 trillion by 2017. It manages W17.6 trillion as of July, according to the ministry of health and welfare.

"This could affect mutual funds, which have been heavily investing in high-yield bonds in the US this year," says one asset manager. "Especially with the won so volatile these days, it may not be prudent if it will be more difficult to access these forwards. It will also be difficult for previous instances in 2007, when South Korean asset managers were rapidly investing in China. These attempts to limit the currency with these methods make it harder for us to invest overseas."