[China Risk, Korean Wave] ③ Market Turmoil if Chinese Bond Funds Withdraw... Exchange Rate Also Unstable

If the economic slowdown in China intensifies, it is expected to cause significant shocks not only to domestic exports but also to the financial and foreign exchange markets. Although the government and the Bank of Korea currently believe that the possibility of a China-originated financial market crisis is low, considering the massive Chinese capital invested in the domestic foreign exchange and bond markets, there is an analysis that the ripple effects could expand across the financial markets depending on future developments in the Chinese economy.

If Chinese Bond Funds Withdraw... Market Turmoil Inevitable

According to the International Finance Center on the 23rd, as of the end of last year, Chinese investment funds in the Korean bond market are estimated at $28.5 billion. Calculated based on the previous day's closing won-dollar exchange rate (1,335.5 won), this amounts to approximately 38.06 trillion won. Considering that the total foreign investment balance in the domestic bond market is between 230 trillion and 240 trillion won, the proportion of Chinese funds in the domestic bond market is not insignificant.

Korea mainly invests heavily in production facilities in China, so direct investment ($102 billion) overwhelmingly dominates the total investment in China ($166.4 billion). Conversely, in China's total investment in Korea ($86 billion), bond investment has a larger share than direct investment ($15.7 billion). Therefore, if the Chinese economic slowdown intensifies, there are concerns that Chinese capital in Korea may withdraw, causing turmoil in the Korean bond market as well.

Among experts, there is increasing speculation that Chinese authorities may regulate overseas capital outflows to stimulate domestic demand and may sell Korean government bonds to recover funds. In fact, China has been actively selling U.S. Treasury bonds since last year. According to Hong Kong's South China Morning Post (SCMP), China's holdings of U.S. Treasury bonds dropped to $835.4 billion in June this year, a decrease of over $100 billion in one year. The U.S.-China conflict is a major cause, but recent capital outflows also aim to defend against yuan depreciation.

Jung Young-sik, senior researcher of the International Finance Team at the Korea Institute for International Economic Policy, pointed out, "Since China holds a significant share in the domestic government bond market, if fund recovery begins in the future, it could act as a destabilizing factor for our capital market or interest rates." Typically, when foreign capital rapidly withdraws from the bond market, interest rates rise and bond market volatility increases. This then spills over into the stock and foreign exchange markets, placing a burden on the real economy.

Weak Yuan and Won Depreciation... Foreign Exchange Market Instability

The market is also on high alert for increased exchange rate volatility due to the weakening yuan. Since Korea has a high economic dependence on China, the won tends to move in tandem with the yuan. Amid a prolonged U.S. tightening cycle and credit rating downgrades that have strengthened demand for safe assets (dollar), Asian currencies are generally weak. Along with the yuan, the won's depreciation has widened, pushing the won-dollar exchange rate to the 1,330?1,340 won range.

The yuan broke through the psychological barrier of 7 yuan per dollar in May, and recently surpassed 7.3 yuan per dollar. The People's Bank of China has lowered benchmark interest rates to support the sluggish economic recovery, which may further weaken the yuan. Park Sang-hyun, a researcher at Hi Investment & Securities, said, "Fear of China's debt risk is strengthening the sentiment for yuan depreciation," adding, "With abundant factors causing won depreciation, the won-dollar exchange rate's sharp rise has not yet calmed."

Especially since Chinese banks account for 50?60% of transactions in Korea's foreign currency call market, there is potential for market instability. Lee Chi-hoon, head of the Emerging Economies Department at the International Finance Center, explained, "Currently, the Chinese foreign exchange fund market is not bad, but if funds become scarce in the future, they could directly or indirectly pull funds from Korea," adding, "In such a case, foreign currency shortages could occur domestically, affecting the financial market."

Additionally, Korean investment funds in China may face increased risk of losses. The Ministry of Economy and Finance recently explained that domestic financial institutions' exposure to Chinese real estate developers is only 400 billion won, so even in the worst case, the damage would not be significant. However, excluding direct investment, bond and stock investments in China exceed $64 billion. If the Chinese real estate crisis spreads to an economic recession, the overall loss scale for the Korean economy could increase.

Expansion of Currency Swaps... Helps Stabilize Foreign Exchange and Financial Markets

The government and the Bank of Korea currently do not see a need to worry about financial and foreign exchange market instability originating from China. A Bank of Korea official explained, "Most of the Chinese funds in the domestic bond market are public funds, so even if the Chinese economy worsens, volatility will be less compared to private funds." However, since there was a significant net outflow of foreign bond funds centered on overseas public institutions earlier this year, it is difficult to be fully reassured.

Senior researcher Jung said, "Efforts are needed to expand currency swaps, which can act as a safety net when foreign exchange and financial markets become unstable, to the U.S., Eurozone, the U.K., and others," adding, "It is also necessary to expand the $35 billion foreign exchange swap agreement between the Bank of Korea and the National Pension Service to reduce foreign exchange demand." He further explained, "Policies that enable overseas retained earnings of companies to return domestically can also support foreign exchange market stability and economic recovery."

On the 22nd, the won-dollar exchange rate started on a downward trend, while stocks such as the KOSPI began on an upward trend. Dealers are conducting foreign exchange operations in the Hana Bank dealing room in Myeongdong, Seoul. Photo by Heo Younghan younghan@

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