BIS "In Strong Dollar Era, Korean Government Bond Liquidity Declines... Greater Impact Than Before"

The "Original Sin's Return" of Non-Reserve Currency Countries
"Dollar Plays a Decisive Role in Emerging Market Sovereign Debt"

An analysis has emerged suggesting that the global strong dollar phenomenon leads to a decline in liquidity in the domestic government bond market. As the tightening by the U.S. Federal Reserve, a key factor behind the strong dollar, continues for an extended period, there are recommendations that the central bank should contribute to liquidity management and financial market stability through foreign exchange market stabilization policies.

The BIS (Bank for International Settlements) recently mentioned in its report titled "The Dollar and Government Bond Market Liquidity: Evidence from Korea" that the Fed's tightening and the strong dollar phenomenon negatively affect liquidity in the domestic government bond market. According to the report, when the dollar index yield increases by 10 percentage points, the government bond bid-ask spread (the difference between selling and buying prices) rises by an average of 0.7 basis points (1bp = 0.01%) per day. This result was derived from an analysis using real-time government bond order book and transaction data from the Korea Exchange from January 2012 to December 2022, and the widening spread translates into increased transaction cost burdens for the Korean market.

Although the focus of this study is Korea, the report explains that considering market size and liquidity, the findings can be applied broadly to emerging market countries including Korea. This is attributed to the "original sin" that explains the structural vulnerability of emerging countries' external capital. The original sin hypothesis was first proposed in 1999 by Barry Eichengreen of UC Berkeley and Ricardo Hausmann of Harvard University, meaning that emerging countries, not being currency anchor countries, have the original sin of being unable to raise external capital in their own currency.

However, since the 2000s, the development of local currency-denominated bond markets in emerging countries has attracted many foreign investors, leading to the "original sin extinction" debate that these countries can sufficiently borrow in their own currency. Recently, the concept of "original sin redux" has emerged, indicating that if the exchange rate rises too much, the likelihood of large-scale capital outflows by foreign investors increases. In such cases, large capital outflows can cause a sharp rise in government bond yields, further destabilizing financial markets.

Outstanding Government Bond Issuance by Major Countries. Since the 2000s, South Korea's bond market has developed, placing it among the top 10 OECD (Organisation for Economic Co-operation and Development) countries (left graph), and the scale has also increased sharply (red line in the right graph). Source: BIS

The report emphasizes that "the dollar acts as a global risk factor and plays a pivotal role in emerging market government bond markets," adding that "the impact of dollar appreciation on government bond market liquidity is further intensified by deteriorating capital raising conditions, declines in financial institutions' BIS capital ratios, and foreign investors' sales of government bonds."

The influence of the U.S. dollar value on Korea’s financial markets, including the government bond market, is expected to grow as Korea enters a low-growth phase. Professor Emeritus Kim Jeong-sik of Yonsei University’s Department of Economics said, "Previously, because we experienced high growth, Koreans invested more in domestic stocks and bond markets than in the U.S., but now, as we enter a low-growth phase, investments in the Korean market are seen as yielding lower returns." He added, "Simply put, our economy will be more influenced by the U.S. economy than before, and the impact of the Bank of Korea’s monetary policy on the domestic financial market will be weaker than in the past."

Professor Kim explained, "Recently, even though the Bank of Korea kept the base interest rate unchanged, loan interest rates rose due to the strong dollar causing U.S. government bond yields to increase. This phenomenon is likely to occur more frequently in the future."

Regarding this, the report suggests that central bank-level foreign exchange market stabilization policies play a significant role in maintaining market liquidity, which is a measure used to assess the stability of emerging countries’ financial systems.

Lee Ji-eun, a Bank of Korea official seconded to the BIS who authored the report, said, "Previously, when the dollar was not strong, stabilization policies related to exchange rates were seen as 'market intervention,' sending negative signals internationally and were perceived as having more drawbacks than benefits. However, now, for emerging countries, financial market instability caused by a strong dollar can occur, and there is a growing consensus internationally that implementing some degree of stabilization policy is desirable."

This content was produced with the assistance of AI translation services.