"After WGBI Inclusion Decision... Foreign Bond Capital's Impact on Exchange Rate Grows"

KCMI Releases Report: "Risk Assessment and Management Directions After WGBI Inclusion"

An analysis has found that the influence of foreign bond capital on the exchange rate has increased since Korea's decision to be included in the World Government Bond Index (WGBI). While this can contribute to exchange rate stability in the current environment of a strong won-dollar exchange rate, it is also diagnosed that in periods of market stress, exchange rate volatility could be further amplified.

The Korea Capital Market Institute stated this in its report "Risk Assessment and Management Directions After WGBI Inclusion," released on May 18. Senior Research Fellow Kang Hyunju and Research Fellow Kang Boseong, the authors of the report, highlighted two main risk areas Korea may face after joining the WGBI: ▲ risks in the foreign exchange and foreign currency funding markets, and ▲ risks related to changes in index status.

"Stabilizing Effect in High Exchange Rate Phase... Volatility Amplified During Stress Periods"

First, the Institute empirically analyzed foreign exchange and foreign currency funding market risks before and after October 8, 2024, the date Korea's inclusion in the WGBI was decided. The analysis found that the channels through which foreign bond capital affects Korea's foreign exchange and currency markets have been structurally changing since the decision. The report noted, "Before the inclusion decision, foreign bond investment mainly consisted of funds responding to arbitrage opportunities, which flowed in through sell-and-buy swaps, impacting the swap market," adding, "After the inclusion decision, there has been a shift toward a greater proportion of funds with foreign exchange exposure."

As a result, the impact of foreign capital inflows on the exchange rate has significantly increased, while in the swap market, a transitional characteristic has been observed, where the diversification of investor composition has reduced the predictability of response channels. The report assessed, "These changes mean that foreign bond capital is shifting to a structure directly linked to exchange rate fluctuations," and "Future changes in capital flows may be transmitted more quickly to foreign exchange market volatility."

Looking at the analysis of changes in U.S. Treasury yields from the previous day, foreign bond trading on the day, and the exchange rate on the day, the immediate response of the exchange rate to a one-standard deviation shock in foreign bond purchases expanded about 8.3 times, from -0.008% before the WGBI inclusion decision to -0.067% after the decision.

The report stated, "In normal times, foreign bond capital inflows are expected to expand spot FX trading, improve foreign exchange market liquidity, and exert upward pressure on the won, which is a positive effect," adding, "In periods like the present, when the upward pressure on the dollar-won exchange rate is strong, the inflow of index funds contributes even more to exchange rate stability." Conversely, "in stress situations such as heightened global risk aversion or changes in index status, mechanical outflows of index funds could amplify exchange rate volatility. While the probability of such events is limited, the potential impact is significant, so preemptive measures are necessary," the report pointed out.

"Potential Adjustment of Korea's Weight in the Index" - Downward Pressure Pathways Analyzed

Regarding index status change risk, the report noted, "After inclusion, there is a risk of downgrade due to deteriorating market accessibility, or the index composition could be adjusted due to the fiscal situations of already included countries and new inclusions." In particular, the report cited ▲ the expansion of government bond issuance by major developed countries, ▲ the potential new inclusion of emerging markets such as India, and ▲ normalization of currently underinvested allocations to China as pathways that could lead to a reduction in Korea's weight in the index.

The expansion of major countries' government bond supply could gradually dilute Korea's weight. In the case of India, which is being considered for WGBI inclusion, its market accessibility rating was upgraded to Level 1 in October 2024, resulting in its inclusion in the FTSE Emerging Markets Government Bond Index (EMGBI). This corresponds to the stage just before WGBI inclusion, which requires Level 2. The report pointed out, "Although the likelihood is limited, if multiple countries are included at once, there is a tail risk that a rapid adjustment of weights could occur in a short period."

In addition, even for China, which has already been included in the WGBI, there is still a risk of a gap between actual asset allocation and the index. The report said, "There appear to be a significant number of asset managers who use the WGBI excluding China as their benchmark, thereby excluding Chinese government bond investment," adding, "As a result, there is upside uncertainty in the size of investment capital flowing into Korea, which could exceed the proportion calculated based on the WGBI index composition." The report further explained that if these investors later switch their benchmark to an index that includes China, there is downside risk that capital may flow out as Korea's weight is reduced.

Accordingly, the report recommended, "In situations where index status changes rapidly, government bond sales can translate directly into won sales, thereby amplifying both index status risk and foreign exchange market risk." It advised that future policy responses should focus on establishing a "pre-emptive response system" to block transmission pathways in the event of a shock. Furthermore, it emphasized the need to maintain policy-level market accessibility and institutional consistency, strengthen sophisticated monitoring of the characteristics of foreign capital by type, and establish an integrated response system linking foreign exchange market stabilization policies with government bond market supply and demand management.

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