The US dollar plays key role in the international financial market. Its functions as the foremost funding currency is reinforced by its use as a vehicle currency for foreign exchange transaction. Almost the half of all cross-border loans and international debt securities are denominated in US dollars, as well as over the three quarters of foreign exchange transactions occur over US dollars.
However, the experience of global dollar shortage during the global financial crisis(GFC) has led the changes in the US dollar funding market landscape after crisis. Non-US banks, which were the major suppliers of US dollar funding before GFC, has reduced its US dollar intermediation business, especially those from European region. Also US dollar funding is increasingly obtained through capital market as the banks conduct less US dollar intermediation. In the short-term dollar funding market, deviations from covered interest parity(CIP) persist since GFC and it is now characterized as low liquidity and higher cost market compare to pre GFC era.
In the case of Korea, abundant liquidity conditions in the spot foreign exchange market has been maintained until recently due to persistent current account surplus as well as the growth trend of incoming foreign portfolio investment. However, liquidity conditions of short-term dollar funding market, typically assessed by CIP deviations in the FX swap market, has been worsening since GFC. According to empirical results in this paper, recent structural changes in the global US dollar funding market influence short-term dollar funding market conditions in Korea through reduced US dollar loans from foreign branches of global banks in Korea.
This report provides the following implications for the Korea’s foreign exchange policies. First, one should closely monitor various cause of foreign exchange market volatility beyond what were considered before the structural changes. This would include changes in the risk appetite of non-banking sector, international debt market conditions, changes of broad dollar index, among others. It is worth stress again that since it is non-banking sector that led the US dollar credit growth recently the focus of foreign exchange market stability policies should extended to those sectors that are not in the locus of macro-prudential policy.
Also it is advised that Korea should maintain its attention on the stable overseas dollar funding sources because cross-border dollar loans through global banks are still the main source of dollar funding in the Korea’s foreign exchange market. In such a respect, one should carefully monitor and analyze impact of global regulatory reform on lending activities of non-US banks, as well as shifting business models of intermediaries. The paper also implies that it would be worthwhile to overhaul the existing macro-prudential policy framework in respond to the recent changes in the US dollar funding market landscape and the measures should be carefully adopted considering recent changes in the global US dollar funding market.