Higher USD funding costs: A comparison between Japan and Korea

In our previous note, we discussed the widening of cross-currency swap (XCCY) spreads for the Japanese yen against the dollar (USD-JPY XCCY) stemming from the voracious demand of USD by Japanese banks. In this note, we look at the case of Korea as the XCCY spreads for the Won have also widened recently (USD-KRW XCCY). The question seems highly relevant given Korean banks’ heavy reliance on USD funding in the past and the ensuing liquidity problems during the Global Financial Crisis (GFC). A renewed hiking cycle is bound to shrink the supply of USD globally and, thus, also for Korean banks.

We explore the underlying reasons for the widening of the USD-KRW XCCY and argue that the situation is not as worrisome as it could seem as first sight. Korea’s situation today is very different from that during the GFC since their net borrowing in USD has been reduced. Furthermore, strict regulatory limits on forex positions have been introduced as a consequence of earlier excesses.

·     Since the summer of 2016, though, regulators are softening foreign currency hedging requirements although still keeping a tight control on foreign liquidity through the introduction a liquidity coverage ratio (LCR) this year.

·     Beyond regulatory control, banks have also become increasingly cautious about USD maturity mismatch by reducing their reliance on short-term USD funding. On top of that, they have maintained a well-diversified source of  USD funding.

Notwithstanding the limited risk, we still believe that the Bank of Korea (BoK) would do well to err on the side caution by building up some additional protection to a potential USD shortage. One way would be to resume the swap line between the Fed (introduced in 2008 and then discontinued). Another possibility – where the Fed not to agree – would be to follow Japan’s model by creating a home-grown USD swap line drawing from the BoK’s reserves.