Debt Management for Foreign Exchange Market Stability:
The Role of the Foreign Exchange Stabilization Fund in Building and Managing Foreign Exchange Reserves
Joosung Jun, Youngim Shin, Hyemi Kim
Commissioned Research Report for the National Assembly Budget Office (NABO), 2023
Summary
Recent rapid changes in the domestic and global economic environment have heightened the importance of policies aimed at maintaining foreign exchange market stability.
This study provides an overview of the institutional frameworks and policy tools related to foreign exchange market stabilization, with a particular focus on the future direction of foreign exchange stabilization bonds and related funds. The analysis estimates Korea’s optimal level of foreign exchange reserves and compares it with actual reserve holdings, while also reviewing international experiences in foreign exchange market management. In addition, the study examines various costs associated with the operation of the Foreign Exchange Stabilization Fund (FESF), an issue that has received relatively limited attention in previous discussions.
Key Policy Implications
Although Foreign Exchange Stabilization Bonds and Monetary Stabilization Bonds serve similar functions as instruments for foreign exchange market intervention, they differ in terms of issuing authority, interest-bearing responsibility, issuance limits, and statutory objectives. Policymakers should therefore consider a broader range of options regarding the appropriate mix of these instruments.
Korea has recently experienced a deterioration in its current account balance, while foreign exchange reserves have declined as authorities intervened to support the value of the Korean won. Over the long run, improving the trade and current account balance to increase net dollar inflows will be essential.
The role of foreign currency-denominated Foreign Exchange Stabilization Bonds as an alternative source of reserve accumulation is becoming increasingly important. In this context, sovereign creditworthiness plays a critical role. A higher credit rating reduces the country risk premium (e.g., CDS spreads), lowering borrowing costs. Accordingly, efforts to strengthen national competitiveness should remain a priority. Expanding transparency regarding foreign exchange market interventions may also be considered.
A review of 38 major foreign exchange trading countries indicates that Korea discloses foreign exchange market information less frequently and with a narrower scope than many peer economies.
Contrary to recommendations from some international organizations, most countries determine the level of disclosure regarding foreign exchange interventions based primarily on national interests. Korea should likewise seek an appropriate balance between the benefits of transparency and credibility and the costs associated with potential accusations of currency manipulation by trading partners. Since the scale of intervention is difficult to estimate precisely, even appropriate policy actions may be subject to differing interpretations.
Analysis of the demand for foreign exchange reserves suggests that, following the 2008 Global Financial Crisis, precautionary motives related to current account shocks and speculative attacks became increasingly important. The motive of comparative hoarding appears to have strengthened significantly.
Estimates based on various adequacy criteria indicate that Korea’s actual foreign exchange reserves were below the optimal level in most years. Moreover, reserve holdings declined sharply in 2022 as authorities intervened to support the won. Given heightened exchange rate volatility, the need to secure additional reserve buffers has increased.
Because Korea is highly dependent on external trade and experiences relatively high exchange rate volatility, discussions surrounding the Foreign Exchange Stabilization Fund have traditionally focused on its benefits. However, as cumulative deficits in the fund continue to rise, greater attention should be paid to the growing fiscal costs associated with its operation.
Although the Foreign Exchange Stabilization Fund is currently excluded from the consolidated fiscal balance because of its financial nature, its deficits may effectively generate deficit-financing liabilities. Since the fund’s deficits have increased substantially since 2010, future fiscal resources may be required to cover accumulated losses. If so, conventional measures of the consolidated fiscal balance may overstate the soundness of public finances.
The cumulative losses of the Foreign Exchange Stabilization Fund can be attributed to three major sources: interest-rate losses, exchange-rate losses, and losses on derivative financial instruments. These losses arise, at least in part, from structural factors such as interest rate differentials between borrowing and investment, exchange rate movements, and investment strategies involving derivatives.
To reduce costs, policymakers should improve maturity structure management in the short run and evaluate a wider range of governance options regarding the use of Foreign Exchange Stabilization Bonds and alternative instruments such as Monetary Stabilization Bonds. In the long run, efforts should focus on strengthening national competitiveness and enhancing international credibility.
Korea has recently experienced simultaneous deterioration in both its fiscal balance and trade balance. Prolonged twin deficits could significantly increase vulnerability to a foreign exchange crisis. Current trade deficits are largely attributable to weak exports of key products such as semiconductors, but policymakers should closely monitor whether these developments reflect temporary cyclical factors or more structural challenges related to global supply-chain restructuring.
Fiscal deficits are increasingly driven by structural factors, including population aging and expanding welfare expenditures. Going forward, policymakers should monitor (1) whether fiscal deficits are financed through foreign capital inflows and (2) whether worsening trade balances contribute to larger fiscal deficits through efforts to offset weakness in aggregate demand.
Debt Management for Foreign Exchange Market Stability:
The Role of the Foreign Exchange Stabilization Fund in Building and Managing Foreign Exchange Reserves
Joosung Jun, Youngim Shin, Hyemi Kim
Commissioned Research Report for the National Assembly Budget Office (NABO), 2023
Summary
Recent rapid changes in the domestic and global economic environment have heightened the importance of policies aimed at maintaining foreign exchange market stability.
This study provides an overview of the institutional frameworks and policy tools related to foreign exchange market stabilization, with a particular focus on the future direction of foreign exchange stabilization bonds and related funds. The analysis estimates Korea’s optimal level of foreign exchange reserves and compares it with actual reserve holdings, while also reviewing international experiences in foreign exchange market management. In addition, the study examines various costs associated with the operation of the Foreign Exchange Stabilization Fund (FESF), an issue that has received relatively limited attention in previous discussions.
Key Policy Implications
Although Foreign Exchange Stabilization Bonds and Monetary Stabilization Bonds serve similar functions as instruments for foreign exchange market intervention, they differ in terms of issuing authority, interest-bearing responsibility, issuance limits, and statutory objectives. Policymakers should therefore consider a broader range of options regarding the appropriate mix of these instruments.
Korea has recently experienced a deterioration in its current account balance, while foreign exchange reserves have declined as authorities intervened to support the value of the Korean won. Over the long run, improving the trade and current account balance to increase net dollar inflows will be essential.
The role of foreign currency-denominated Foreign Exchange Stabilization Bonds as an alternative source of reserve accumulation is becoming increasingly important. In this context, sovereign creditworthiness plays a critical role. A higher credit rating reduces the country risk premium (e.g., CDS spreads), lowering borrowing costs. Accordingly, efforts to strengthen national competitiveness should remain a priority. Expanding transparency regarding foreign exchange market interventions may also be considered.
A review of 38 major foreign exchange trading countries indicates that Korea discloses foreign exchange market information less frequently and with a narrower scope than many peer economies.
Contrary to recommendations from some international organizations, most countries determine the level of disclosure regarding foreign exchange interventions based primarily on national interests. Korea should likewise seek an appropriate balance between the benefits of transparency and credibility and the costs associated with potential accusations of currency manipulation by trading partners. Since the scale of intervention is difficult to estimate precisely, even appropriate policy actions may be subject to differing interpretations.
Analysis of the demand for foreign exchange reserves suggests that, following the 2008 Global Financial Crisis, precautionary motives related to current account shocks and speculative attacks became increasingly important. The motive of comparative hoarding appears to have strengthened significantly.
Estimates based on various adequacy criteria indicate that Korea’s actual foreign exchange reserves were below the optimal level in most years. Moreover, reserve holdings declined sharply in 2022 as authorities intervened to support the won. Given heightened exchange rate volatility, the need to secure additional reserve buffers has increased.
Because Korea is highly dependent on external trade and experiences relatively high exchange rate volatility, discussions surrounding the Foreign Exchange Stabilization Fund have traditionally focused on its benefits. However, as cumulative deficits in the fund continue to rise, greater attention should be paid to the growing fiscal costs associated with its operation.
Although the Foreign Exchange Stabilization Fund is currently excluded from the consolidated fiscal balance because of its financial nature, its deficits may effectively generate deficit-financing liabilities. Since the fund’s deficits have increased substantially since 2010, future fiscal resources may be required to cover accumulated losses. If so, conventional measures of the consolidated fiscal balance may overstate the soundness of public finances.
The cumulative losses of the Foreign Exchange Stabilization Fund can be attributed to three major sources: interest-rate losses, exchange-rate losses, and losses on derivative financial instruments. These losses arise, at least in part, from structural factors such as interest rate differentials between borrowing and investment, exchange rate movements, and investment strategies involving derivatives.
To reduce costs, policymakers should improve maturity structure management in the short run and evaluate a wider range of governance options regarding the use of Foreign Exchange Stabilization Bonds and alternative instruments such as Monetary Stabilization Bonds. In the long run, efforts should focus on strengthening national competitiveness and enhancing international credibility.
Korea has recently experienced simultaneous deterioration in both its fiscal balance and trade balance. Prolonged twin deficits could significantly increase vulnerability to a foreign exchange crisis. Current trade deficits are largely attributable to weak exports of key products such as semiconductors, but policymakers should closely monitor whether these developments reflect temporary cyclical factors or more structural challenges related to global supply-chain restructuring.
Fiscal deficits are increasingly driven by structural factors, including population aging and expanding welfare expenditures. Going forward, policymakers should monitor (1) whether fiscal deficits are financed through foreign capital inflows and (2) whether worsening trade balances contribute to larger fiscal deficits through efforts to offset weakness in aggregate demand.