A recent statement from Bank of Korea governor nominee Shin Hyun-song has signaled a significant shift in how policymakers view the nation's currency volatility.
He pointed to a 'Wag the dog' phenomenon, where the 'tail'—offshore derivative markets—is dictating the movement of the much larger 'dog', the onshore spot foreign exchange market. In simple terms, speculative bets made in markets outside Korea, primarily through Non-Deliverable Forwards (NDFs), are having an outsized impact on the won's value, more so than the actual buying and selling of currency for trade or investment. This has become a critical issue as the won recently plunged to a 17-year low against the dollar.
Several factors have created this environment. First, the interest rate differential between Korea and the United States is a major driver. With the U.S. Federal Reserve holding rates significantly higher than the Bank of Korea, investors have less incentive to hold won-denominated assets, creating a natural downward pressure on the currency. Second, geopolitical tensions in the Middle East have pushed oil prices back above $100 per barrel. As a major energy importer, this worsens Korea's terms of trade, increases demand for dollars to pay for imports, and further weakens the won.
This combination of fundamental weakness makes the won vulnerable. Offshore players can use the less regulated NDF market to build large positions against the currency, and these movements can overwhelm the actual supply and demand in the domestic market, causing sharp and excessive price swings. The recent plunge to the 1,530 level, followed by a rapid bounce, highlights this derivative-driven volatility.
In response, the nominee's proposal is not a short-term fix but a structural one: build an offshore won settlement system and promote the won's internationalization. The goal is to create a regulated, transparent channel for offshore won trading, effectively bringing these influential transactions into a more stable framework. By improving the market microstructure, authorities hope to reduce the NDF market's excessive influence and anchor the won's value more closely to economic fundamentals.
- Non-Deliverable Forward (NDF): A type of forward contract for currencies where the profit or loss is settled in a major currency (like the U.S. dollar) at the end of the contract, without the physical exchange of the underlying currency. It's often used for speculation or hedging in markets with currency restrictions.
- Wag the dog: A phrase used to describe a situation where a smaller or less important part of something is controlling the larger, more important part.
- Market Microstructure: The study of how exchange mechanisms and trading processes affect price formation, liquidity, and transaction costs in financial markets.