No Massive Capital Outflow from Korean Foreign Exchange Market despite Interest Rate Differential

The difference in interest rates between Korea and the United States, which has reached 2 percentage points for the first time in history, is expected to continue for quite some time. However, the Korean foreign exchange market has been calm, starting at a low point in early trading despite concerns over increased volatility.

The U.S. Federal Reserve’s baby step (an 0.25 percentage point increase in the key interest rate) on July 26 (local time) widened the divergence between Korea (3.50 percent) and the United States (5.25 to 5.50 percent) to 1.75 to 2.00 percentage points on July 26. This marked the first time the Korean foreign exchange market saw a 2 percentage point inversion based on the top end.

As a non-key currency country, Korea is bound to be burdened by the widening interest rate divergence with the United States. This is because it is difficult to rule out the possibility that foreign funds in the Korean stock and bond markets will leave in search of higher interest rates, forcing the Korean won to depreciate. Another concern is the current level of tightening in the United States, which is likely to continue throughout the second half of this year.

However, the Korean foreign exchange market seemed unaffected. In the morning of that day, the won-dollar exchange rate began at 1271.1 won, down 3.4 won, on the Seoul foreign exchange market, hovering in the 1,260 won range in early trading. The Korean government, the BOK, and financial authorities are banking on the prospect of no massive foreign capital outflow crisis despite heightened uncertainties in financial markets.

“Despite the prospect of widening interest rate differentials at home and abroad, the exchange rate has remained stable and the Korean foreign capital market is in good shape,” Choo Kyung-ho, Korean deputy prime minister and minister of planning and finance, said in an emergency macroeconomic and financial meeting he chaired in Seoul on July 27. Foreign investment funds have seen net inflows of more than 22 trillion won so far this year, and inflows climbed in May and June after the interest rate differential between Korea and the U.S. reached 1.75 percentage points.

However, the BOK’s woes are likely to grow as Powell left open the possibility of another rate hike in September. If the divergence between Korean and U.S. interest rates becomes wider and prolonged, the BOK will have no choice but to seriously consider resuming its tightening program. The BOK will monitor foreign capital flows and foreign exchange market volatility to decide whether or not to raise the benchmark rate further on Aug. 24.