## wpiea2019262-print-pdf - 2010

## Source details

**Canonical URL:** [wpiea2019262-print-pdf - 2010](https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019262-print-pdf.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/wp/2019/wpiea2019262-print-pdf.pdf.md)
- [Structured JSON version](/-/media/files/publications/wp/2019/wpiea2019262-print-pdf.pdf.json)

---

### Appendix B: Off-balance sheet hedging and inflows — key points
- Use of off balance sheet hedging instruments can potentially help explain inflows during periods of increased financial volatility.
- Resident investors may reduce foreign exposure through use of off balance sheet hedging as an alternative to selling foreign assets.
- Such hedging could result in non-resident related inflows if the foreign counter party bank wishes to keep an unchanged net open position.

### Conclusions (summary points)
- The patterns in Korean capital flows have recently been changing.
  - Traditionally Korea has experienced destabilizing capital outflows during periods of heightened global volatility.
  - The volatility in net capital flows has declined since 2015, and Korea also recently experienced safe-haven like capital flows into bond markets during certain global risk-off episodes.
- Risk management behavior of a growing domestic investor base can be part of the explanation.
  - Korea’s institutional investor base has increased in size in terms of domestic balance sheets as well as their involvement in cross border financial intermediation.
  - Many investors use Value-At-Risk (VaR) based risk management frameworks.
  - When the riskiness of an asset in a portfolio increases without its return changing, the portfolio’s share of this asset will have to be reduced to keep the riskiness of the portfolio constant.
  - Heightened global volatility can thus cause retrenchment back to Korean assets, or domestic investor driven increases in foreign funding.

### Empirical findings using flow of funds data
- The data is consistent with an increasing role for domestic institutional investors in capital flow responses during risk-off episodes.
  - The increase in Korea’s net and gross foreign assets is reflected primarily in growth in the foreign positions of:
    - general government (reflecting mainly the national pension service),
    - investment funds and insurance firms,
    - and, to a lesser extent, depository institutions (banks).
  - Institutional investors have seen more foreign asset growth than foreign liability growth, and have hence become increasingly net long in foreign assets/exposure.
- Figure 8: Correlation between net foreign exposure and net capital inflows during risk-off episodes.
  - For (a) Total Economy: coef=0.23, t−values=2.56, R−squared=0.1
  - For (b) Total Economy, ex. non financials and households: coef=0.55, t−values=3.64, R−squared=0.25
  - Net capital inflow relative share is the ratio of sector net inflows out of sector asset over the ratio of total economy net inflows out of total economy asset.
  - Net foreign exposure is net foreign exposure for each sector in percent of total asset for each sector.
  - Sectors include general government, households, non-financial corporations, financial corporations, pension fund, insurance companies, depository institutions, investment funds and other FCs.
  - Each dot corresponds to a sector during a specific risk-off episode. The episodes considered are illustrated in Figure 3.

### Appendix B — The Role of Off-Balance Sheet Hedging: findings and quantitative facts
- Residents can reduce net foreign exposures via currency derivatives; this reduction can manifest as capital inflows by non-residents in BOP statistics.
- Size of Korean FX derivatives market (2017):
  - Average daily turnover of derivatives related to the Korean won: USD 31 billion.
  - This is 166 percent of the daily turnover of spot transactions involving Korean won.
  - This is approximately 1 percent of the world market turnover in derivatives.
- Within the 2017 derivative market composition:
  - FX swaps account for the largest market: 64 percent.
  - Forwards account for the second largest market: 34 percent.
  - Currency swaps and options account for less than 4 percent of the market.
- Forward market features:
  - Non-deliverable forwards (NDFs) make up around 63 percent of total turnover in the forward market.
  - 76 percent of the NDF market is traded off-shore.
- Drivers of demand for foreign currency derivatives:
  - Exporters hedge receipts in foreign currency while input costs are mainly in local currency; importers hedge for the opposite exposure.
  - Korean asset managers build foreign-currency asset positions and use derivatives to hedge exposures, sometimes temporarily in response to increased global financial volatility.
- Hedging mechanics and capital-flow channels (stylized):
  - When a Korean bank takes on FX exposure from a client, it can:
    - Sign an offsetting forward/swap with a foreign bank branch, transferring exposure to the foreign counterparty; that counterparty may buy Korean won in the spot market and invest proceeds in Korean bonds — resulting in a non-resident inflow into the Korean bond market.
    - Borrow foreign currency, delivering foreign currency at loan maturity and offsetting the risk — also generating non-resident inflows.
  - Both hedging responses can produce capital inflows from non-residents.
- Example magnitudes:
  - Korean gross foreign asset position at end-2018: USD 1520.5 billion.
  - Roughly USD 879 billions of that can be assumed held by institutional investors, the national pension fund and financial institutions.
  - If these investors hedge an additional 1 percent of total foreign assets (and foreign branches keep net open positions unchanged), the resulting simulated non-resident inflow into Korean loans and bonds would be USD 8.8 billion.
  - Foreign investors hold USD 667 billion in Korean debt and equities; if they reduce this exposure by 1 percent, the resulting outflow would be USD 6.7 billion — smaller in magnitude than the inflow generated by residents in the scenario above.

### Table and turnover statistics (selected)
- Spot daily turnover (selected years shown in source): 2011 Spot 19.1; 2012 Spot 18.0; 2013 Spot 18.3; 2014 Spot 17.5; 2015 Spot 20.0; 2016 Spot 19.4; 2017 Spot 19.6.
- Derivatives total daily turnover (selected years shown in source): 2011 Derivatives Total 27.7; 2012 27.4; 2013 27.9; 2014 27.7; 2015 28.5; 2016 29.0; 2017 31.0.
- Forwards daily turnover (selected years shown in source): 2011 Forwards 7.5; 2012 6.6; 2013 7.1; 2014 7.6; 2015 8.3; 2016 9.6; 2017 10.1.
- FX swaps daily turnover (selected years shown in source): 2011 FX swaps 19.2; 2012 19.8; 2013 19.6; 2014 19.0; 2015 19.2; 2016 18.4; 2017 19.8.
- Trade location and deliverability of forwards (April 2016, average daily turnover, million USD):
  - Onshore: DF 14,454; NDF 7,357; Total 21,811.
  - Offshore: DF 2,985; NDF 22,718; Total 25,703.
  - Total: DF 17,439; NDF 30,075; Total 47,515.

### Policy implications and research needs
- The findings highlight the need for more research into interaction of financial regulation and capital flows.
  - With a growing domestic investor base, policies affecting the incentive of financial institutions to manage their risks are increasingly important in understanding capital flows.
  - Such policies are often implemented for prudential reasons, but may have implications for how domestic investors adjust their portfolios in response to global volatility.
  - Reference is made to Bruno and Shin, 2014, who have studied how capital flows sensitivity is affected by regulation aimed at banks’ non-core liabilities.

### Appendix C — Data construction and limitations (methodology highlights)
- Data source: Flow of Funds (FOF) for Korea provided by the Bank of Korea.
- FOF versions and methodology:
  - FOF uses SNA 2008 methodology for period 2008q4-2018q3 and SNA 1993 methodology for earlier period 2002q4-2013q4.
  - The combined series exhibits a structural break in 2008q4.
- Sectoral breakdown in FOF:
  - Total Domestic Economy, of which: General government; Bank of Korea; Households; Non-Financial Corporations; Financial Corporations (broken down into Depository Institutions (banks), Insurance Corporations, Pension Funds, Investment Funds and Other Financial Institutions); Rest of the World.
  - Note: In FOF the Bank of Korea is under financial corporations; the analysis separates BOK to show BOK capital flows more clearly.
- Constructing cross-border stocks and flows:
  - FOF instrument breakdown provides partial information on nationality of issuer; specific instrument categories are associated with foreign counterparties (e.g., Gold and SDRs; Currency and Deposits (cross foreign issuers); External securities (debt securities issued by foreigners); Loans external components; Equity and Investment Fund Shares Issued by nonresidents; Trade Credit external components; Foreign Direct Investment; Other foreign Claims and Debts).
  - For asset categories lacking direct foreign/cross-border assignment (Currency and Deposits; Loans and Trade Credits), the foreign-asset share is approximated as the ratio of holdings by the Rest of the World on the liabilities side divided by total domestic-economy holdings on the asset side; this economy-wide share is applied to all sectors.
  - On assets, under 5 percent of total foreign positions are in categories that cannot be assigned to foreign counterparties, so approximation error is small.
  - On liabilities, about half of total foreign liabilities positions are in categories that cannot be assigned to foreign counterparties; using economy-wide approximated shares across sectors introduces larger potential inaccuracy for liabilities and flows.
  - Because portfolio adjustment behavior differs across sectors (affecting flows), the authors rely mainly on stock measures in the paper.
- Treatment of financial derivatives:
  - FOF defines derivatives differently from IIP/BOP and does not allow division by foreign counterparties or currency denomination.
  - Derivatives positions are market-value based (e.g., mark-to-market), making them not directly comparable to on-balance sheet stock positions; initial contracts often have zero market value despite large notional amounts.
  - Conclusion: financial derivatives are excluded from the FOF-based construction of cross-border stocks and flows.
- Net flows construction:
  - Net flows are constructed as gross liabilities inflows minus gross asset outflows.
  - Users should note the structural break in constructed series in 2008q4 due to differing instrument categories under SNA 2008 and SNA 1993.

*Source: Own calculations based on Korean Flow of Funds, Bank of Korea (as presented in the provided content).*

### 2010.   In  Appendix  B,  we  also  discuss  how  use  of  off  balance  sheet  hedging  instruments  can

### wpiea2019262-print-pdf - 2010

### Appendix B: off balance sheet hedging and inflows
- Use of off balance sheet hedging instruments can potentially help explain inflows during periods of increased financial volatility.
- Resident investors may reduce foreign exposure through use of off balance sheet hedging as an alternative to selling foreign assets.
- Such hedging could result in non-resident related inflows if the foreign counter party bank wishes to keep an unchanged net open position.

### Conclusions (summary points)
- The patterns in Korean capital flows have recently been changing.
  - Traditionally Korea has experienced destabilizing capital outflows during periods of heightened global volatility.
  - The volatility in net capital flows has declined since 2015, and Korea also recently experienced safe-haven like capital flows into bond markets during certain global risk-off episodes.
- Risk management behavior of a growing domestic investor base can be part of the explanation.
  - Korea’s institutional investor base has increased in size in terms of domestic balance sheets as well as their involvement in cross border financial intermediation.
  - Many investors use Value-At-Risk (VaR) based risk management frameworks.
  - When the riskiness of an asset in a portfolio increases without its return changing, the portfolio’s share of this asset will have to be reduced to keep the riskiness of the portfolio constant.
  - Heightened global volatility can thus cause retrenchment back to Korean assets, or domestic investor driven increases in foreign funding.

### Empirical findings using flow of funds data
- The data is consistent with an increasing role for domestic institutional investors in capital flow responses during risk-off episodes.
  - The increase in Korea’s net and gross foreign assets is reflected primarily in growth in the foreign positions of:
    - general government (reflecting mainly the national pension service),
    - investment funds and insurance firms,
    - and, to a lesser extent, depository institutions (banks).
  - Institutional investors have seen more foreign asset growth than foreign liability growth, and have hence become increasingly net long in foreign assets/exposure.
- Figure 8: Correlation between net foreign exposure and net capital inflows during risk-off episodes.
  - For (a) Total Economy: coef=0.23, t−values=2.56, R−squared=0.1
  - For (b) Total Economy, ex. non financials and households: coef=0.55, t−values=3.64, R−squared=0.25
  - Net capital inflow relative share is the ratio of sector net inflows out of sector asset over the ratio of total economy net inflows out of total economy asset.
  - Net foreign exposure is net foreign exposure for each sector in percent of total asset for each sector.
  - Sectors include general government, households, non-financial corporations, financial corporations, pension fund, insurance companies, depository institutions, investment funds and other FCs.
  - Each dot corresponds to a sector during a specific risk-off episode. The episodes considered are illustrated in Figure 3.

### Policy implications and research needs
- The findings highlight the need for more research into interaction of financial regulation and capital flows.
  - With a growing domestic investor base, policies affecting the incentive of financial institutions to manage their risks are increasingly important in understanding capital flows.
  - Such policies are often implemented for prudential reasons, but may have implications for how domestic investors adjust their portfolios in response to global volatility.
  - Reference is made to Bruno and Shin, 2014, who have studied how capital flows sensitivity is affected by regulation aimed at banks’ non-core liabilities.

*Source: Own calculations based on Korean Flow of Funds, Bank of Korea (as presented in the provided content).*

### References

### References

### Key citations
- Tobias Adrian and Hyun Song Shin. Procyclical Leverage and Value-at-Risk. NBER Working Papers 18943, National Bureau of Economic Research, Inc, Apr 2013.
- Valentina Bruno and Hyun Song Shin. Assessing macroprudential policies: Case of south korea. Scandinavian Journal of Economics, 116(1):128–157, 2014.
- Ricardo J Caballero and Alp Simsek. A Risk-Centric Model of Demand Recessions and Macro-prudential Policy. BIS Working Papers 733, Bank for International Settlements, 2018.
- Committee on the Global Financial System. The role of margin requirements and haircuts in procyclicality. CGFS Papers 36, Mar 2010.
- Danmarks Nationalbank. Monetary Review 1st Quarter 2015. Technical report, Danmarks Nationalbank, 2015.
- Linda Goldberg, Signe Krogstrup, John Lipsky, and Helene Rey. Why is financial stability essential for key currencies in the international monetary system? Column, VOX-EU, July 2014.
- Linda S. Goldberg and Signe Krogstrup. International capital flow pressures. Staff Reports 834, Federal Reserve Bank of New York, February 2018.
- Maurizio M. Habib and Livio Stracca. Getting beyond carry trade: What makes a safe haven currency? Journal of International Economics, 87(1):50–64, 2012.
- Yuko Hashimoto and Signe Krogstrup. Capital Flows: The Role of Bank and Nonbank Balance Sheets. Unpublished manuscript, International Monetary Fund, 2019.
- IMF. Increasing Resilience to Large and Volatile Capital Flows: The Rule of Macroprudential Policies – Case Studies. IMF Policy Paper 733, International Monetary Fund, 2017.
- Signe Krogstrup and Cédric Tille. Foreign Currency Bank Funding and Global Factors. IMF Working Papers 18/97, International Monetary Fund, May 2018.
- Robert N. McCauley and Chang Shu. Non-deliverable forwards: Impact of currency internationalisation and derivatives reform. BIS Quarterly Review, December 2016.
- Angelo Ranaldo and Paul Soederlind. Safe haven currencies. Review of Finance, 14(3):385–407, 2010.

### Appendix B — The Role of Off-Balance Sheet Hedging: findings and quantitative facts
- Residents can reduce net foreign exposures via currency derivatives; this reduction can manifest as capital inflows by non-residents in BOP statistics.
- Size of Korean FX derivatives market (2017):
  - Average daily turnover of derivatives related to the Korean won: USD 31 billion.
  - This is 166 percent of the daily turnover of spot transactions involving Korean won.
  - This is approximately 1 percent of the world market turnover in derivatives.
- Within the 2017 derivative market composition:
  - FX swaps account for the largest market: 64 percent.
  - Forwards account for the second largest market: 34 percent.
  - Currency swaps and options account for less than 4 percent of the market.
- Forward market features:
  - Non-deliverable forwards (NDFs) make up around 63 percent of total turnover in the forward market.
  - 76 percent of the NDF market is traded off-shore.
- Drivers of demand for foreign currency derivatives:
  - Exporters hedge receipts in foreign currency while input costs are mainly in local currency; importers hedge for the opposite exposure.
  - Korean asset managers build foreign-currency asset positions and use derivatives to hedge exposures, sometimes temporarily in response to increased global financial volatility.
- Hedging mechanics and capital-flow channels (stylized):
  - When a Korean bank takes on FX exposure from a client, it can:
    - Sign an offsetting forward/swap with a foreign bank branch, transferring exposure to the foreign counterparty; that counterparty may buy Korean won in the spot market and invest proceeds in Korean bonds — resulting in a non-resident inflow into the Korean bond market.
    - Borrow foreign currency, delivering foreign currency at loan maturity and offsetting the risk — also generating non-resident inflows.
  - Both hedging responses can produce capital inflows from non-residents.
- Example magnitudes:
  - Korean gross foreign asset position at end-2018: USD 1520.5 billion.
  - Roughly USD 879 billions of that can be assumed held by institutional investors, the national pension fund and financial institutions.
  - If these investors hedge an additional 1 percent of total foreign assets (and foreign branches keep net open positions unchanged), the resulting simulated non-resident inflow into Korean loans and bonds would be USD 8.8 billion.
  - Foreign investors hold USD 667 billion in Korean debt and equities; if they reduce this exposure by 1 percent, the resulting outflow would be USD 6.7 billion — smaller in magnitude than the inflow generated by residents in the scenario above.

### Table and turnover statistics (selected from Table 1 and Table 2)
- Spot daily turnover (selected years shown in source): 2011 Spot 19.1; 2012 Spot 18.0; 2013 Spot 18.3; 2014 Spot 17.5; 2015 Spot 20.0; 2016 Spot 19.4; 2017 Spot 19.6.
- Derivatives total daily turnover (selected years shown in source): 2011 Derivatives Total 27.7; 2012 27.4; 2013 27.9; 2014 27.7; 2015 28.5; 2016 29.0; 2017 31.0.
- Forwards daily turnover (selected years shown in source): 2011 Forwards 7.5; 2012 6.6; 2013 7.1; 2014 7.6; 2015 8.3; 2016 9.6; 2017 10.1.
- FX swaps daily turnover (selected years shown in source): 2011 FX swaps 19.2; 2012 19.8; 2013 19.6; 2014 19.0; 2015 19.2; 2016 18.4; 2017 19.8.
- Trade location and deliverability of forwards (April 2016, average daily turnover, million USD):
  - Onshore: DF 14,454; NDF 7,357; Total 21,811.
  - Offshore: DF 2,985; NDF 22,718; Total 25,703.
  - Total: DF 17,439; NDF 30,075; Total 47,515.

### Appendix C — Data construction and limitations (methodology highlights)
- Data source: Flow of Funds (FOF) for Korea provided by the Bank of Korea.
- FOF versions and methodology:
  - FOF uses SNA 2008 methodology for period 2008q4-2018q3 and SNA 1993 methodology for earlier period 2002q4-2013q4.
  - The combined series exhibits a structural break in 2008q4.
- Sectoral breakdown in FOF:
  - Total Domestic Economy, of which: General government; Bank of Korea; Households; Non-Financial Corporations; Financial Corporations (broken down into Depository Institutions (banks), Insurance Corporations, Pension Funds, Investment Funds and Other Financial Institutions); Rest of the World.
  - Note: In FOF the Bank of Korea is under financial corporations; the analysis separates BOK to show BOK capital flows more clearly.
- Constructing cross-border stocks and flows:
  - FOF instrument breakdown provides partial information on nationality of issuer; specific instrument categories are associated with foreign counterparties (e.g., Gold and SDRs; Currency and Deposits (cross foreign issuers); External securities (debt securities issued by foreigners); Loans external components; Equity and Investment Fund Shares Issued by nonresidents; Trade Credit external components; Foreign Direct Investment; Other foreign Claims and Debts).
  - For asset categories lacking direct foreign/cross-border assignment (Currency and Deposits; Loans and Trade Credits), the foreign-asset share is approximated as the ratio of holdings by the Rest of the World on the liabilities side divided by total domestic-economy holdings on the asset side; this economy-wide share is applied to all sectors.
  - On assets, under 5 percent of total foreign positions are in categories that cannot be assigned to foreign counterparties, so approximation error is small.
  - On liabilities, about half of total foreign liabilities positions are in categories that cannot be assigned to foreign counterparties; using economy-wide approximated shares across sectors introduces larger potential inaccuracy for liabilities and flows.
  - Because portfolio adjustment behavior differs across sectors (affecting flows), the authors rely mainly on stock measures in the paper.
- Treatment of financial derivatives:
  - FOF defines derivatives differently from IIP/BOP and does not allow division by foreign counterparties or currency denomination.
  - Derivatives positions are market-value based (e.g., mark-to-market), making them not directly comparable to on-balance sheet stock positions; initial contracts often have zero market value despite large notional amounts.
  - Conclusion: financial derivatives are excluded from the FOF-based construction of cross-border stocks and flows.
- Net flows construction:
  - Net flows are constructed as gross liabilities inflows minus gross asset outflows.
  - Users should note the structural break in constructed series in 2008q4 due to differing instrument categories under SNA 2008 and SNA 1993.

*Source: wpiea2019262-print-pdf - References*

---


_Source: https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019262-print-pdf.pdf_