FxWirePro: FII’s in Korean equities likely to append stress on KRW

Amongst EM currencies, KRW FX is most sensitive to broader global equity market weakness because offshore stock holdings of Korean residents, for the most part, have been hedged back into KRW, and any diminution in the value of those holdings would have to be followed by an unwinding in those hedges (i.e. KRW selling).

Those holdings are estimated to now stand at ~USD215bn. Whilst equity market concerns have not materialized yet, the fact remains valuations are disconcertingly high in many DM economies, especially in the US.

We shift the strongest point in the EM FX cycle to Q4 from Q3, and also selectively revise some of our near-term country forecasts stronger. Supportive factors in the near term include a very slow Fed tightening cycle, a longer period of stability in Chinese growth, falling volatility, and solid EM fundamentals (growth momentum, external positions, and real yields).

The biggest risk to a turn in EM sentiment is through the growth channel, not developed market policies, as long as fundamentals remain cooperative. The 2004-2008 Fed tightening cycle showed that EM currencies can flourish; this is being repeated in the current cycle. Until a meaningful catalyst emerges, we favor stronger currencies and buying into developed market policy-induced sell-offs.

KRW could also come under pressure should the local equity markets correct. Foreign holdings of local equities have risen by a sizeable 8.5ppts of GDP since the end of last year and now stand at 35.6% of GDP versus the 25.8% average for the past decade.

However, this week has seen close to USD1bn in net outflows, which would be the largest week of outflows since early 2016. Outflow episodes of this magnitude tend to coincide with periods of weaker won performance, particularly over a 2-3 week horizon after they occur (refer above figure).