South Korea's cross-currency swap market was distorted by the financial watchdog's strict regulation on foreign currency liquidity. The cross-currency dollar/won swap market was reversed between short and long tenors.

The two-year cross-currency swap rate, measuring the cost of won funds for foreigners exchanging dollar funds into won, jumped 10 basis points (bps) to 2.03 percent on Thursday. The 10-year swap rate closed at 1.25 percent, up relatively small extent of around 6 bps from Wednesday's close.

According to term structure of interest rates, the swap rate with longer maturity should be higher than the one with shorter maturity under the normal conditions as the long-term contracts need to compensate for additional risks of longer time. The country's cross-currency swaps showed a normal yield curve in the first half of 2011, but the yield curve was changed into the flat one in the second half and ended up inverted late last year.

The reversal of the curve came as local banks turned to long- term funding for foreign currency liquidity after the regulator induced the lenders to refrain from foreign borrowing with shorter maturity. Amid continuing risks over Europe's debt crisis, the financial regulator instructed local banks to lengthen the maturity of external funding. "Short-term dollar funding began reducing from the third quarter of last year. As seen in the 2008 global financial crisis,credit events boosted long-term dollar funding as local players brace for the potential refinancing risks by increasing long-term debts borrowed from overseas;" Lee Jae-hyung, a fixed income analyst at Dongyang Securities in Seoul, told Xinhua Friday.

Lee noted that regulatory factors had a much impact on local players' turn to longer-term dollar funding, saying that the cross- currency swap market was distorted more or less although the regulation aimed to manage the potential foreign-currency liquidity risk in advance.

REGULATION

South Korea's financial watchdog instructed local banks to reduce short-term foreign debts in a bid to preemptively counter the possible foreign currency liquidity risks amid lingering concerns over the European fiscal crisis.

Kim Young-dae, deputy governor of the Financial Supervisory Service (FSS), on Tuesday told a seminar in central Seoul that the regulator planned to keep up its strict management over foreign currency liquidity, saying it may consider the liquidity management as factors to evaluate banks.

According to the FSS data, the refinancing rate of foreign debts that mature in one year or more at 12 domestic banks came in at 174.4 percent in December, staying above the 150-percent level since July. The rate above 100 percent means local lenders increase their fresh foreign borrowing rather than repay them.

The rollover rate of short-term external debts with a maturity of less than one year stood much below the longer one. The short- term rollover rate came to 120.3 percent in December after falling below the 100 percent the previous month.

REVERSAL

Following the stricter regulation, local players expanded their long-term dollar funding in the cross-currency swap market. The difference between 2- and 10-year swap rates widened to minus 78 bps on Thursday.

Simply speaking, a player would suffer losses of 78 bps if he takes position of swap receive with 10-year maturity for dollar funding, and builds position of swap pay with 2-year maturity for dollar funds operation. That means a negative carry position, which finances long-term dollars with high borrowing costs and invests the borrowed dollars into short-term assets with low rates.

Growing dollar supply in the short-term foreign exchange (FX) funding market drove the FX swap points higher. The 12-month FX swap points closed at 20.3 won Thursday, sharply up from 13.8 won a month before. The FX swap point measures the difference between forward and spot rates.

AMPLE LIQUIDITY

Globally ample liquidity made it possible for local players to lift their long-term dollar funding. Although the financial regulator induced local banks to expand long-term funding, the lenders would have failed to finance dollars in the cross-currency swap market without supply of dollars by major central banks.

The U.S. Federal Reserve agreed to lower the interest rate on dollar swap lines with five major central banks by 50 basis points in a bid to offer easier access to dollars. The outstanding Fed swap lines reached 99.8 billion U.S. dollars as of the end of December, up from 2.3 billion dollars in early December.

The European Central Bank (ECB) offered 489 billion euros to a total of 523 eurozone banks through the three-year lending program at an interest rate of 1.0 percent. The ECB planned to provide additional liquidity to the region's banks in late February.