Bank of Korea issue note finds shallow markets amplify global risk off shocks, supports FX intervention and macroprudential measures in Korea

The Bank of Korea has published an issue note examining how financial frictions shape the impact of global risk-off shocks across 17 economies and in Korea specifically. The paper finds that countries with shallower financial and foreign exchange markets suffer larger currency depreciation and tighter domestic credit conditions when global risk sentiment deteriorates. Using a Korea-calibrated integrated policy framework model, it concludes that foreign exchange intervention and macroprudential measures, used alongside conventional interest rate policy, would improve outcomes relative to relying on interest rates alone. A central contribution is a new measure of market depth based on how strongly the uncovered interest parity premium reacts to global risk-off shocks. In the panel analysis, emerging markets are shown to have materially shallower markets than advanced economies, and Korea’s estimated sensitivity is above the emerging market average. Relative to deep-market economies, currencies in mid-depth economies depreciate 0.39 percentage points more and in shallow-market economies 1.05 percentage points more after a global risk-off shock. Short-term interest rate spreads also widen more as markets become shallower, with spreads rising 7.14 basis points in the shallow group. The Korea model adds a domestic credit spread channel to capital outflows and shows that shocks become more contractionary as market depth declines. Under the model, adding foreign exchange intervention and macroprudential policy reduces welfare loss by 18.3% versus monetary policy alone, mainly by limiting the GDP gap.