The Bank of Korea (BOK) will extend by six months, through the end of this year, its program of paying interest on excess foreign currency reserve deposits (FX reserves) that financial institutions place with the central bank. The measure is seen as an effort to stabilize foreign exchange supply and demand by encouraging financial institutions to hold foreign currency domestically, while responding to a surge in the won-dollar exchange rate by bolstering foreign exchange reserves.
The BOK's Monetary Policy Board decided Wednesday to keep the interest rate on FX reserves linked to the U.S. Federal Reserve's policy rate target range, as before. FX reserves refer to foreign currency funds that financial institutions deposit with the BOK in excess of mandatory reserve requirements. The BOK began paying interest on FX reserves for the first time early this year and extended the program as the high exchange rate persisted recently.
In a high exchange rate environment, banks gain a greater incentive to hold foreign currency domestically, as they can earn risk-free interest income by depositing dollars with the central bank. The FX reserves increased in this way also help the BOK build up its foreign exchange reserves.
The latest measure also aligns with recent market stabilization efforts by foreign exchange authorities. The authorities conducted a joint verbal intervention at the director-general level Monday, and the National Pension Service also moved to sell forward contracts.
"When foreign exchange reserves increase, the authorities have greater capacity to respond to the market, which has a psychologically stabilizing effect," a foreign exchange market expert said.
