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Issue Report

Collection of full-length papers and in-depth analysis of economic and management issues.

Financial Stress Index

Financial Stress Index

JEONG Young-Sik

Aug. 10, 2010

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Originally released on June 23, 2010

ABSTRACT

Korea has experienced financial instability whenever an external or internal shock occurs. To answer the need for a comprehensive method to judge the causes and conditions of financial instability and to devise responses, Samsung Economic Research Institute constructed a new gauge, the SERI Financial Stress Index, which consists of the money, foreign exchange and stock markets assessed in eight sub indices.

The SERI FSI rose to an unstable level in the spring of this year, climbing from 4.3 in March to 16.16 in May. That was above the 13.72 average during the time frame analyzed with the FSI, beginning in 1996. However, the figure is below the FSI crisis threshold point (31.93) and those seen during the Asia currency crisis in 1997 and global financial crisis in 2008.

The foreign exchange market was the main reason for the rise in instability in the spring. It was responsible for 62.8% of the increase, followed by the stock market (32.0%), and the money market (5.2%). In this case, the influence of the foreign exchange market was higher than while that of the money market significantly decreased compared to the 1997 and 2008 crises.

This was also seen in international comparisons of post-crisis and pre-crisis periods. Compared to foreign countries, the instability of the foreign exchange market in Korea was more pronounced after a crisis than before it. Based on standard deviation of foreign exchange fluctuations, Korea 's rank in foreign exchange volatility plunged from 13 th before the global financial crisis to 34 th after the crisis. (A total of 38 currencies are subjected, and lower rank means high volatility.)

The SERI FSI revealed financial crises in Korea since 1996 have originated in the foreign exchange market. The reasons are: the nation's financial markets are mostly open; foreign capital is mostly invested in stocks, which are subject to rapid inflows and outflows; the size of the foreign exchange market is small and foreigners are important traders; financial companies are deficient in management competency and global business; and foreign exchange reserves fail to stabilize the market effectively. Moreover, regulations on foreign exchange soundness either worked improperly or were not in place at all.

Since 2000, the overall financial market has affected the real economy, not vice versa in Korea. To prevent a repeat of a financial crisis, foreign exchange authorities should extend foreign currency liquidity regulations to domestic branches of foreign banks, and apply regulations on "hot money," which typically involves sudden surges of short-term capital seeking fast gains. In the mid-and long term, authorities need to revamp the structure of the foreign exchange market through the expansion of foreign exchange trading, promotion of market makers and revitalization of direct cross-currency trading. In addition, financial institutions need to upgrade their ability to manage global tasks and make the won a hard currency.

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