South Korea is sounding the trumpet of a currency defense battle! Pension funds “go to the front line” to launch flexible hedging mechanisms

The Zhitong Finance App learned that as South Korea fights fiercely with the Korean won exchange rate, which has continued to weaken since this year, the country's state-level pension fund organizations are expected to assume a more important role in the financial system in the future to ensure exchange rate stability. At a time when the exchange rate of the Korean won (against the US dollar) is close to its lowest level in 16 years and the market has strong expectations for a “structural shortage of dollars/unilateral weakening of the Korean won,” the South Korean government transformed the National Pension Service (NPS) from a “passive large dollar buyer” to a “quasi-official foreign exchange market supply and demand regulator”, using its oversized transactions to fix the imbalance between onshore dollar supply and demand and reinforce the policy signals released by the South Korean government to boost the won.

Korea National Pension Service (NPS), one of the world's largest pension funds, is about to carry out hedging transactions more flexibly to help ensure currency stability, mainly because the country's government is struggling with the weakness of the Korean won. Its management committee said in a statement on Monday, but no further details were given. The fund also extended its $65 billion foreign exchange swap agreement with the Bank of Korea (Bank of Korea) for another year, until the end of 2026.

After the currency plummeted 8% in the second half of this year due to continued outflows of capital from the stock market and investment in overseas markets, the South Korean government is seeking a number of measures to support the won. As the country's largest institutional investor and has about $542 billion in overseas assets, NPS often helps hedge against the downward pressure on the Korean won through collaborative hedging and foreign exchange operations.

For the South Korean government, it is urgent to support the Korean won exchange rate. Otherwise, as South Korea's promised investment of up to 350 billion US dollars in the US begins to be implemented, the decline in the Korean won exchange rate may begin to fall into a situation that is difficult to recover. According to the trade agreement reached between the South Korean government and the Trump administration at the end of October, since South Korea promised to invest up to 350 billion US dollars in the US, the US will limit tariffs on South Korean goods to 15%, drastically reducing the 25% equivalent tariff from the previous 25%.

“Due to the large scale of NPS transactions, its impact on the foreign exchange market is significant,” said Lee Min-hyuk, a senior economist from Seoul Kookmin Bank (Kookmin Bank). “These measures can mitigate the recent overall imbalance between onshore foreign exchange supply and demand.”

More flexible hedging policies give South Korea's national pension more room or room for maneuver to further support the won. Currently, it has set an upper limit on the total ratio of strategic and tactical hedging assets at about 15% of its global asset allocation, and is specifically implemented through various methods, including selling dollar forward contracts.

Therefore, as far as NPS is concerned, there are two specific triggers: one is to extend the $65 billion foreign exchange swap with the Bank of Korea, so that the NPS's “demand to buy dollars” can be met more through the central bank's internal channels of reserves to reduce the impact of its direct purchase of US dollars on the exchange rate in the spot market; the second is to liberalize the US dollar supply (or reduce dollar demand) at key points through forward/instant methods, etc., to stabilize the exchange rate at a lower cost of “explicit intervention.”

The reason why the NPS plans to gradually increase at this moment is the combination of multiple pressures: the phased outflow of foreign capital into the Korean stock market, the continued increase in overseas asset allocation, and corporate foreign exchange holdings are boosting demand for the US dollar; at the same time, the central bank is constrained by weak Korean won and housing price fluctuations, and there is limited room for monetary policy maneuver, so it relies more on “non-interest rate tools” to smooth exchange rate fluctuations and suppress expectations of inflation and market panic.

Furthermore, uncertainties at the domestic political and governance levels in South Korea are still fermenting, and the need to stabilize financial market sentiment and risk premiums is stronger than ever; using the NPS as a “policy collaborator”, it can not only form stronger market signals, but also make it easier for the Bank of Korea to continue to provide a stable framework without frequently using direct intervention methods.

strategic hedging

In particular, in response to the NPS's current release of a strategic foreign exchange hedging framework that will adopt a more flexible approach, some media previously reported in December last year that if the exchange rate deviates significantly from its long-term average of more than 20 years, the fund is obligated to hedge up to 10% of its foreign currency holdings. This also means that 10% may no longer be the hedging limit for a special period under a more flexible mechanism.

This NPS statement and the so-called “more flexible” signal revealed by the central bank are more likely to be reflected in triggering and execution levels (frequency, speed, tools, and how to distribute between strategy/tactics) and not necessarily equivalent to an immediate 10% increase in the upper limit.

At the same time, the swap arrangement allows the National Pension Service to obtain the US dollars it needs directly from the Bank of Korea system, thereby helping to reduce the actual demand for the US dollar currency in the foreign exchange spot market.

This month, NPS has restarted selling the US dollar to support the won. The won fell 0.3% to around 1,472 won to $1 on Tuesday. The exchange rate between South Korea's sovereign currency and the US dollar is close to its weakest level since 2009.

Level of hedging

Economists from Citigroup Inc. (Citigroup Inc.) said that a new hedging method similar to this model led by NPS is expected to trigger a large-scale sell-off of the dollar around 1,470 to 1,475 won.

“Measures to stabilize the foreign exchange market require dealing with two critical trade-offs: how to maximize the effects of policy signals while maintaining broad and flexible triggering conditions, and how to balance the apparent cost of foreign exchange hedging with its potential benefits,” Kim Jin-wook, an economist at Citibank in Seoul, wrote in a research report.

Min Kyung-won, an economist from Woori Bank, said that if this flexible processing method means there is more room for maneuver around the current 10% limit of strategic foreign exchange hedging, then it may be significant. He emphasized that in order to have a larger impact on the market, hedging ratios need to be managed more dynamically.

If the National Pension Fund (NPS) is “more flexible,” meaning that strategic foreign exchange hedging is no longer as dead as the current “hedging up to 10% of overseas assets” framework card (e.g., wider trigger conditions, faster start-up, more operating space, and even greater flexibility around 10%), but if the hedging ratio can be adjusted more frequently and more actively as the exchange rate and the US dollar supply and demand are tight, then NPS can sell more dollars/increase hedging when the Korean won weakens, and the actual contribution to the stable exchange rate will increase significantly.