Dollar and government bond liquidity: evidence from Korea

BIS Working Papers  |  No 1145  | 
15 November 2023



This paper examines how the US dollar affects government bond liquidity in Korea, a representative emerging market economy (EME), and when the effects become more pronounced. I highlight how the limited intermediation capacity of EME dealers can dampen liquidity through tightened funding liquidity conditions and financial channels of exchange rates.


EME government bond liquidity and how it is linked to exchange rate fluctuations have received less attention than that of major advanced economies. I fill this gap by estimating liquidity using unique real-time trade and quote data from the Korea exchange and analysing the impacts of the US dollar on government bond liquidity. My findings shed light on how EME dealers respond to foreign currency risks and worsened funding liquidity conditions during periods of US dollar appreciation. This evidence highlights the importance of currency market stabilisation to achieve domestic financial stability.


I show that a strong US dollar adversely affects Treasury bond liquidity in Korea by increasing the bid-ask spread and the price impact of trades and lowering market depth. Specifically, a 10 percentage point increase in the broad dollar returns is associated with an increase in the relative quoted spread by 0.7 basis points on average per day. The effects are more pronounced when uncertainty and government bond liquidity increase, when banks have lower total capital ratios and greater exposure to foreign currency loans, and when there is a large foreign investor sell-off of Korean government bonds. The dollar, acting as a global risk factor, plays a pivotal role in EMEs' government bond markets.


Using unique tick-by-tick data from an exchange, this paper examines the relationship between the US dollar and liquidity in the Korean government (Treasury) bond market. We find that a strong US dollar deteriorates the Treasury market's liquidity by increasing the bid-ask spread and the price impact and lowering market depth. The effects of fluctuations in the broad US dollar index on Treasury market liquidity become more pronounced when funding liquidity conditions are tighter, when banks' total capital ratio is lower with greater foreign currency risk, or when there is a larger sell-off of Korean Treasury bonds by foreign investors. The empirical evidence supports the financial channel of exchange rates affecting Treasury market liquidity. In particular, a strong dollar as a global risk factor is likely to limit the market intermediation capacity of emerging market dealers through the currency exposures of borrowers or dealers and thus tighten market conditions.

JEL classification: E58, F34, G12

Keywords: dollar, exchange rate, Treasury bond liquidity, funding liquidity, foreign investors