1. Recently, foreign investment in Korean securities has generally shown net outflows, primarily driven by equity funds. On a longer time horizon, capital inflows and outflows tend to be wider than in the past due to significant fluctuations in global risk since the COVID-19 pandemic in 2020.
2. This paper uses U.S. mutual fund disclosure data from the U.S. Securities and Exchange Commission (SEC) as a proxy for foreign investment in Korean securities. Unlike the external financial liabilities data in the International Investment Position (IIP), the U.S. mutual fund disclosure data include detailed information such as investment strategies, currency hedging details, and currency denominations of bond holdings, enabling a multi-faceted analysis.
3. Excluding valuation effects, U.S. mutual funds' investments in Korean securities have generally declined since 2019. This decrease in U.S. mutual funds' holdings in Korean securities is due to a drop in total foreign investment by mutual funds and is not limited to Korea.
4. An analysis by investment strategy shows that the share of passive funds has continued to rise, exceeding half of U.S. mutual funds' investment balances in Korean securities as of the third quarter of 2024. When valuation changes are excluded, it is shown that despite the rising share of passive funds, the global risk sensitivity of capital flows into and out of Korean securities by U.S. mutual funds has not increased compared to the past.
5. However, given the growing share of (passive) equity funds that are mostly unhedged and thus are highly sensitive to global exchange rate volatility, more attention should be paid to exchange rate volatility indicators when monitoring capital flows.
6. On the other hand, in the future, Korea's inclusion in the World Government Bond Index (WGBI) and the growing share of (passive) bond funds may lead to a higher currency hedging ratio for U.S. mutual funds' investments in Korean securities, thereby weakening the relationship between capital flows and the KRW/USD exchange rate. However, as the share of (passive) equity funds is also rising, the overall relationship between capital flows and the above exchange rate is expected to be determined by the relative magnitude of change in the shares of bond and equity funds.
7. Korea's inclusion in the WGBI slated for this year is expected to contribute to easing imbalances in supply and demand in the foreign currency funding market and lowering treasury bond yields. As a result of the overvaluation of treasury bonds, demand may shift to other types of bonds such as corporate bonds, thereby improving the overall financing conditions for domestic companies. However, given the U.S. mutual funds' preference for bonds denominated in key currencies such as the U.S. dollar, there may be limitations in reducing the risk premium of KRW-denominated corporate bonds.