Dollar and government bond liquidity: Evidence from Korea

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 Korea 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 barometer of global financial conditions is likely to limit the market intermediation capacity of emerging market dealers and thus tighten emerging market conditions.