(Reuters) – South Korea looks increasingly close to imposing some form of foreign exchange controls, albeit relatively moderate ones, to try to stop gyrations in the won and end the constant risk of sudden capital flight.

South Korea | Thailand

The issue has been on the boil for months, but the won’s dive this week on a mix of the euro zone tremors and North Korea’s war-like rhetoric, appears to be persuading policy makers they must do something, though the turbulence makes the timing tricky.

Foreign bank branches are likely to be included in measures.

The question now seems to be less if, than when and how.

“I felt sick,” one senior official, involved in policy discussions, said of seeing such a scary fall in the won early this week. He asked not to be identified.

At one stage on Tuesday, the won plunged 5 percent against the dollar, an unusually large move for a currency even in emerging markets.

At its low point, the won had dropped 6.5 percent from the end of last week. Then it turned and rallied 9 percent to close the week little changed.

The won faces one of its worst months since the 1997/98 Asia financial crisis almost pushed the economy into the abyss, underlining investor fright as they fret about a renewed financial crisis stemming from the euro area debt storm.

This time, Asia’s fourth-largest economy, is relatively strong and its banking system largely sound. But after such currency volatility, officials lament that it remains vulnerable to sudden capital outflows.

SHORT-TERM CURRENCY DEBT

For a number of reasons, South Korea tends to have large short-term currency debt, currently about 60 percent of currency reserves, or a ratio three times that of Taiwan.

The nearly 40 foreign bank branches operating here account for more than 60 percent of the total owed by all banks operating in South Korea.

A major factor behind the high level of short-term debt is a high level of demand for dollar hedging by heavy industry exporters — a dominant part of the economy — owing to a long gap between orders and delivery. For shipbuilders it is typically around three years.

But because the forward market is not liquid — importers tend not to hedge — banks end up with long dollar forward positions which they have to square on the spot market. To cover that time gap, they borrow in the money market, which leads to the short-term debt positions.

It is that short-term debt which most concerns officials.

BEGGING FOR DOLLARS

The last major hit was in late 2008 at the height of the global credit crunch when foreign banks pulled out funds to meet demands at their cash-squeezed head offices, leaving South Korean banks begging for dollars.

The official declined to be identified but said everyone on what he called the Finance Ministry frontline was on board with the need for some form of regulation.

However, the Financial Services Commission — the chief regulator which would impose any controls — has so far declined publicly to come down clearly on either side, saying it is still looking into the issue.

Officials make no secret of their concern and that they have been looking at a wide range of measures, but still debate which ones would work without scaring off investors and foreign banks or stepping out of line with other G20 governments.

Foreign bankers in Seoul warn that draconian measures — such as including them in foreign exchange liquidity controls applied to local banks — would simply see them go elsewhere.

One senior foreign banker said foreign banks account for about $75 billion in offshore borrowing, about a third of which is directly related to trade financing. The rest is mostly invested in local bonds.

OPTIONS UNDER STUDY

Korea announced measures in November to protect banks against the impact of capital flight, including a ban on trade in foreign exchange forwards worth more than 125 percent of the value of exports.

A senior official at the Financial Supervisory Service regulator said further limits on currency forwards was a possibility being studied.

But officials say, contrary to market speculation, they had no plan to put limits on positions in non deliverable forwards. Such a move would be a last resort, they said.

Most officials ask not to be identified in discussing the increasingly sensitive issue. Foreign bankers are worried they will be a target of tighter controls, while some parliamentarians question why foreign banks are not a target.

Critics question why the last set of foreign exchange liquidity controls was only aimed at local banks.

The argument has gathered momentum with the latest heavy inflow of funds, much of it directed at the relatively high yielding bond market and which could leave just as quickly.

Officials say Thailand, mostly retail investors, is currently the biggest buyer of South Korean T-bonds.

Foreign investors have bought a net 7.3 trillion won worth of bonds so far this month, compared to 6.5 trillion won worth of net selling in the main stock market .

In April, foreigners were net buyers on both markets for a total of 12.7 trillion won.

EXCESSIVE INFLOW

“The excessive inflow of capital to domestic markets can cause serious problems. The government has agreed to introduce regulations on foreign exchange once the European crisis eases,” presidential economic adviser Shin Hyun Song told the JoongAng daily earlier this week.

The Princeton University professor, on secondment to the president as he prepares to host the G20 summit later this year and seen as a proponent of more regulation, said the focus would be on regulations on forward currency positions.

“The regulations are necessary in order to obtain independence for monetary policies and overcome the markets’ vulnerability caused by too much liquidity,” he said.

But he did not go into details.

However, one top official — who declined to be identified — said it was still not a done deal.

He said the government would certainly wait until after the June 4-5 meeting of G20 finance ministers meeting in the South Korean port city of Busan when financial market regulation is expected to be high on the agenda.

(Additional reporting by Lee Shinhyung, Lee Soo-jung and Yoo Choonsik)