Keep in mind the might of bond vigilantes

Whether foreign bond investors will become benefactors or turn into merciless vigilantes will depend on our government and market performance.

South Korea’s government debt will be joining FTSE Russell’s major global bond index tracking sovereign bonds of developed economies from next year. The World Government Bond Index (WGBI) is composed of the sovereign bonds of 26 countries and serves as a leading sovereign benchmark next to the Bloomberg- Barclays Aggregate Bond Index and the JP Morgan Government Bond Index. Korea’s inclusion is tardy, given its GDP rank as No. 12 in global scale and its sovereign net issue volume of 84 trillion won ($62.5 billion) for next year.

Once the inclusion becomes effective from November 2025 after a year of a phase-in period, Korean bonds will represent about 2.22 percent of the index followed by funds of more than $2.5 trillion, meaning $56 billion could make their way into the Korean capital market. When foreign investors become more active in the Korean bond market, yields can fall and help stabilize the foreign exchange rate. Reduced bond yields lessen the debt financing cost for the government, allowing more fiscal maneuvering room for the country in need of astronomical welfare spending to fight a low birthrate and fast aging.

The presidential office congratulated the government for its continued efforts to improve international credibility and sustain fiscal integrity. The London-based index provider also commended the government for its steps to better market access such as lifting taxes on foreign bond investment and extending the business hours of the Seoul forex market.

However, the WGBI also comes with the risk of aggravating volatility during rocky market conditions. Although the WGBI is mostly tracked by central banks and sovereign funds seeking long-term security, demand for shorter-maturity bonds also can increase. The bond market can come under the whims of foreign investors like the stock market.

During chain jitters across Southern Europe after the Greek fiscal crisis in 2011, Italian and Spanish sovereigns trading on the WGBI were hammered by heavy selling by foreign investors. Long-term investors can turn into bond vigilantes if they question fiscal sustainability or macroeconomic management of the issuer. Vigilantes proved their mighty force when they dumped British treasuries to punish conservative prime minister Liz Truss for her half-backed tax cut program to eventually oust her after less than a month in office in 2022.

The government must become more vigilant in defending fiscal integrity and be careful not to lose market confidence. As FTSE Russell pointed out, Seoul should not repeat a bigoted policy like a ban on short selling. Whether foreign bond investors will become benefactors or turn into merciless vigilantes will depend on our government and market performance.