South Korea’s central bank on Wednesday warned against an increase in volatility of cross-border capital movements as the prolonged economic slowdown could spark a reversal of foreign funds inflows.

A series of credit rating upgrades on Korea and quantitative easing by major central banks are helping more foreign capital flow to into Asia’s fourth-largest economy, making the won appreciate more than 5 percent to the U.S. dollar so far this year.

The warning came as risks of a sudden reversal of foreign capital persist because any deterioration of external conditions like Europe’s debt crisis could hurt the Korean economy.

The Bank of Korea said in a semi-annual financial stability report that volatility of cross-border foreign capital flows could increase if the impacts of the eurozone debt woes spill into the real economy in a full swing.

“If then, Korea would face sharp deterioration in its foreign exchange soundness as short-term speculative money as well as massive long-term funds could fly out of the country,” the report showed.

Korea underwent high volatility of the local currency and a sharp decline in its FX reserves at the height of the 2008 global financial crisis as foreign investors massively pulled their money out of the Seoul markets.

Mindful of risks from such capital flows, the government has taken a set of steps to smooth out cross-border capital flows since 2010, including a bank levy and tighter rules on banks’ FX derivative positions. The central bank and the financial watchdog plan to inspect banks’ handling of currency forward positions from next month amid the won’s ascent.

Meanwhile, the report said that the growth pace of household debt has slowed, but debt-servicing burdens for self-employed people and low-income families are sharply increasing, pointing to the worsening quality of household debt.

The BOK said a pile-up in household debt is feared to undercut Korea’s long-term growth potential, as it would dent domestic demand and curb the economic growth. Household debt stood at 922 trillion won (US$845.1 billion) as of end-June.

Downward pressure on housing prices is predominant in Seoul and its adjacent areas amid weak demand and population aging, it added.

The Financial Services Commission said Tuesday that the amount of Korea’s mortgage loans with potential default risks has amounted to nearly 150 trillion won on falling housing prices. It said that as many as 570,000 households face difficulty in repaying mortgage debt.

The BOK also warned against default risks of unhealthy firms are growing as corporate profitability and their financial soundness are worsening amid the slowing economy. (Yonhap News)