The government will provide incentives to banks that expand foreign currency deposits in a bid to reduce damage from possible capital flights in case of financial market instability, the Bank of Korea said Thursday.

Korean banks and local branches of foreign banks held $37.3 billion in foreign currency savings, or about three percent of total deposits, as of April. The proportion is much lower compared to Taiwan (10 percent) which has a similar economic structure.

For companies and individuals in Korea who mostly use the domestic currency, making deposits in foreign currencies risks exchange rate fluctuations and is disadvantageous compared to won-denominated savings in terms of interest rates.

As local banks cannot secure enough foreign exchange through deposits, they depend mostly on borrowing from abroad and bond issues.

Such wholesale funding makes them more vulnerable to rapid capital flights at times of financial market instability.

Greater dependence on wholesale funding, which is costlier than retail funding, also means lower profitability of the banks’ foreign exchange sales and a national loss.

The government, therefore, plans to help raise foreign currency savings at local banks, which tend to remain relatively stable during financial crises, in three stages, the BOK said.

In the first stage, where the foreign currency deposit target is between four and five percent of total deposits, the government plans to cut the levy on non-deposit foreign currency borrowing of banks that increased foreign exchange deposits.

Also, non-residents will be exempted from interest income tax on their foreign currency savings at local banks.

The government is considering raising the cost of foreign currency borrowing in the second stage, where the target is between six and nine percent.

In the third stage, regulations on transactions related to foreign currency deposits will be eased as part of efforts to raise the ratio to 10 percent, the central bank said.

By Kim So-hyun (sophie@heraldcorp.com)