The foreign exchange rate is an important price variable not just in the sense that it influences a wide range of economic activities such as exports and imports, but because it is often taken as reflecting the comparative strength of a country’s economic fundamentals against others. It also influences and is influenced by the country’s macroeconomic policies.
South Korea is paying especially close attention to the exchange rate movement because it is a very open economy, relying heavily on foreign trade of goods and fund flows to and from its financial markets. Bitter experiences of a plunge in the value of the won currency several times in the past also underline the country’s anxiety.
In this context, the recent trend of the won’s exchange rate deserves a close watch. The won’s value has weakened against the dollar this year, in contrast to earlier expectations by many market experts that it would gradually rebound on the back of recovering exports and the resultant pickup in economic growth.
Exports grew for the past five consecutive months over a year earlier and look set to post growth this month again, following a 12-month run of annual declines. On the local stock markets, foreign investors were net buyers of shares worth more than 14 trillion won ($10.4 billion) so far this year, according to preliminary data from the Korea Exchange.
These improving conditions, however, have failed to lift the won, which has lost 3.8 percent against the dollar since the beginning of this year. It was the fourth-worst performance among currencies of the Group of 20 major economies, trailing just behind the Australian and Russian units, according to data from the Bank of Korea.
The won’s weakness was attributable mainly to the dollar’s strength rather than any of South Korea’s specific economic conditions, as the latest inflation and labor market data on the US economy continued to exceed expectations and prompted investors to keep pushing back the likely timing of the first interest-rate cut by the Federal Reserve.
Reflecting that the dollar index rose 2 percent this year to date, and all but one of the G20 currencies have weakened during the period against the US greenback. This means South Korean policymakers may not have to worry about the won’s weakness too much when reviewing policies, but should focus more on the domestic situation.
In particular, there has long been an argument that a widening gap in the South Korean policy interest rate below that of the US would spur massive capital flight out of South Korea and trigger a plunge in the won’s value. However, an increasing amount of anecdotal research has shown this theory to be overly generalized or overstated.
Despite these findings from recent research studies, minutes from the Bank of Korea’s policy meetings disclosed board members emphasizing the need to pay attention to the interest-rate gap with the US when considering lowering the country’s policy rate, citing a potential impact on the capital flow and the won’s exchange rate.
It is undeniable that the Bank of Korea and the government, together responsible for the foreign exchange policy, need to closely monitor domestic and global factors affecting the won’s value. But their policy should aim at keeping the stability of the foreign exchange market rather than bringing down the rate below a specific level.
Moreover, we need to take into account the comparative change of the currency’s value instead of the nominal value. On the surface, the won’s average nominal value against the dollar in February this year stood at a sharp 12 percent below that in December 2019, just before the start of the COVID-19 pandemic, according to the Bank of Korea’s data.
But the won’s real effective exchange rate, a measure against a weighted average of several foreign currencies and adjusted for inflation, has dropped only 4 percent over the above-mentioned period, faring better than a 5 percent fall for the Chinese yuan and a 29 percent loss for the Japanese yen, according to data from the Bank for International Settlements.
Moreover, South Korea’s consumer price inflation has been on a clear downward path since hitting its peak in the middle of 2022, which itself was far lower than the levels seen in many other advanced economies. Core and service-sector inflation readings, both of which better reflect the underlying price trend, are declining even more clearly.
In February, the consumer price index rose by 3.1 percent from a year earlier, accelerating from a 2.8 percent gain in January. However, the service sector and core inflation either slowed or stayed on the downward trend because the headline inflation was driven mostly by a few volatile items such as fruits and vegetables.
In addition, South Korea can be said to have some more room than before in keeping the won slightly down because a weaker won is generally good for export industries and this year’s economic recovery is widely believed to be driven by exports.
Yoo Choon-sik
Yoo Choon-sik worked as the chief Korea economics correspondent at Reuters and is now a business and media strategy consultant. -- Ed.
