By Anthony Michell
Professor at KDI School of Public Policy and Managment & CEO of Korea Associates Business Consultancy
We have just started living in an age of global market failure, with governments around the world attempting to rectify this failure with drastic actions such as lending money against questionable assets, and directly investing in bank shares.
Despite the seriousness of the acceleration of the world economic crisis since September 2008, the Korean government has been slow to act. Even last weekend the measures were inadequate. In particular, action is needed to reduce the short-term demand for dollars.
Korea has probably the worst financial system in the world to be able to deal with a world economic crisis of the type we now face.
Korea has a very shallow and imperfect market mechanism for foreign exchange (FX) despite being the tenth largest trading nation in the world and having the sixth largest FX reserves, and one of the highest, if not the highest short term demand for dollar futures in the world (as measured by the daily on-shore futures volume).
Basically since the changes made towards a floating rate in 1997-8, the measures to deepen the system by making the won fully convertible, instead of forcing the won through a narrow dollar gateway, were never taken.
The result of this negligence (it was planned to move forward in 2010) is that the Korean system artificially increases the demand for dollars, and reduces the demand for won.
Manageable in good years with a current account surplus, this system creates the equivalent to a flat tyre in bad years (there is nothing wrong with the vehicle itself, but without a reinflated type it is in trouble.).
No one in the government outside of the Bank of Korea research department and a few think tanks seems to have stopped to ask why the demand for short term dollars is so high, and how to reduce the demand for dollars and increase the demand for won.
Now, the Korean government needs to use more intelligence in the way it handles exchange rate volatility.
In the short run, the exchange rate rests on three factors: supply and demand for dollars, the market mechanisms and rigidities in the system, and sentiment, information and misinformation in the market.
In the present situation, the crippled market mechanisms and rigidities in the system are the main problem.
It is commonplace that Korea's financial structure is the weak point in the Korean economy. The Capital Consolidation and Asset Management Act which comes into force February 2009 is part of the correction, but the fundamental macroeconomic issue is that the won is not a fully convertible currency.
If I take won to another country, I cannot open a won deposit account in London or New York. I cannot borrow won in any market except Korea.
This forces me to convert the won I would quite happily hold at the frontiers of Korea. If the won were convertible, I could place a deposit in London and borrow pounds sterling against it.
The won is itself a frog in a well. Outside the well the Baht, the NT$, the HK$ and nearly every other Asian currency is a store of value wherever you go, but not the Korean won
The won has a single window to the outside world ― the U.S. dollar. Worse you can only hedge against the U.S. dollar, not against cross rates. I cannot cross hedge against the won-yen rate, so I should hold foreign currency rather than won to remove one risk in the process.
Demand for Won
All this means there is a greater demand for foreign currency, and a lower demand for won at Korea's borders, physical and financial.
In normal times, a convertible won would increase the demand for won by 15 to 20 percent, merely because pockets of won would exist around the world.
Today, many foreigners would see holding won deposits in New York at 5.5 percent interest or higher with the coming revaluation as an upside as an attractive form of cash to be in.
Certainly you would not sell won at 1,350 if you thought it would be at 1,000 in a year's time, and were earning 5.5 percent, in the meantime.
Sentiment and Misinformation
The Korean media and the presumed low level of knowledge of future traders, feed rumors into the market which feed the anti-won sentiment.
The Financial Times of London, which seems to take special delight in treating Korea's special features as some kind of humorous joke, feeds this. Even President Lee Myung-bak is a victim of this in his advice to citizens to travel abroad less, and to drive less.
Strategy and Finance Minister Kang Man-soo also feeds the panic by suggesting that the nation or banks are running out of dollars.
Make no mistake. The volatility of the won has nothing to do with the probable size of Korea's current account deficit in 2008.
The total size of the current account deficit for 2008 will only be a bit more than the equivalent of one days currency trading on the FX market, and only 4 percent of the nation's FX holdings.
During the financial crisis of 1997-98, I promised myself never to forecast foreign exchange rates.
The reason was that the movement is so irrational and run by people who are only looking to the next trade and the next hour.
As David O'Rear, then my colleague in EIU and now Chief Economist of the Hong Kong Chamber of Commerce put it. "Value does not enter into FX markets, which are driven by the greed and sentiment of a herd of 20 something traders."
Although my intention is not to forecast, the fact is that the Korean won will go back to the 930-950 band, against the dollar and to the 10 won to the yen band.
How Can We Change Market Sentiment?
If the governments of the world knew the answer to this question, half the financial crisis could be solved. In general, governments are removing parts of the system from the market.
The Korean government could do this, for a limited time period, by nationalizing the currency hedging system. This means that the demand for dollars today, which is a demand for certainty for won tomorrow, could be replaced purely by a demand for won, and Korea's need for short term trade dollars - about equal to the size of the FX reserves, would disappear.
This would put the pain of SMEs directly in the hands of the government.
Aren't There Dangers in Liberalizing Won?
There are dangers as well positive steps in taking this measure. Old-fashioned economic managers like Minster Kang will remember the days of the 1970s and worry about the fact that the finance ministry can no longer control the global demand for won.
Nor can he control the globalizing economy of Korea. Yes, there are dangers for the frog to leave the well, but it cannot be a member of the global community without doing so.
Anthony Michell is a professor at KDI School of Public Policy and Managment & CEO of Korea Associates Business Consultancy. ― ED.