Local currency expected to remain strong after near-term volatility

By Kim Jae-kyoung

With the eurozone debt crisis continuing to linger despite European leaders’ efforts to contain it, the Korean won has remained highly volatile against the U.S. dollar.

Although Korea’s economic fundamentals are considered strong, investors and market participants here are now paying close attention to the course of the local currency as the epicenter of the crisis, in many previous cases, was outside of the country.

Since there are both upside and downside risks to the won-dollar exchange rate, it is hard to forecast how the exchange rate will unfold down the road. However, this time would be different from the past, according to most analysts and experts.

Most remain very bullish about won’s future. They share the view that the local currency will show wild ups and downs in the short term due to external uncertainties but is expected to gain ground against the greenback in the long term, possibly appreciating to as strong as 975 per dollar a year from now.

“In the medium run the won will gain ground relative to the dollar for two reasons. First, South Korea has a current account surplus and the U.S. does not. Second, interest rates in the U.S. are likely to stay very low due to the recession,” Mauro F. Guillen, director of the Lauder Institute at the Wharton School, told Business Focus.

“In the short run government actions, investors’ movements of capital and central bank attitudes will have impact. It is difficult to predict, though. I think the won will in general tend to appreciate, unless the central bank signals that it is getting too strong and sells won,” he added.

Bank of America Merrill Lynch is one of the most bullish global investment banks. It forecast the won to appreciate to 1,120 in the first quarter of 2012, 1,050 in the second quarter and 980 in the third quarter.



Bullish on won’s future

“Financial stress in the euro area is deeper than we expected, creating strong pressure on the won, although we remain positive on the won beyond the near term,” Goldman Sachs economist Kwon Goo-hoon said.

“Following the near-term weakness, we expect the local currency to strengthen against the dollar, supported by the trade surplus and policy focus on price stability,” he added. “Macro-prudential measures introduced in 2010-11 could be relaxed if upward pressure on the exchange rate intensifies.”

The U.S. investment bank recently revised its three-, six- and 12-month forecasts for the won-dollar rate to 1,100, 1,070 and 1,037 from 1,080, 1,050 and 1,030.

“We expect the current account surplus to decline by almost 30 percent in 2011 relative to 2010. However, the current account is still likely to record a surplus (of around 1.5 percent of GDP) in 2011. Given expected capital inflows, this should strengthen the won,” Kwon said.

The Korean won gained around 5.5 percent against the greenback over the past two months. The won closed at 1126.80 won per dollar Friday, up 76.5 won from 1,193 won on Sept. 22.

The biggest rationale for a stronger won in the future is that Korea is able to cushion the blow from the eurozone debt crisis. Most analysts agree that Korea is much better prepared against external shocks than it was in 2008 both in terms of financial systems and economic fundamentals,

In a recent research note, HSBC economist Ronald Man said that Korea’s financial system is at less risk to external conditions than in 2008.

“Whether it is exposure to shaky European banks, or short-term external debt altogether, Korea has strengthened its position over the past three years to withstand liquidity pressures,” Man said.

“Lower asset claims by European banks, higher foreign reserves and a reduction in short-term external debt are all in the mix. Distortions spreading from the EU may hurt Korea’s financial system, but the pain should not be as sharp as what it would have been in 2008,” he added.

Several key indicators measuring Korea’s external stability have improved over the past years. Foreign exchange reserves rose to $311 billion in October, while lower short-term debt ratio has fallen to 37.6 percent and loan-to-deposit ratios have improved to 97.8 percent.

Kwon of Goldman Sachs said, “The fund flow could remain volatile amid risk averse sentiment globally in the near term; however, any signs of a slowdown in Chinese inflation or better-than-expected U.S. economic numbers would help stabilize the won, as well as the equity market.

Won’s volatility

Although the won is expected to remain firm against the U.S. dollar in the medium- and long-term, it is highly probable that the local currency will remain highly volatile in the near term due to lingering jitters abroad, such as the fiscal crisis in Europe and concerns over the U.S. recession.

High levels of volatility have a negative impact on the economy by deteriorating terms of trade and making it harder for the central bank to tame inflation.

In fact, in the midst of financial unrest in global markets, the Korean won was one of the most vulnerable currencies among Asia’s major currencies in October, with the local currency showing the highest volatility.

“Since Korea has high dependence on international trade and the current market is open to foreign capital, the economy is susceptible to external shocks,” a ranking official from the Financial Services Commission (FSC) said, asking not to be named.

“However, Korea is now on a much better footing than Western countries suffering from fiscal crises. Unlike the U.S. and European countries, Korea has gotten more ammunition. There is more room for the country to opt for policy tools to cushion external blows,” he said.

According to the BOK, the daily percentage change of won’s value to the U.S. dollar against the previous day, which tracks the degree of won’s volatility, reached 0.71 percent in October, the highest among nine Asian currencies, followed by the Malaysia ringgit (0.62 percent), the Singaporean dollar (0.56 percent), the Thailand baht (0.30 percent) and the Japanese yen (0.25 percent).

Market analysts say that won’s high volatility was the mixed result of the fall in the trade account surplus and rising concerns over capital outflows due to the eurozone debt crisis.

“In the second quarter, won’s volatility remained stable on the back of solid performance in the balance of international payments and foreign investors’ strong purchase of local bonds,” Korean Center for International Finance analyst Lee Sang-won said.

“However, the local currency turned highly volatile as the current account has become less supportive. In addition, market participants turned wary over massive capital flight for safe assets, which has swayed the currency market,” he added.

John Praveen, managing director and chief investment strategist of Prudential International Investments Advisors, point out that the Korean financial market has been vulnerable to external shocks due to the export linkage of Korea with the U.S. and other developed economies.

“In order to minimize the external shocks, the country should further improve domestic demand by raising infrastructure and business investment spending as well as further encouraging growth in domestic consumption,” he said.