FX stability, not currency strength
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By Ronald Man
Add up Korea’s foreign reserves and swap lines and you will find that the country has almost $490 billion in foreign exchange assets. However, by the end of this month it will fall to around $430 billion when extended swap arrangements with Japan put in place a year ago expire.
Make no mistake, Korea still has a ton of foreign reserves left to help shield its currency from excessive volatility even without the swap lines and policymakers in Seoul have become good at using them when necessary. We believe foreign exchange stability should remain a priority, especially at a time when the won is strengthening, making Korean goods more expensive and therefore less competitive.
There are three key reasons for this.
Firstly, Korea is a solid global competitor and its strength will not be easily eroded by the recent appreciation of its currency. Years of research and innovation have given the country the upper hand in capturing market share from the very best across the world. Last year, Korea accounted for 3.1 percent of global exports, up from 2.5 percent 10 years ago, driven by electronics, shipbuilding and high-tech machinery. Its long-time rival, Japan, has seen its share decline from 6.6 percent to 4.5 percent over the same period.
The future is still bright for Korean exporters, even if the won appreciates a bit more. Benefits from trade will be unlocked through free trade agreements with key trading partners. Formal negotiations with its largest trading partner, China, started this year and are expected to be concluded by May 2014. When implemented, this agreement should give strong Korean industries, such as automobiles, greater access to Chinese consumers, thus enabling them to exploit their edge over China.
Secondly, foreign exchange stability reduces uncertainty faced by Korean businesses. Korea remains a trade-dependent economy, with total trade equivalent to the country’s gross domestic product (GDP). This can leave the cash flow of local businesses vulnerable to swings in the foreign exchange market. For one, a large share of their revenue comes from overseas consumers. For another, manufacturing companies depend heavily on imported raw materials. Consequently, a more volatile won, among many other factors, may make companies think twice before taking on new investment projects.
Given that Korean growth has decelerated for three consecutive quarters and is now operating below potential, policymakers in Seoul need to ensure the economy is well positioned for a global recovery. Increasing business confidence would help set the stage for a much needed pickup in investment. Spending on new machinery has contracted by an average of 0.3 percent year-on-year each quarter since 2011, gradually running down the economy’s productive capacity.
Thirdly, maintaining a high supply of foreign exchange ammunition will protect the economy from external shocks. Since the 2008 global financial crisis, Korea’s foreign reserves have risen more than 30 percent, while its short-term overseas debts has fallen 25 percent. Thanks to wise policy decisions, the country now has more money to protect itself from potential dollar pressures when debt matures. Indeed, increased resilience to external shocks was a key factor behind the recent upgrade of Korea’s sovereign credit ratings by Moody’s, S&P and Fitch.
Putting everything together, Korea’s economic fundamentals are strong and this provides policymakers in Seoul with plenty of resolve to maintain foreign exchange stability.