ANALYSIS Strong dollar, weak won: Is there any way out?
Concerns over Chinese economy, EU gas and U.S. Fed must ease for won to reverse course
Stephen Lee is chief economist at Meritz Securities, Seoul / Courtesy of Meritz Securities
By Stephen Lee
The Korean won has weakened severely against the U.S. dollar, sending its value to 1,362 won per dollar as of Sept. 2 ― the lowest since April 2009. Excluding global financial crisis periods, the currency value is the lowest since April 2001 when the global economy had just started recovering from the IT bubble recession.
The won-dollar rate was once below 1,300 right after the U.S. Federal Reserve's Federal Open Market Committee (FOMC) meeting, on the hopes that the Fed might pivot to decelerating the pace of its rate hikes. The dollar index (DXY), measuring the dollar value against six major currencies, came down to 105 by the end of July from the previous peak of 108. Now the index has moved up even further beyond 109, which is the highest since 2001.
The resurgence of the dollar index has stemmed from the weakening euro ― now below parity ― as well as concerns that the Fed will keep raising rates aggressively. In addition, the weakening Chinese yuan, amid China's sluggish recovery and the central bank's rate cuts, has caused the Korean won to weaken further. Is there any way out? It is never easy but it is possible if the factors that have caused the strong dollar and weak won reverse their courses. Here are the details on what will need to happen.
China: Economy must rebound to reduce yuan's declining pressure
Unlike other emerging market currencies, the value of the Chinese yuan against the dollar is well explained by 2-year government bond yields between the two nations. The most recent rate cut from the People's Bank of China pushed Chinese yields lower. Now the Chinese 2-year yield is 120 basis points below that of the U.S. Since the U.S. Fed is seeking additional rate hikes to curb inflation, Chinese yields should rebound in order to reduce the declining value of the yuan vis-a-vis the dollar.
But that situation does not seem easy as the Chinese economy is facing headwinds. Its sluggish income growth below 3 percent only leads to small rebounds in retail sales, while causing a real estate downturn as well. Housing construction is contracting, as a result of lacking demand. The source of funds for real estate has shrunk 29.3 percent year-on-year during January-July 2022, as constructors are receiving fewer down payments and mortgages ― a main source of revenue for building houses. Construction is being delayed, and homebuyers can't move into their houses. Mortgage boycotts are further deteriorating sentiment.
The Chinese policy authorities have finally begun to address this problem. The People's Bank of China slashed its five-year loan prime rate by 15 basis points to alleviate the interest burden for homebuyers. The government is seeking to create special loan pool of 200 billion yuan to be directly injected into uncompleted projects to finish up construction. Any effective measures enabling constructors' funding ― i.e. share issues, government guarantees, etc. ― can be responses halting the housing market downturn, which can bode well for the economy and the yuan. We are waiting for further measures.
Europe: Energy prices must stabilize
The unusual surges in European energy prices ― particularly natural gas ― are causing concerns about economic fundamentals and have further weakened the euro. Dutch TTF gas futures have breached 300 euros per megawatt, a six-fold rise since the beginning of this year.
Multiple factors have attributed to the gas price surge. The ongoing outage at the Freeport LNG terminal in Texas limits gas shipments from the U.S. to Europe. What is worse is that Russia has been cutting gas deliveries to Germany through the Nord Stream I pipeline. The delivery volume has shrunk to only 20 percent of the prewar level. Furthermore, Russia has been frequently cutting deliveries due to maintenance purposes with only short notice. Whether the cuts remain temporary or become permanent is uncertain, further pushing up the gas price.
Since Europe's transition toward clean energy is far from complete, Europeans have to rely on Russian gas to produce electricity. German producer prices for electricity generation have tripled during the recent 18 months and are due to be imputed to end-users. Manufacturing as well as households could suffer, as higher energy tariffs could reduce the purchasing power to spend on other goods and services.
This problem depends solely on Russia. My baseline scenario for Russian actions is that Russia may start to compromise before winter in terms of war and gas deliveries. This belief is because Russian domestic demand has weakened severely since the war, resulting in decreasing imports and a widening trade surplus. If they intend to have a surplus trade balance and keep their economy on track, oil and gas exports to Western Europe must hold up.
United States: Concerns over near-term hawkish Fed must ease
Concerns about the hawkish Fed are further driving the dollar to rally. Fed Chair Jay Powell's Jackson Hole Conference speech reaffirmed the Fed's will to combat inflation until the job is done. Market participants were once concerned that the Fed may move on with another 75-basis-point hike in September, following the hikes of June and July. But I think we should separate the issue of the Federal Funds Rate staying higher for longer, from the Fed's possible pivot towards decelerating the pace of its rate hikes.
If the Fed decides to decelerate the pace of its rate hikes starting in September as many expect, any overshooting of the dollar caused by concerns over the continuation of giant steps could lift. A deceleration scenario seems likely in my view, as the Fed has now pledged to watch inflation, employment and growth data together when deciding rate policies in the incoming meetings. Inflation is likely to have passed its peak in June and is opt to decline further as producer prices wane and the housing market slows. The job market is robust but becoming less overheated as job openings and wage growth decline. Economic growth has started to slow down in rate-sensitive sectors ― namely investment ― and the cumulative effects of the rate hikes will be reflected with a time lag. With the Federal Funds Rate now standing at neutral, a cautious hike seems warranted when breaching that level.
To sum up, the current weak won against the strong dollar can reverse its course, albeit in a limited manner, when three global factors that prompted the trend are resolved. They are: 1) China implements effective measures to curb the decline of their real estate market and their economy rebound; 2) Russia starts to compromise with its counterparts with regard to the war and gas deliveries in the coming months; and 3) the Fed moves to decelerate its rate hikes. Nothing seems to be easy, implying that the won may stay weak for some time. My guess about the possible order of a resolution of this situation in the medium term is likely to be: the U.S Fed, then China, followed by Russia.
The writer is the chief economist at Meritz Securities, Seoul.