CONTRIBUTION Vulnerable won-dollar rate - down or up?
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By Jeon Yong-bae
The foreign exchange rate for the U.S. dollar versus the Korean won has been rising steadily for the last three months, going up from 1,263 won per dollar at the end of last year to over 1,340 won per dollar currently. The won has depreciated by more than 5 percent this year, weakening relatively more than other currencies such as the euro, Japanese yen and Chinese yuan. There are several reasons for the weakness of the Korean won this year.
Jeon Yong-bae
Firstly, the U.S. raised interest rates more aggressively than Korea last year and this year. The U.S. Federal Reserve has not stopped its rate hikes since March last year, with the latest hike at the March FOMC meeting.
However, the Bank of Korea (BOK) did not follow the Fed by raising its own policy rate because of concerns about an economic recession and high-level household debt, which stands at over 1,050 trillion won. At the April policy meeting, the BOK decided once again to freeze the rate at 3.5 percent. Fortunately, the U.S. March CPI was up merely 5 percent showing its downward trend, signaling the Fed's policy may pivot sooner than expected.
Secondly, Korea's economic situation is not favorable to the won. Korea suffers from decreasing exports, deteriorating profitability and rising raw material prices. There are no signs of a prompt economic recovery considering its record-low birth rate, demographic cliff, high level of household debt and rising interest payment burdens.
Thirdly, the Korean trade balance and current account do not look good. The backbone of the Korean economy is exports. Korea is one of the top seven countries in global trade because of the large volumes of cars, ships, semiconductors, smartphones and electronics it exports to global markets.
However, semiconductor exports have decreased by more than 40 percent compared to a year ago. In March, the Korean trade deficit was $4.6 billion, and this year's total deficit as of April 20 amounts to $26.7 billion, already exceeding half of last year's deficit. It is hardly likely that this deficit trend will turn around in the near future.
Fourthly, the Korean government's fiscal status has also deteriorated due to decreasing tax incomes and increasing social welfare expenditures. The fiscal deficit for January and February recorded 24.6 trillion won, which increased by 9.3 trillion won year-on-year. Korea's fiscal condition is expected to show negative flows for the time being.
Fortunately, since the foreign reserve is as high as $426 billion at March-end and foreign debt is relatively low, it is unlikely that Korea will face a foreign exchange risk or an IMF rescue event. Nevertheless, the government needs to prepare contingency plans to prevent any serious risks.
It is likely that the won-dollar rate will keep rising until the second half of the year. Last month, Federal Reserve Chair Jerome Powell delivered another forceful message to markets that an early pivot back to rate cuts will not happen until inflation is under control. The “dot plot” ― a graphical representation of the Fed's rate trajectory ― has become more realistic: the median policy rate for this year-end has risen to 5.1 percent for 2023.
The BOK is in a dilemma between deterring inflation and reviving the economy. High inflation can impose severe economic hardships on every sector. It is true that in a high-interest-rate environment, corporations with high debt and vulnerable households will suffer from rising interest payment burdens and encounter bankruptcy risks.
The government, financial firms and corporations need to prepare contingency plans to survive the worst-case scenarios of a global economic recession through self-stress tests. Warren Buffett said, “Only when the tide goes out do you discover who's been swimming naked.”
The writer is a senior consultant and auditor of Franklin Templeton Investments Korea, where he previously worked as CEO, and is professor of University of Maryland Global Campus' MBA program.