ContributionWhy Korea’s FX reserves is no cause for concern

Yang Seok-jun / Courtesy of Yang Seok-jun

Korea's foreign exchange reserves currently stand at just over $400 billion (567.5 trillion won), having crossed this threshold for the first time in June 2018.

The total peaked at around $470 billion in 2021 but is now on the decline. There is growing concern that it will fall below $400 billion in the near future.

However, it is important to recognize that while this year's number remains similar to 2018, the conditions surrounding it have changed significantly.

Until mid-2014, Korea, then a leading emerging market economy, had a negative net international investment position (IIP), with residents' investment abroad remaining well below nonresidents' investment in Korea.

As a result, the level of foreign exchange reserves emerged as the main indicator of external soundness, and the market showed significant sensitivity to fluctuations in these reserves.

However, the current net IIP is over $1 trillion. It should be noted that in addition to the foreign exchange reserves that meet its definition, other investments account for more than that.

For example, the foreign investments of the National Pension Service (NPS), other institutional investors and even individual residents have all increased substantially, as have the government's alternative investments.

With all these changes, changes in foreign exchange reserves should be relatively less noticeable than before.

Historically, there has been a period of concern about the absolute level of the reserves. This was due to major credit rating agencies assessing whether reserves were sufficient to prevent a crisis.

In response, the International Monetary Fund (IMF) developed its own formula, called the Associating Reserve Adequacy for Emerging Markets (ARA EM) metric, to assess the adequacy of reserves for emerging markets.

The current level of Korea's foreign exchange reserves is below the threshold according to this formula.

However, the IMF no longer officially uses this quantitative assessment method for Korea, a developed financial market with well-established floating rates on part with Australia, New Zealand, Canada, Denmark, Norway and Sweden.

These advanced economies undergo qualitative assessments, including stress tests — a more refined and nuanced approach.

According to the IMF's Article IV Consultation Report released in February, Korea's foreign exchange reserves are assessed to be sufficient to withstand a wide range of flexible shocks.

Compared to India, another leading emerging market economy in Asia, Korea's external soundness may be more pronounced.

While India's foreign exchange reserves exceed those of Korea by more than $200 billion, this has been achieved primarily through substantial capital inflows, with the current account remaining in a persistent deficit.

This balance of payments structure is behind India's difficulty in creating a sovereign wealth fund. In addition, India also has a significant net investment deficit. In this regard, unlike Korea, the IMF uses a quantitative assessment method for foreign exchange reserves.

Meanwhile, it has been observed that Korea's foreign exchange authorities' market intervention has been prudent.

Their approach is not to defend a certain level, but rather to stabilize the fluctuation of the exchange rate and facilitate market trends in line with global financial developments.

Since Donald Trump announced his trade policies last year, Korea's export-dependent currency has weakened significantly due to the increasingly strong U.S. dollar. Toward the end of last year, rumors circulated in the market that the authorities would intervene heavily to prevent the exchange rate from breaching the psychological resistance level of 1,500 won per dollar, regardless of the amount used.

However, official reserve statistics have since shown that such concerns were exaggerated.

It is reasonable to say that Korea's current account surplus, which exceeded expectations last year, has been actively supplied to the market at a new high level.

A thorough examination of the factors contributing to the recent decline in Korea's foreign exchange reserves provides further reassurance that the situation is not a cause for concern.

It is widely recognized that the decline in foreign exchange reserves is mainly due to a foreign exchange swap transaction between the NPS and the Bank of Korea (BOK).

The NPS is allowed to strategically hedge up to 10 percent of its foreign investment assets, worth about $48 billion. Since the liquidity in the currency hedging market between the dollar and the Korean won is insufficient to cover the volume, the NPS is allowed to enter into swap transactions with the BOK up to $65 billion when making a new overseas investment or settling the existing forward exchange position at the expiration date.

The resulting reduction in reserves due to the swap transactions is usually replenished when the swap matures.

However, it is likely that two institutions will agree to roll over the swap until the won has appreciated sufficiently, thereby leaving the foreign exchange reserves reduced.

Yet this should not be a cause for concern, as the reduced amount has merely been reclassified from the reserves to the out-of-the-reserves under the more than $1 trillion of net investment surplus.

Safeguarding the reserves is not a pressing concern at this time.

In fact, it may be even better to shrink them at this point, since the accumulation of the world's ninth-largest reserves could be cited as a rationale for Trump's actions if he misinterprets the trade surplus with the U.S. as the consequence of Korea's policy of weakening the won.

It is clear that the view of Korea's foreign exchange reserves needs to change, and it has already changed considerably.

It is imperative to maintain a more reasonable level of foreign exchange reserves because the era of the more the better is over.

Indeed, the Korean government has already invested in alternative products that are not conceptually included in foreign exchange reserves. This represents a net asset value of more than $45 billion at the end of 2024.

Now is the time to explore new ways to diversify more into higher-risk and higher-yielding long-term assets that are not tied to the boundary of foreign exchange reserves, and to set up a management system for future generations.

Of course, it cannot be overemphasized that foreign exchange reserves, while serving as a last resort, are not intended to defend a particular exchange rate and need to be managed effectively.

Yang Seok-jun is a visiting fellow at the Korea Capital Market Institute. Previously he served as the group leader of the Reserve Management Group at the BOK.