Wons rally may hit the wall

Supported by short-term speculation, recent gain of Korean currency against the dollar seems vulnerable.

By Cho Jin-seo

Last Friday saw the Korean currency’s value reaching the highest level since the financial crisis. At 1,083 won per dollar, the won has gained 4-percent in just 40 days ― a faster appreciation than most other countries in Asia.

In Seoul’s foreign exchange market, traders believe that the government has reset its unofficial line of defense from around 1,100 won per dollar to around 1,080. Reports say that last week there were a number of attempts to buy the dollar whenever the rate threatened to fall below 1,080, which they suspect to be organized by the government.

Without the government intervention, the suspicion goes, the rate could fall further and the won would become more expensive to buy. But most traders believe that the won-dollar rate is not likely to go down far below.

“I think the consensus is that it will stay above 1,050 won,” a trader at a major Korean bank said on the condition of anonymity. She also warns that won is a very volatile currency and foreign capital can leave the country faster than they enter. “Let’s say that something happens in North Korea. That will immediately send the exchange rate sky high. This kind of risk is always with the won.”
Though forecasts defer, market analysts at least agree on that the rising of the won has been possible because of high inflation and the prospect of interest rate hike.

Inflation, which hit 4.7 percent in March, made the government allow the sudden fall of the exchange rate, which they normally do not let happen. The low interest rate in the United States is another reason that money is flowing into Asian countries including Korea, which has pushed up the value of their currencies all together.

But situations can change. Many see that the U.S. Federal Reserve will raise its target interest rates in the second half of the year to keep the country’s inflation in check. That can reverse the flow of money from emerging countries to the U.S. as a high interest rate lures investment, the Seoul trader says.

A look at the long-term history of the won-dollar exchange rate supports this view. In the short term, the rate has fallen steadily (which means that won has become stronger, or more expensive, against the dollar) since the peak in 2009. But still, it is 20 percent cheaper compared to its pre-crisis level in 2007, when 900 won equaled a dollar.

Broadly speaking, the won has been weakening (the won-dollar rate rising) for decades, even though there were brief anomalies such as the 1998 Asian crisis and 2008 U.S. financial crisis (Below 800 was the norm in the early 1990s). There are many theories and explanations about this perpetual depreciation of the won such as higher inflation than advanced economies and the government’s export-oriented policy. But one thing is certain that the won’s value cannot go back to its 2007 level.

Speculation-fueled appreciation

The remaining question for investors is that how long the current rally of the Korean won can last. The answer depends on how much support it is receiving from the foreign capital inflow as well as from the government’s economic policy.

Economic fundamentals look good. Thanks to brisk exports, Korea’s trade balance was $3 billion in profit in March, which was a third higher than the same month of last year. The current account has been in the black since October 2010, meaning that there is a plethora of dollars flowing into the balance sheets of big export firms, such as shipbuilders, electronics makers and steelmakers.

The capital market too has seen a large inflow since the earthquake in Japan. Foreigners from the U.S., China and elsewhere have bought 4.7 trillion won worth of Korean stocks and bonds since March 16, during which period there was no single day that they have sold more shares than they bought.

But this large capital inflow may not be sustainable. According to Cho In-kang, the head of capital bureau at Financial Services Commission (FSC), 60 percent of this recent foreign capital inflow was short-term speculative funds that have more than 500 percent of an annual portfolio turnover rate. In other words, they do not hold the same stocks more than two to three months on average.
“Considering the nature of the investment vehicles, it is too early to say that the situation is stable,” Cho said in his briefing on Thursday. Furthermore, funds based in Europe have been constantly cashing out from Korea as the euro is becoming stronger against the dollar as well.

Another concern is that the relationship between the exchange rate and the capital inflow is a chicken-egg problem. Foreign investors buy Korean stocks when they believe the Korean won will become stronger - for example, the recent 4-percent rise in the won’s value means that their return will become 4 percent higher in the dollar. But once they sense that the trend will reverse, investors can exit the Korean stock and bond market en messe and rush to sell the won, which will further depreciate the won in a vicious cycle.

Some see that there are signs that this tipping point may be nearing. According to Daewoo Securities analyst Yoon Yeo-sam, foreigners since March 31 have been selling bond futures in Korea on days when the exchange rate goes up - an indication that the foreign investors are preparing to cash out and run away.

The last but not the least important question is inflation. In February, the monthly inflation hit 4.7 percent compared to a year ago mainly because of the rise in oil prices. This led the government to allow the won-dollar rate to fall so Korea can import oil, iron and wheat at a cheaper price.

But the inflationary pressure can be eased in the coming months, as the international markets for metals and foods are finally seeing price drops in recent weeks.

“The good news is that from April, the consumer prices will calm down,” said Yoon Jeung-hyun, the Minister of Strategy and Finance, on Friday during a National Assembly hearing. If he is telling what he really believes, then the government may have less reason to see the won getting more expensive and feel more compelled to help exporters by making the won cheaper - the same strategy that has been here for years, if not decades.