Managing market expectations will be key

By Park Chong-hoon

The Korean won continues to depreciate, showing no signs of improvement this year. Starting the year at the 1,190 level, the currency has reached the mid-1,400s to the dollar, down 17.2 percent year to date, largely due to a strengthening of the U.S. dollar. Furthermore, relative to emerging market countries such as India, Indonesia and Malaysia, the Korean won has declined the fastest this year since the 2008 global financial crisis.

The current situation is also exceptional to the extent that the Bank of Korea (BOK), which rarely comments on the exchange rate, has said that its interest rate policy is being affected by the won's weakness.

Given the previous bad experience with a weak Korean won during the Asian financial crisis and the global financial crisis, there is rising anxiety among market participants that a weak won might pose a further risk to domestic corporate credit ratings. If business performance worsens due to the weak exchange rate, in addition to rising raw material prices and financial costs, corporate credit ratings could face downgrades similar to those during the global financial crisis.

Companies' borrowing capacity is drying up due to weak corporate bond investment sentiment, but current credit ratings do not objectively reflect this reality. Concerns are growing that this could cause stress in the credit and capital markets, or burden banks as the financial health of companies that borrowed money in U.S. dollars deteriorates.

However, we believe such concerns about distress in Korea's financial system are excessive. The won's weakness against the U.S. dollar is not an issue related only to the won, but more due to a strong U.S. dollar resulting from rapid U.S. Federal Reserve (Fed) rate hikes relative to other central banks.

As the BOK hikes its base rate to catch up with the Fed, the narrowing interest rate differential should prevent a significant depreciation of the Korean won going forward. As of the second quarter of 2022, Korea had foreign reserves of $416.7 billion and net foreign currency assets of $744 billion, which means that the country is able to repay all of its short- and long-term debt in a worst-case scenario, unlike during the Asian financial crisis of 1997-1998.

That said, we also need to consider other potential structural factors behind the won's recent weakening.

First, unlike in the past, U.S. dollar supply has not kept up with demand. Usually, Korea earns enough USD through trade account and current account surpluses, and uses it for capital investment while retaining some as foreign currency reserves, which have steadily increased in the past years. But as retail investors and the National Pension Service have recently increased their overseas asset investment, the need for U.S. dollars now exceeds the current account surplus.

Korea is becoming a dollar-deficient country. Its trade balance ― normally a key source of U.S. dollars ― has been in deficit for six months, and its current account balance was in a deficit in August. As such, the supply of U.S. dollars has decreased, forcing a steeper won depreciation.

Second, the Korean won is not a reserve currency. As a result, the currency was more volatile during the global financial crisis. Furthermore, as the Korean won is a proxy currency for the Chinese yuan (CNY), it has also faced an adverse impact of a slowing Chinese economy due to China's COVID-zero policy measures.

So, the questions on everyone's minds are how long will the Korean won continue to weaken, and what might trigger an appreciation of the Korean won?

We see a couple of catalysts for the won to strengthen again. First, Korea's trade and current account balances need to improve. As most of the country's current account is composed of the trade balance, the latter, in particular, needs to turn around. For this to occur, its increasingly high import bill recently due to elevated oil prices needs to ease up. But while oil prices have moderated in the second half of the year (compared to the first half), thus helping the trade balance, they could rise again on any adverse turns in the Russia-Ukraine conflict and as winter approaches.

Second, exports would need to increase significantly. We have low expectations of this, as the recent drop in semiconductor prices and falling semiconductor exports warn of a receding global economy due to broad-based interest rate hikes, which bodes poorly for a strong export turnaround.

Furthermore, China's economic rebound is crucial to export growth in Korea. In recent months, Korean exports to China have declined due to lockdowns in China that have affected China's imports and the supply chain. The ongoing U.S.-China trade dispute, especially in semiconductors, will also likely hamper Korea's chances of an export rebound.

Third, controlling capital outflows appropriately could help improve the Korean won's strength. The government may need to provide more incentives for overseas investors to enter Korea. It is already making efforts to balance U.S. dollar demand/supply, including through the National Pension Service and BOK currency swaps, adjusting shipbuilders' credit lines, tax exemptions for foreign investors in Korea Treasury Bonds (KTBs, and supporting inclusion of KTBs in the World Global Bond Index (WGBI)).

Although it is difficult to foresee the immediate impact of such government measures on the Korean won given high market volatility, we think they will begin to contribute to the won's normalization if the market stabilizes.

Overall, we believe that maintaining a stable Korean won level is essential to curbing inflation and further capital outflows. We believe the market hypothesis that the Korean won's recent weakening may be a precursor to another financial crisis is not justified. However, the hypothesis may become a reality if investors continue to behave pessimistically based on bad experiences during previous financial crisis periods.

Park Chong-hoon (ChongHoon.Park@sc.com) currently heads the Korea Research Team at Standard Chartered Korea. Before joining the bank, he worked as a senior research fellow and head of telecommunication policy at the Korea Information Society Development Institute (KISDI).