Remember it wasn’t so long ago that the won hit 1,500 won to the US dollar. I remember a few who send money home regularly hoarding their Korean won, waiting for that glorious day when the won to dollar exchange rate got back down around the W1,200 mark. It’s been relatively good for Canadians over the year, but even they took a hit this year with many foreign English teachers seeing their pay take an almost 30% pay cut and probably lead to a few more teachers staying in Korea to see just if the won will strengthen in late 2009 and into 2010. Well, let’s go to the experts over at SERI and see what they think.
One of the main concerns today is the fluctuating exchange rate. The won/dollar exchange rate, which was at 1,250 won in early September, plunged to 1,155 won on October 15. Some experts even claim that the won/dollar exchange rate will break through the 1,100 won barrier and fall further to the three digit range. Against expectations, however, the won/dollar exchange rate took a different turn and surged again as if it were on a rollercoaster to the 1,190 range on October 22. Today, we’re going to look at reasons behind the fluctuating exchange rate, future direction of the won/dollar exchange rate and effective responses.
First, let’s look at the background of the falling won/dollar exchange rate. The dollar, which strengthened substantially due to a strong preference toward safer assets, started to weaken as the global financial crisis began to ease. As the dollar lost its excessive premium as the key global currency, a dollar carry trade began on the back of massive dollar liquidity pumped into the global financial market and ultra low US interest rates.
The substantial deterioration in the US dollar’s credibility is another factor behind the plunge. Credibility was lost as the US posted massive budget deficits and talks of replacing the dollar’s key currency status elevated.
Domestic factors also put downward pressure on the won/dollar exchange rate. Dollar liquidity stemming from Korea’s trade surplus and current account surplus pushed down the rate. The accumulated current account surplus by August exceeded US$32 billion.
Stock and bond investment by foreigners rose sharply. The net inflow of foreign currencies through stock investment amounted to US$40.7 billion from January to August. Particularly, stock purchases by foreigners have been brisk since the won/dollar exchange rate started to fall sharply in July. Almost 60% of net stock purchases by foreign investors were concentrated in the period after July.
Why then, has the won/dollar exchange rate surged again? It has been mainly attributed to domestic factors rather than external ones. First, foreign investors started to act differently from prior to October. Foreigners were slow in purchasing stocks, even selling them in large numbers. In the Non-Deliverable Forward (NDF) market, foreign investors, who used to sell dollars, became the buying force.
Growing concerns over intervention by financial authorities is another factor driving up the rate. Rumors are spreading in the foreign exchange market that financial authorities are considering the application of regulations regarding short-term foreign debt and foreign exchange liquidity to foreign bank branches in Korea.
What is the future direction of the exchange rate? Let’s consider first what path the dollar will take. The dollar’s depreciation amid the global financial crisis has almost come to an end. The other two factors such as the dollar carry trade and weak dollar credibility will remain effective forces in influencing the rate in the future.
In addition, for a closer look, we need a broader perspective to predict the dollar’s future. The past three periods of the weakening dollar have similar aspects to the current weak dollar. The US is suffering from a twin deficit which is a current account deficit and a budget deficit, relatively high consumer prices, and the deterioration of credibility. Recent talks of replacing the international key currency and ultra low interest rates in the US have also weighed down the dollar’s value.
In mid-August, an extraordinary development arose. The dollar libor fell below the yen libor for the first time since 1993. The dollar’s credibility deteriorated further than ever before. There are even raised voices in the emerging markets and the international community to replace the dollar as the key currency status by Special Drawing Rights or SDRs. China, Russia and Brazil are using their own currencies as the settlement currency in trade. The Middle East, Central Asia and Central and South America have a plan to create their own regional currency. Consequently, the dollar may strengthen temporarily due to a possible interest rate hike in the US and concerns over a possible financial crisis in some countries but overall, it will be difficult for the dollar to regain strength.
How will the won/dollar exchange rate develop in the future? Will the won strengthen substantially? First, in terms of dollar demand-supply, supply will exceed demand for the time being thanks to a continuous trade surplus and overseas capital inflows. Though supply will likely shrink in 2010.
In terms of the real effective exchange rate, the won will continue to strengthen against the dollar. The real effective exchange rate is the weighted average of a country’s currency relative to an index or basket of other major currencies adjusted for inflation. After the global financial crisis last year, the won was significantly undervalued. The won will likely strengthen further in the mid- to long-term if the won/dollar exchange rate returns to equilibrium. This means that the won will strengthen even against other major currencies such as the yen and yuan.
In conclusion, the won will likely strengthen further. In consideration of a mild global economic recovery and weak base for domestic demand, the strong won has the potential to derail the Korean economy from its recovery path. So, financial authorities should make efforts to ease upward pressure on the won. To this end, financial authorities should reinforce the demand-supply management of foreign currencies and tighten supervision and regulations over hot money flowing into the domestic market. Companies also need to prepare for high volatility in the exchange rate and further strengthening of the won. In particular, domestic exporters should streamline their business management and shift their business structure to a higher value-added model in preparation for a stronger won.
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