[보도] What makes Korean currency so vulnerable

The won, which traded at around 936 against the U.S. dollar early this year, tumbled to 1,150 in mid-September after U.S. investment bank Lehman Brothers filed for bankruptcy. Then it slid even further to hit 1,513 on Nov. 24, marking the weakest level so far this year and matching the level seen in March 1998 when the nation was bailed out by the International Monetary Fund.

As of end-November, the won plunged 36.2 percent against the dollar, outpacing the euro's fall of 11.8 percent and the pound's decline of 22.6 percent.

With the financial market debacle escalating beyond expectation, the won-dollar rate has suffered unprecedented fluctuations. The volatility of the won-dollar rate soared by 3.3 times as the daily standard deviation between the currencies jumped to 3.3 over the last three months, compared to 0.9 over the first nine months of this year.

During the corresponding period, the volatility of the euro and the pound increased 1.8-fold and 2.1-fold, respectively.

The reason the won tumbled so sharply with increased volatility was the demand and supply conditions for the dollar and the structural problems of the won-trading foreign exchange market.

Strong demand for the greenback

One of the key factors behind the won's weakness is a surge in the global demand for U.S. dollars.

Following the spread of the U.S. financial crisis across the world, international investors have scrambled to exit emerging markets and Korea has suffered. Foreign investors' net sale of Korean shares stood at $37 billion from January until Dec. 12, accounting for about 36 percent of the regional loss among seven Asian countries, including Japan, Taiwan and India.

Foreign investors' massive capital flight sent the nation's capital account into an accumulative shortfall of $35 billion for the first 10 months of this year after enjoying a surplus since 2002.

The demand for the dollar also increased in the non-financial sector. A hike in the prices of oil and raw materials sent the nation's current account into a deficit. After sustaining a surplus since the 1997-98 Asian financial debacle, the current account swung to a deficit in December 2007 and posted about $9 billion in shortfall for the first ten months of this year.

During the corresponding period of last year, both the current account and capital account recorded $5.3 billion and $6.5 billion in surplus, respectively, contributing to the won's solid strength against the dollar. But in 2008, the deficit amounted to $46 billion, sparking excessive demand for the dollar and speeding up the won's fall.

Another reason behind the won's persistent slump is foreign exchange futures trading related to overseas investment funds. Local residents' investment in foreign stocks enjoyed an unprecedented boom in 2007, leading to a sharp increase in the forward exchange contracts to hedge against currency exposure risk. The overseas stock investment funds drew a total of $50.1 billion last year while the sell-offs of the currency forward contracts amounted to $27.2 billion. However, global shares plunged since last summer in the wake of the global financial crisis, resulting in an excessive hedge by those overseas investment funds.

While overseas investment funds scrambled to liquidate their huge forward positions, local lenders hoarded their dollars on the spot market to hedge against currency risks, aggravating the dollar shortage and accelerating the won's fall against the dollar. The situation made many market players believe that the won would fall further. Exporters, the key dollar suppliers, increased their dollar holdings and delayed the conversion while refiners and other importers scurried to secure more dollars in fear of the won's capitulation, another factor that swelled the pinch of the dollar shortage. In recent days, however, exporters began to sell more of their dollar reserves on expectations of the won's rebound, contributing significantly to the won's rise to 1,300 to the U.S. dollar.

Characteristics of the Korean foreign exchange market

Another culprit behind the won's sharp depreciation can be found in the structure of the Korean foreign exchange market.

The local foreign exchange market is relatively small, given the size of Asia's fourth-largest economy. Korea accounted for 0.83 percent of the global foreign exchange trading volume in 2007 whereas Australia took up 4.26 percent. Meanwhile, Korea contributed 1.78 percent to the world's gross domestic product and took over 2.59 percent of the international trade while the corresponding figures for Australia were 1.51 percent and 1.06 percent, respectively. In the case of Norway with a similar size foreign exchange market to Korea, its weight was merely 0.7 percent in the world GDP and 0.74 percent in international trade.

In such a small foreign exchange market, about 98 percent of the transactions have been done in U.S. dollars. In the third quarter of 2008, the nation's daily average foreign exchange trading amounted to $41.4 billion, of which $40.4 billion was for the greenback. Furthermore, the size of the spot market shrank to a daily average of $3.2 billion in November, less than a half of the trading volume in September, driven by a global dollar crunch in the wake of the financial crisis and a domestic dollar shortage brought on by months of current account and capital account deficits.

Therefore, the won's excessive fall to the dollar may not be a surprise when the demand for the dollar surges due to larger import bills or foreign investors' exit out of the local stock market due to bad news in international financial markets.

The possibility of a repeat of the currency crisis brought up by some analysts at home and around the world added downward pressure on the won. The fear was sparked by a significant drop in the nation's foreign exchange reserves and the country's swinging to a net debtor in the third quarter due to higher external debt. Korea's foreign exchange reserves declined to $200.5 billion as of end-November, falling for eight consecutive months after peaking at $264.2 billion as of end-March. The reserves were hammered by the sustained current account deficit and the authorities' massive dollar-selling intervention to protect the won. As of the end of the third quarter, Korea posted a net debt of $25.1 billion, the first shortfall in nearly eight years, with its external debt amounting to $425.1 billion and its overseas credit totaling $400 billion.

The major reason for the deterioration in the nation's balance sheet was a sharp increase in short-term overseas borrowings by the local banking sector. Banks' short-term external borrowings stood at $159.4 billion as of end-September, accounting for 37.5 percent of the nation's entire external debt. The current debt including long-term loans that mature in less than a year surged to $227.1 billion, larger than the nation's foreign exchange reserves as of end-November.

Under the circumstances, some foreign media published ill-grounded reports about the Korean economy, fanning fears of a crisis. These reports directly hit the Korean stock and foreign exchange markets, sparking sharp fluctuations in stock prices and the won-dollar rate.

Yet the chances of a repeat crisis are not as high as warned by the foreign press. According to the International Monetary Fund's yardstick, Korea's appropriate level of foreign exchange reserves (amounting to three months of current imports) are about $160 billion, comfortably staying below the nation's current reserves.

Even if the foreign currency reserves are deemed as insufficient, more than $90 billion in dollar credit line is available as a result of the currency swap facilities with central banks in the United States, Japan and China. Furthermore, the corporate and financial sectors enjoy pretty sound and stable financial structures, unlike in the 1997 Asian financial crisis.

Requirements for stability

The stabilization of the foreign exchange market requires an improvement in the supply and demand conditions for the greenback.

With the world economy staggering from a global financial storm, Dubai-based crude oil prices plunged to $43 per barrel on Dec.17 from the record high of $140 seen on July 4. Falling oil prices sent the nation's current account into a surplus of $4.9 billion in October. November will likely see a surplus at around $2 billion, providing a major relief to the dollar crunch. The government will also have to actively tap its currency swap facilities signed with the United States, China and Japan in order to protect the won for a while. In the mid- and long-term, the won-dollar rate is likely to return to stability, with a current account surplus increasing on sluggish domestic demand and cheaper oil. Also the dollar supply will increase as the global financial storm fizzles out in the face of international collaboration on liquidity support and aggressive fiscal expansion, as well as when foreign investors begin to buy into local shares.

The government will also have to introduce an incentive system to encourage banks to secure dollar liquidity early, while gearing up for their tapping the state guarantee on banks' external borrowings of up to $100 billion over the next three years.

The dollar-based international transaction system should be changed. With about 98 percent of foreign currency traded in the greenback, it's inevitable that the U.S. economic conditions or a change in the dollar supply have a significant impact on the Korean foreign exchange market. Korea's bilateral trade with Japan and China amounted to $226.2 billion for the first 10 months of 2008, accounting for 30.3 percent of the entire international trade. The dependence on the U.S. dollar can be reduced if East Asian countries settle their international transactions more in local currencies such as the Chinese yuan and the Japanese yen.

An institutional firewall should be established to restrain banks from borrowing excessively from international financial markets as a sharp increase in their external debt sparked fears about the health of the Korean economy in this financial crisis as well as the 1997-98 Asian financial meltdown.

By Chang Jae-chul