[Contribution] Some misconceptions about Korean won

Arguments about rate hikes, external debt woes, and FX funding risks have misled market participants

By Stephen Lee

Stephen Lee, chief economist of Meritz Securities

There was no winner in the investment scene except the U.S. dollar in 2022, which has rallied as much as 18.6 percent during the year, and 8.4 percent (based on DXY: USD versus six major currencies) year-to-date until Dec. 23 with the recent retreat.

Non-U.S. currencies have depreciated, with the Korean won not being an exception. It started the year at 1,189 won per dollar, and saw 1,440 won per dollar by Sept. 28, before coming down to 1,281 won per dollar by Dec. 23. The currency is down 7.2 percent vis-a-vis the U.S. dollar so far this year. It showed a rollercoaster ride just as other non-U.S. currencies did.

During the steep depreciation of the Korean won ― eg. when it was above 1,400 won per dollar, there were arguments insisting that the value of the Korean won could fall further, due to some structural reasons. Here are some of the arguments which I believe are misleading.

First, the BOK needs to hike its policy rate aggressively to prevent a further weakness of the won: Some have been worrying that narrowing interest rate spreads or a reversal of the interest rate gap between the U.S. and Korea will eventually lead to capital outflows and hence result in the weakness of the won.

Interest rate parity has not been working in Korea. It may look like it is working today, but it is a consequence of higher U.S. interest rates having the yield spread of U.S.-Germany and U.S.-Japan to widen. This situation has created a globally strong dollar affecting the won afterwards.

It is worth noting that the Korea-U.S. 3-year treasury bond yield spread has matched well with the DXY since 2000. The Korean won is not included in the DXY, so this implies that the historical dollar rally was generally based on rising U.S. interest rates, which applies similarly today.

Besides, when the policy rate difference between the U.S. and Korea were reversed in July (FFR higher than BOK base rate), there were no capital outflows. Foreign investors have net bought Korean equities since then, and foreign investors' bond holdings were up 3.2 trillion won during July-November 2022. Note that any country selecting rate hikes to prevent capital outflows or capital flight are those with a structural current account deficit, which relies heavily on foreign capital. Korea does not fall into this category.

But didn't the BOK say that they are addressing the Korean won when they decide their policy rate? The answer is yes, however, BOK policy does not directly affect the Korean won. We can think of the BOK's ex-post reaction to the supply shock on inflation. When the won depreciates, it will boost import price pressures and that will affect consumer prices and inflation expectations more.

To prevent inflation running from a second-round effect on higher inflation expectations, the BOK chooses aggressive rate hikes. We saw this situation in October when BOK raised its base rate to 50bps. In contrast, when the won appreciated in November, a hike of 25bps was enough.

Second, 2022 is a reminder of 2008 when Korea had its own problems: As the value of Korean won fell to its lowest point since March 2009, some raised concerns that the current episode is similar to that of the global financial crisis, when Korea had external debt problems. Back then, short-term overseas borrowing surged before the crisis, in an effort to hedge currency forwards. The global credit crunch had domestic banks pay back what they had borrowed in a short period of time, and this led the Korean won value to dive toward 1,600 won per dollar.

The nation does not have an external debt problem like this today. Some comparison in numbers can be helpful. First, short-term external debt as a percentage of the total stands at 26.8 percent as of the third quarter this year versus 51.8 percent in the third quarter of 2008 (before the fallout of the Lehman Brothers collapse). Second, short-term external debt as a percentage of foreign exchange reserves stands at 43.4 percent in the third quarter this year versus 78.5 percent in the third quarter of 2008. Third, among the short-term external debt, borrowing accounts for only 54.6 percent in the third quarter this year. This figure was 81.8 percent in the third quarter of 2008. Such stabilization in external debt positions are consequences of macro-prudential policies adopted after the global financial crisis.

Third, the nation's FX market faces a funding problem, so a currency swap is necessary: Such concerns surfaced as the won-dollar rate approached the level seen in the previous crisis, but this situation was far from true. To gauge any funding problem, we would need to observe 1) whether there exists any global credit crunch, or 2) whether the Korean won swap basis falls steeply. None of these two conditions were met during 2022.

We saw a global credit crunch in early 2020 upon the spread of COVID-19 but not in 2022. The Korean won's one-year swap basis was stabilized at -100bps mainly throughout the year. Even if we had any funding risks, I believe a currency swap with the Federal Reserve was unnecessary. It is because the Bank of Korea gained its eligibility to use the FIMA (Foreign and International Monetary Authorities) Standing Repo Facility, a program introduced after COVID-19 to create a backstop source of constant dollar liquidity in times of liquidity crisis.

What's ahead for the won?

Ruling out the previous three misconceptions, the main driver of the Korean won has been the U.S. dollar. Hence, the Korean won's direction will solely depend on the movement of U.S. dollar going forward. It seems likely for the U.S. dollar's strength to ease, prompting the Korean won to strengthen gradually in 2023.

First, Federal Reserve is likely to pause its rate hike cycle in the first quarter 2023. Under an economic downturn, such a pause will lead market yields to fall, narrowing interest rate spreads between advanced countries.

Second, the Eurozone will likely come out from a shallow recession by April, as gas demand eases and more supply comes from non-Russian areas.

Third, non-U.S. central banks are on their path to normalization, with the ECB executing balance sheet runoffs starting March 2023, and the BOJ allowing higher JGB yields upon their shift of yield curve control.

In particular, if the first two conditions are met, financial market participants will seek economic recovery possibilities and turn to a more risk-on attitude. This situation could further appreciate the won.

The writer is the chief economist at Meritz Securities, Seoul