[The Editors' Verdict] Appropriate Level of Foreign Exchange Reserves? Internationalization of the Korean Won Is the Answer

▲Kim Kyung-soo, Professor Emeritus at Sungkyunkwan University

The debate over the appropriate level of foreign exchange reserves is a recurring topic whenever the Korean economy experiences foreign exchange instability. The COVID-19 pandemic reignited this debate. Once foreign currency funds (dollars) enter the domestic market through any channel, they are recycled overseas unless kept as cash in a drawer. If the rollover of foreign currency funds supplied domestically by banks borrowing from abroad is refused in an emergency and there are no funds to recover domestically, a sovereign default occurs. Therefore, foreign exchange authorities must hold sufficient foreign exchange reserves.

After the East Asian foreign exchange crisis, Martin Feldstein, an American economist who was a professor at Harvard University, argued that a country's foreign exchange stability cannot rely solely on the International Monetary Fund (IMF) and cannot be resolved by sound macroeconomic policies alone, thus requiring extraordinary measures. As alternatives, he suggested reducing short-term external debt, creating collateral credit institutions, or expanding foreign exchange reserves. Subsequently, emerging countries accumulated massive foreign exchange reserves. However, holding foreign exchange reserves incurs significant operating costs. These reserves consist of highly liquid and creditworthy assets such as short-term U.S. Treasury securities, which generate very low interest income, while the interest costs on Foreign Exchange Stabilization Bonds (Oepyeongchae) issued to finance these reserves or Monetary Stabilization Bonds issued to absorb money supply are much higher. If foreign exchange reserves ultimately stem from private sector external debt, these interest costs increase further.

During the 2008 global financial crisis, although Korea was a net creditor country without maturity mismatches, it failed to prevent foreign exchange instability caused by the banking sector's massive external debt. Ultimately, the crisis was overcome through a liquidity swap with the U.S. Federal Reserve (Fed). The 2008 crisis was an event where the rational behavior of individual economic agents, such as foreign exchange hedging that induced foreign currency borrowing, caused negative externalities for the entire economy. Foreign exchange authorities imposed macroprudential regulations to control short-term external debt, akin to Pigovian taxes levied on polluting companies.

This year, despite no currency or maturity mismatches in all sectors except non-financial corporations, foreign exchange instability occurred. Fortunately, the foreign exchange market calmed down after re-establishing a liquidity swap with the U.S. Fed.

The Greenspan rule, which requires accumulating foreign exchange reserves equal to short-term external debt, and the more conservative appropriate reserve levels suggested by the IMF or the Bank for International Settlements (BIS) are not very helpful in the face of foreign exchange instability. China, which held over $4 trillion in foreign exchange reserves, lost $1 trillion due to foreign exchange instability starting in 2015.

During financial crises, the media headlines read "just $200 billion to spare." During the pandemic, it was "barely $400 billion." If reserves exceeding $600 billion, more than the BIS proposal, had been accumulated, the headline might have been "Will $600 billion collapse?" Regardless of cost, no amount of foreign exchange reserves is sufficient because exchange rates are heavily influenced by psychological factors. Foreign exchange authorities must balance the fear of declining reserves with the fear of soaring exchange rates.

Even a small but reliable Fed swap acts as a firefighter because quality is more decisive than quantity for foreign exchange stability. Australia, which has a similar economic size to Korea but holds the highest sovereign credit rating, has foreign exchange reserves of just about $40 billion. This is because the internationalization of the Australian dollar has advanced significantly. Since the private sector can issue foreign debt in Australian dollars or hedge in U.S. dollars in international financial markets, the rational behavior of economic agents does not cause negative externalities for the economy as it does in Korea. Truly advanced countries should not be swayed by the inflow and outflow of foreign capital, and the internationalization of the Korean won is the only alternative to becoming an advanced country. Although late, it is time to prepare and implement a roadmap for the internationalization of the Korean won.

Kyungsoo Kim, Professor Emeritus, Sungkyunkwan University

This content was produced with the assistance of AI translation services.