"Excessive Austerity in Korea Causes High Exchange Rates"

Moon Hongcheol, DB Financial Investment Researcher
"Excessive Monetary Policy Tightening in Response to Currency Weakness
May Become a Vicious Cycle Leading to Exchange Rate Increase"

On the 7th, when the won-dollar exchange rate surpassed 1,380 won for the first time in 13 years and 5 months, dealers were working in the dealing room of Hana Bank in Euljiro, Seoul. Photo by Mun Ho-nam munonam@

[Asia Economy Reporter Junho Hwang] As the U.S. raises interest rates, voices are growing that the Bank of Korea should narrow the Korea-U.S. interest rate gap and respond to potential inflation caused by exchange rates. However, there are concerns that excessive tightening could actually lead to a higher exchange rate.

On the 13th, Hongchul Moon, a researcher at DB Financial Investment, analyzed, "Excessive monetary policy tightening in response to currency weakness can become a vicious cycle that drives exchange rate increases."

He stated, "In the past, contrary to common sense, the won/dollar exchange rate rose (won weakened) when Korean interest rates were higher than those in the U.S.," adding, "This appears to be due to the very large proportion of foreign trade relative to economic size and the openness of the capital market." He further added, "When the won was weak, prices fell, which is analyzed to be due to global demand slowdown (= decrease in Korean exports)."

Typically, currency weakness is countered by raising interest rates. This is because the relationship between interest rate differentials and exchange rates, and currency weakness, act as factors that increase domestic prices. However, despite the European Central Bank (ECB)'s giant step (a 75 basis point increase in the benchmark interest rate), the euro has shown weakness. The burden of high interest rates added to the eurozone, which is suffering from high energy prices, is believed to have lowered the eurozone's investment attractiveness by potentially damaging economic growth.

Researcher Moon explained, "For a model that explains exchange rates by interest rate differentials to work, it must be a normal situation where economic improvement and inflation rise accompany interest rate hikes. Only then does the logic that growth is high, so interest rates rise and the currency strengthens, become natural." He added, "The current eurozone is not like that. In other words, when looking at exchange rates, the principle of fundamentals is important."

He forecasted, "In Korea's case, if domestic interest rates rise rapidly amid a slowdown in external demand, even the remaining domestic consumption and investment will slow down, damaging growth," adding, "This will be a factor that encourages won weakness." From a foreign investor's perspective, it is rational to abandon the country most sensitive to global demand slowdown first. If any country tightens its currency strongly, it is his view that investment capacity may be reduced based on rational judgment.

He predicted, "In this situation, looking at export growth rather than other indicators can help gauge the future trend of the exchange rate. Exports could shrink by up to -20% by the end of the year, and the appropriate exchange rate at that time would be around 1,430 won." However, he noted, "This is based on the assumption that there is no global credit crisis, and if a recession accompanied by a crisis occurs, the upper side should also be considered."

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