[Insight & Opinion] Trouble Whether High or Low... The Dilemma of Exchange Rate Policy

Depending on Currency Swap and U.S. Rate Hike
Rising Exchange Rate: Higher Import Prices and FX Losses
Falling Exchange Rate: Threat to Export Competitiveness

This week, there are two major events in South Korea's financial and foreign exchange markets. One is the size of the interest rate hike by the U.S. Federal Reserve (Fed) on the 21st, and the other is whether a currency swap agreement can be reached at the South Korea-U.S. summit. If the Fed's rate hike exceeds 0.75 percentage points, there are concerns that the exchange rate will rise sharply above 1,400 won. Conversely, if the South Korea-U.S. currency swap is concluded, the exchange rate is expected to decline and stabilize.

However, both a high and low exchange rate pose problems. If the currency swap is not concluded and the U.S. raises rates sharply at the same time, the exchange rate will rise significantly, causing difficulties for the Korean economy due to rising import prices and capital outflows driven by concerns over foreign exchange losses. The Bank of Korea will eventually have to raise the base rate by more than 0.5 percentage points in October, and from early next year, when the effect of the rate hike becomes visible, there is a high risk of financial crisis due to a real estate bubble burst and deterioration of household debt.

On the other hand, if the currency swap is concluded, the exchange rate will show a downward stabilization, stabilizing import prices and likely reducing capital outflows. During the 2008 global financial crisis, the exchange rate, which had risen to 1,500 won per dollar, fell to the 1,250 won range due to the South Korea-U.S. currency swap. The problem is that if the exchange rate falls, export competitiveness weakens, which may lead to a deterioration in the trade balance and a decline in external creditworthiness, potentially causing another crisis.

In particular, with the Japanese yen and Chinese yuan exchange rates rising, South Korea's export competitiveness could weaken further. Since the Abe administration, Japan has adopted the exchange rate strategy of Professor Koichi Hamada of Yale University, implementing an accommodative monetary policy during U.S. rate hikes to enhance export competitiveness. This time as well, Bank of Japan Governor Kuroda raised the yen-dollar exchange rate to 144 yen per dollar without intervening in the foreign exchange market regulated by the U.S., using an accommodative monetary policy. China has also understood Japan's strategy and raised the yuan exchange rate above 7 yuan per dollar.

However, South Korea finds it difficult to raise the exchange rate due to concerns over rising import prices and capital outflows. Conversely, if the exchange rate falls, exports may decline due to Japan and China's beggar-thy-neighbor policies, leading to economic recession and worsening trade balance. The Korean economy is likely to fall into the "Hamada trap" due to this exchange rate policy dilemma. It is urgent for policymakers to devise measures to escape this dilemma.

First, the won-dollar exchange rate should be managed at an appropriate level considering the exchange rates of Japan and China. If the South Korea-U.S. currency swap is concluded, concerns over dollar supply will be alleviated, and the won-dollar exchange rate is expected to decline. However, with U.S. rate hikes continuing until the end of this year or early next year, the yen-dollar exchange rate is expected to rise to 150 yen per dollar. There is a high possibility that the won-yen exchange rate will fall rapidly. In the past, excessive declines in the won-yen exchange rate have often worsened South Korea's current account balance.

If the South Korea-U.S. currency swap is not concluded and the Fed raises rates sharply, policymakers can either raise rates sharply to prevent capital outflows or focus on increasing exports to enhance national creditworthiness. Considering that a sharp rate hike can prevent capital outflows but may cause a real estate bubble burst and household debt deterioration, policymakers should gradually raise rates while simultaneously promoting export policies to shift the trade balance to surplus. Now, when exchange rate policy is caught in a dilemma, wise policy choices by policymakers are more important than ever.

Kim Jeongsik (Professor Emeritus at Yonsei University, Chairman of the Financial Ombudsman Committee, Financial Services Commission)

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