[Insight & Opinion] Aftermath of a Strong Dollar... Preparing for a Foreign Exchange Crisis

Similarities to the 1980s:
Stability Comes First...
Export Expansion is Essential

[Asia Economy] The Korean economy has so far avoided the risk of a foreign exchange crisis thanks to its trade surplus with China. Looking at Korea's trade structure, it runs an annual trade surplus of about $20 billion with China, about $15 billion with the United States, and a deficit of about $20 billion with Japan. The surplus with China compensated for the deficit with Japan, and the surplus with the U.S. maintained a current account surplus, thereby sustaining Korea's external creditworthiness. However, recently, as the technological gap with China narrows and U.S. imports from China decrease due to the U.S.-China hegemonic rivalry, concerns are rising over the deterioration of Korea's current account balance caused by China's low economic growth.

Another challenge is the possibility of the U.S. strengthening protectionism. As history repeats itself, the last time the U.S. experienced such high inflation was in 1979 and the early 1980s. At that time, inflation rose to 14% due to the second oil shock, and Paul Volcker, then Chairman of the Federal Reserve (Fed), used a high-interest-rate policy by raising the policy rate from the 10% range to 22% to curb inflation. The high interest rates kept the dollar strong, the U.S. experienced a recession, and the trade deficit expanded.

During that period, the Reagan administration established policies to address the trade deficit after stabilizing inflation in the late 1980s. First, it attempted to revalue the Japanese yen and German mark, which had weakened due to the strong dollar. The next step was a strong protectionist trade policy. With Japan, import restrictions were imposed through the first semiconductor agreement in 1986 and the second in 1991, and strong protectionist measures such as market opening and tariff imposition were taken against other countries with trade surpluses with the U.S. Japan, unable to actively respond to these U.S. policies, suffered a 20-year economic stagnation.

The current U.S. inflation and interest rate hikes resemble the early 1980s situation. Like then, cost-push inflation is being experienced due to rising oil and raw material prices, and the Fed is sharply raising interest rates to control inflation. The currencies of trade partners, including the yen, are sharply depreciating, and the strong dollar is already widening the U.S. trade deficit. With U.S. interest rate hikes expected to continue until the first half of next year, concerns about a prolonged global recession are growing. The problem is that if exports to China decrease and the U.S. strengthens protectionism after the high-interest-rate policy, Korea's current account balance could deteriorate. A worsening current account balance would lead to a decline in external creditworthiness, potentially plunging Korea into another foreign exchange crisis.

The Korean economy is currently exposed to the risk of a foreign exchange crisis as concerns over capital outflows grow due to U.S. interest rate hikes. To prevent capital outflows, the interest rate gap with the U.S. must be reduced, but a significant interest rate hike could cause household debt defaults and a real estate bubble collapse. Policymakers are caught in a dilemma between a foreign exchange crisis and a financial crisis.

What is the solution to avoid the current crisis while also mitigating the aftershocks of U.S. interest rate hikes? It is for the Bank of Korea to gradually raise interest rates to reduce the risk of a financial crisis while simultaneously stabilizing the foreign exchange market by enhancing external creditworthiness through increased exports. To increase exports, Korea must diversify its export destinations away from China and hold export promotion meetings chaired by the president frequently, prioritizing external economic stability in policy. If exports increase, Korea can respond to the aftershocks of U.S. interest rate hikes such as protectionism and China's slowing growth, thereby reducing the risk of crisis for the Korean economy.

Kim Jeong-sik (Professor Emeritus, Department of Economics, Yonsei University)

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