[Insight & Opinion] One Year of the Yoon Suk-yeol Administration: Solutions for Exchange Rate Stabilization

It has been one year since the launch of the Yoon Suk-yeol administration. During this time, the economic team has achieved many accomplishments, such as stabilizing inflation and reestablishing the market economy system. However, recently, as the interest rate gap between Korea and the U.S. widened and the trade deficit expanded, the exchange rate has risen, raising concerns about capital outflows from the Korean economy once again. In fact, exchange rate stability is an Achilles' heel for the Korean economy. When the exchange rate rises, import prices increase, which can cause inflation, previously lowered, to rise again. The Bank of Korea will face additional pressure to raise interest rates, and the Korean economy will be exposed to financial distress risks. Moreover, the rise in the exchange rate can significantly increase foreign exchange losses, further accelerating capital outflows. The Korean economy could enter a vicious cycle of capital outflows and exchange rate increases.

The primary cause of the exchange rate increase is the strengthening of the dollar due to U.S. interest rate hikes, which weakens the Korean won. Domestic fundamental deterioration is also a cause. Excessive interest rate hikes have raised concerns about financial distress, and the trade deficit has expanded due to a decrease in exports. Looking ahead, if U.S. interest rates remain steady, the exchange rate may fall; however, if domestic economic fundamentals worsen, the exchange rate could still rise. This is evident from the recent greater depreciation of the won compared to other foreign currencies. It is urgent for policymakers to establish proactive measures to prevent capital outflows and stabilize the exchange rate.

First, efforts must be focused on increasing exports to maintain a current account surplus. The current account balance is an indicator of a country's external creditworthiness and a signal of foreign exchange crises. The Korea Development Institute (KDI) forecasts a current account surplus of $16 billion this year, but the possibility of a current account deficit cannot be ruled out if overseas travel demand surges in the summer or if international crude oil prices rise in the winter. A current account deficit would increase capital outflows and further raise the exchange rate, exposing the Korean economy to crisis. Policymakers should diversify export markets, which are currently concentrated in China, and expand tax and financial support for export companies to maintain a current account surplus and prevent capital outflows.

Additionally, caution is needed regarding further interest rate hikes. As the interest rate gap between Korea and the U.S. widened to 1.75 percentage points due to U.S. rate increases, pressure to raise rates has increased amid concerns about capital outflows. However, raising interest rates does not necessarily prevent capital outflows. Capital outflows can occur not only due to interest rate differences but also because of exchange rate increases or economic recessions. Further interest rate hikes could raise the already increasing loan delinquency rates, worsening household and corporate financial distress. It could also deepen the economic recession and cause a sharp drop in real estate prices, increasing capital outflows. In the past, even when the interest rate gap between Korea and the U.S. widened, capital outflows did not occur if the exchange rate fell. Policymakers need to respond to capital outflows by stabilizing the exchange rate rather than by raising interest rates.

Preventing a hard landing of the economy is also important. If a hard landing occurs, causing corporate bankruptcies and a real estate bubble collapse, stock prices will fall, and foreign investment capital will exit. Recently, the International Monetary Fund (IMF) projected this year's economic growth rate at 1.5%, lower than last year's 2.6%, while the global credit rating agency Standard & Poor's (S&P) forecasted an even lower 1.1%. If exports do not increase in the second half of the year, a hard landing is a concern. Policymakers should use fiscal policies, including supplementary budgets if necessary, and ease regulations on businesses and real estate to ensure a soft landing, preventing capital outflows and stabilizing the exchange rate.

Past experience shows that when the U.S. raised policy interest rates by more than 3 percentage points, most emerging market countries faced crises due to export declines and economic recessions within 1 to 2 years. This is because interest rate hikes affect the economy with a time lag. From early last year to recently, the U.S. Federal Reserve (Fed) raised rates by 5 percentage points. From this year onward, vigilance against financial and foreign exchange crisis risks is necessary. As the Yoon Suk-yeol administration marks its first year, it must prevent the Korean economy from being exposed to crisis through exchange rate stabilization. Now is a time when careful and correct policy choices by policymakers are more necessary than ever.

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

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