"Highest Won Depreciation Rate Among 34 Countries in February This Year... Impact of Trade Balance Shock"

Bank of Korea, June Monetary and Credit Policy Report

[Image source=Yonhap News]

From August last year to early this year, while the US dollar fluctuated between strength and weakness, the rate of change in the Korean won exchange rate significantly exceeded the average rate of change of other currencies. In particular, in February this year, the depreciation rate of the won exchange rate was more than twice the average of other currencies, recording the highest depreciation rate among 34 countries, which was analyzed to be influenced by about 40% due to trade balance shocks.

On the 8th, the Bank of Korea stated in its Monetary and Credit Policy Report in the section titled "International Comparison and Factor Analysis of Recent Exchange Rate Volatility and Rate of Change" that "the volatility of the won exchange rate (monthly standard deviation of daily exchange rate changes) has remained at a high level since March last year, and the rate of change in the won exchange rate (change from the end of the previous month to the end of the current month) has also expanded significantly since the second half of last year."

According to the report, from January 2010, after the global financial crisis, to April 2023, the long-term average volatility of the won exchange rate (0.5%p) was lower than the average (0.62%p) and median (0.58%p) of 34 major countries, ranking 20th among them. However, since the US Federal Reserve (Fed) began raising interest rates in March last year, it has consistently exceeded the long-term average. The won's exchange rate volatility is lower than that of most advanced countries and emerging countries in South America but higher compared to East Asian countries such as China, Taiwan, and Thailand.

The Bank of Korea conducted a panel analysis on 31 major advanced and emerging countries and found that exchange rate volatility increased with higher financial openness, a higher ratio of short-term external debt to foreign exchange reserves, more flexible exchange rate regimes, and lower dollar liquidity. The Bank explained, "This result aligns with the empirical fact that exchange rate volatility tends to be relatively large in advanced countries with high financial openness, while it is smaller in East Asian countries that adopt strong capital controls and rigid exchange rate regimes."

Comparing the exchange rate changes of major countries' currencies during events that triggered US dollar strength since the global financial crisis, the won's rate of change was relatively small. These periods include ▲the Eurozone debt crisis (August 29, 2011 ? July 24, 2012), ▲US monetary policy normalization (July 1, 2014 ? March 13, 2015), and ▲the US-China trade dispute (April 16, 2018 ? August 14, 2018).

However, from August last year to early this year, during the US dollar's cycle of strength and weakness (strength → weakness → strength), the absolute value of the won's exchange rate change significantly exceeded the average of other currencies. In particular, in February, the won's depreciation rate was more than twice the average of other currencies, recording the highest depreciation rate among 34 countries.

To understand the background of the expanded rate of change in the won exchange rate in early this year, the Bank of Korea conducted a model analysis and found that the interest rate differential between domestic and foreign rates and trade balance shocks had a negative effect (appreciation) on the won exchange rate, while the credit default swap (CDS) premium had a positive effect. The interest rate differential and CDS shocks affected the exchange rate within the same month, whereas trade balance shocks influenced the exchange rate with a one-month lag.

The Bank of Korea stated, "About 40% of the unexpected increase in the won exchange rate in February this year was explained by trade balance shocks," adding, "It is also believed that expectations of a strengthened Fed tightening stance, which were not included in the model, acted as a depreciation factor." It was also explained that countries such as Thailand, South Africa, Argentina, and Russia, which experienced significant trade balance deterioration early this year, saw their currencies depreciate sharply during the US dollar strength phase in February.

The Bank of Korea added, "Since the global financial crisis, the volatility of the won exchange rate has generally remained stable, being higher than that of East Asian countries but lower than that of other countries," explaining, "This is because South Korea has higher financial openness and exchange rate regime flexibility compared to East Asian countries, but lower financial openness than advanced countries."

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