[Song Seungseop's Financial Light] Why Exchange Rates at Financial Crisis Levels Are Frightening

Won-Dollar Exchange Rate Approaches 1,300 Won
Soars to 2009 Financial Crisis Levels
Rising Inflation and Increased Risk of Capital Outflow

Finance is difficult. It is filled with confusing terms and complex backstories intertwined. Sometimes, you need to learn dozens of concepts just to understand a single word. Yet, finance is important. To understand the philosophy of fund management and consistently follow the flow of money, a foundation of financial knowledge is essential. Accordingly, Asia Economy selects one financial issue each week and explains it in very simple terms. Even those who know nothing about finance can immediately understand these ‘light’ stories that illuminate the ‘light’ of finance.

[Asia Economy Reporter Song Seungseop] The won-dollar exchange rate is soaring rapidly. The 1300 won level is also under threat, and warnings are emerging that this could deal a significant blow to the Korean economy. But why has the exchange rate risen, and what negative effects does it bring?

How much Korean money is needed to get 1 dollar?

First, you need to understand the concept of the exchange rate. The exchange rate is the ratio at which one country’s currency is exchanged for another’s. Imagine paying 1000 won for a 1-dollar coffee in the United States. No one would accept that. You need to exchange it into U.S. currency. The rate at which Korean money is exchanged for U.S. money is the exchange rate. In Korea, the amount of Korean money you pay to get 1 dollar is called the exchange rate (won-dollar). If you exchange 1 dollar for 1000 won, the exchange rate is 1000 won.

However, the exchange rate is not fixed. It changes moment by moment depending on various situations. Sometimes you may have to pay 2000 won for 1 dollar, and other times only 500 won. If you pay 2000 won for 1 dollar, the exchange rate is 2000 won, and we say the exchange rate has ‘risen.’ Conversely, if you only pay 500 won for 1 dollar, we say it has ‘fallen.’

When the exchange rate changes, the value of money naturally changes as well. What happens to the value of Korean money when the exchange rate rises? It falls (won depreciation). Imagine the exchange rate rising from 1 dollar = 1000 won to 1 dollar = 2000 won. Previously, 1000 won had the value of 1 dollar, enough to buy a coffee. But when the exchange rate rises, 1000 won is worth only 0.5 dollars (1 dollar = 2000 won). Its value has dropped so much that you can’t even buy a cup of coffee. Conversely, the value of the U.S. dollar has increased.

[Image source=Yonhap News]

The opposite happens when the exchange rate falls. If the exchange rate drops from 1 dollar = 1000 won to 1 dollar = 500 won, the value of Korean money has increased (won appreciation). Previously, 500 won was worth 0.5 dollars (1 dollar = 1000 won), but with the exchange rate falling, it now holds the value of 1 dollar. Now, you can buy a coffee with just 500 won.

So why does the exchange rate change? There are many reasons, but it changes according to supply and demand. Imagine there are many people wanting dollars or the supply of dollars decreases. It becomes harder to get dollars, so the value of the dollar rises. Relatively, the value of Korean money falls. Since you have to pay more Korean money to get 1 dollar, the ‘exchange rate rises.’ Conversely, if dollar demand decreases or dollar supply increases, the ‘exchange rate falls.’

Why is an exchange rate at financial crisis levels dangerous?

On the 13th, KOSPI opened at 2,570.01, up 19.93 points (0.78%) from the previous trading day, as dealers were working in the dealing room at the Hana Bank headquarters in Jung-gu, Seoul. On the same day, the won-dollar exchange rate started trading at 1,290.8 won, up 2.2 won from the previous trading day. Photo by Jinhyung Kang aymsdream@

One reason the exchange rate is soaring in the current international economy is the increased demand for dollars. As the Ukraine crisis prolongs and the international economy becomes unstable, demand for the dollar, considered a safe asset, has surged. Recently, the U.S. Federal Reserve (Fed) also raised the benchmark interest rate by 0.5 percentage points. More people would want to deposit money in dollars in the U.S. where interest rates have risen. As more people seek dollars, the dollar’s value increases (dollar appreciation), and the won’s value decreases (won depreciation). Naturally, the amount of Korean money needed to exchange for the now more valuable 1 dollar has increased (exchange rate rise).

As of the 13th, the exchange rate is about 1284 won. It even surpassed 1290 won during the day. Experts predict it may exceed 1300 won, as there are many expectations that the Fed may raise the benchmark interest rate again. To put this in perspective, this is at the level of the 2009 financial crisis. It’s the exchange rate from 13 years ago.

What happens when the exchange rate rises? It’s not always bad when the exchange rate rises. When the exchange rate rises, even if you earn the same amount of dollars, you can earn more won. However, if the exchange rate is excessively high, negative effects increase. Prices of imported goods priced in dollars rise, and domestic inflation also increases. The burden of money borrowed overseas in dollars by companies or the government increases.

Also, from the perspective of foreigners investing in Korea, if the exchange rate rises and the won’s value falls, they suffer losses (exchange rate losses). If they worry about this and withdraw their investments, the risk of capital outflow increases, which in turn heightens financial market instability. This is why the media and experts view the rising exchange rate with concern.

[Image source=Yonhap News]

The government began to act urgently as the exchange rate soared. On the 11th, Deputy Prime Minister and Minister of Economy and Finance Choo Kyung-ho launched an emergency economic task force (TF). On the 13th, President Yoon Suk-yeol held a ‘Macroeconomic and Financial Situation Review Meeting’ attended by Deputy Prime Minister Choo and Bank of Korea Governor Lee Chang-yong. At the meeting, President Yoon stated, "The government must accurately recognize the economic situation and proactively respond to the crisis based on this understanding."