[Insight & Opinion] Foreign Exchange Market Solutions Should Focus on Boosting Exports

Urgent Need for Exchange Rate Stabilization
Export Growth Is Key to Preventing a Currency Crisis

As the exchange rate approaches the 1,300 won level, concerns in the foreign exchange market are rising. If the exchange rate increases alongside the U.S. interest rate hikes, foreign capital outflows could intensify further. The most urgent task for the new government’s economic team, beyond price stability, is to stabilize the exchange rate to help the Korean economy escape the risk of a foreign exchange crisis.

First, policy focus should be placed on increasing exports. The Korean economy has repeatedly faced crises during periods of U.S. interest rate hikes. In 1997, it experienced a foreign exchange crisis, and in 2008, although the foreign exchange market stabilized through the Korea-U.S. currency swap, it faced a mini foreign exchange crisis with the exchange rate nearing 1,600 won. After these crises, policymakers accumulated foreign exchange reserves and implemented various countermeasures, such as lowering the proportion of short-term foreign debt to 26% through the macroprudential "three sets" policy.

However, the reason for facing a crisis again now is that exchange rate policy has focused more on domestic price stability than on increasing exports. In fact, interventions in the foreign exchange market to lower the exchange rate led to a decrease of $62 billion in foreign exchange reserves in 2008, and a $21.5 billion decrease in May compared to October of last year. The problem is that while lowering the exchange rate can stabilize prices in the short term, it soon leads to a decline in exports, worsening the trade balance and lowering external credibility, which in turn causes the exchange rate to rise further. Therefore, policymakers should maintain the exchange rate at an appropriate level and focus policies on increasing exports.

Additionally, caution is needed regarding the trade deficit with China. China accounts for 26% of Korea’s exports, a very high proportion. Recently, imports from China have increased significantly, while export growth has slowed. In May, the trade balance with China turned negative for the first time in 27 years, and this trend is expected to continue for the time being. This is due to China’s catching up, narrowing the technological gap between Korea and China, and Korea’s wage increases weakening price competitiveness. If the trade deficit with China persists, the Korean economy may face an expanding trade deficit, causing greater instability in the foreign exchange market. Policymakers should lower inflation expectations to curb excessive wage increases, increase support for technological development to enhance export competitiveness, and diversify the export structure concentrated on China to respond to the decline in exports to China.

Active response is also required to Japan’s "neighbor impoverishment" policy. Japan and China have always responded to periods of U.S. interest rate hikes with accommodative monetary policies that raise their exchange rates. This time as well, Bank of Japan Governor Haruhiko Kuroda is employing a strategic monetary policy of lowering interest rates during the U.S. rate hike period. As a result, the Japanese yen exchange rate has surpassed 135 yen, and it is expected to exceed 140 yen as U.S. interest rates rise further.

The reason Japan can use this decoupling policy is that the Japanese yen is an international currency, so even with an interest rate gap with the U.S., the risk of capital outflow is low, and despite prolonged low interest rates, inflation remains low and no real estate bubble has formed. The problem is that the depreciation of the yen reduces Korea’s exports. In the past, during U.S. interest rate hikes, Japan responded with a combination of low interest rates and high exchange rates, causing Korea to experience a crisis, and there are concerns that the same situation will repeat this time. Therefore, policymakers need to manage the exchange rate considering the extent of yen depreciation. The won-yen exchange rate should be managed so that it does not deviate significantly below the 1,000 won per 100 yen level to prevent deterioration of the trade balance.

To avoid a crisis, the Korean economy must catch three rabbits at once: prevent capital outflows through exchange rate stability, suppress inflation, and avoid economic recession. These policy goals can be achieved through export growth and a trade surplus. When exports increase, the foreign exchange market stabilizes, import prices fall, capital outflows are prevented, and the economy can be stimulated. Policymakers should carefully observe the response strategies of Japan and China during periods of U.S. interest rate hikes.