"High Exchange Rates to Persist Until First Half of Next Year" ... Due to US Monetary Policy Normalization and Russia-Ukraine Conflict

Improvement in Exports Difficult to Expect Due to Global Dollar Strength
Concerns Over Profitability Deterioration from Rising Raw Material Prices

Seoul Jung-gu Korea Chamber of Commerce and Industry. / Photo by Jinhyung Kang aymsdream@

[Asia Economy Reporter Jeong Dong-hoon] The won-dollar exchange rate has surpassed the 1,350 won level for the first time in 13 years since the financial crisis, raising concerns that the high exchange rate may persist for a considerable period, necessitating countermeasures.

On the 4th, the Korea Chamber of Commerce and Industry's SGI released a report titled "Evaluation of the Recent Exchange Rate Increase," stating that the global economic recession concerns and the normalization of U.S. monetary policy have sustained the strength of the dollar, and this phenomenon is unlikely to be resolved in the short term.

The won-dollar exchange rate entered the 1,200 won range in February this year and has continued to rise, reaching the mid-1,300 won range. However, the report pointed out that the upward movement is mainly due to the global strength of the U.S. dollar, and the depreciation of currency value is not occurring only in the won.

Short-term Factors for Exchange Rate Increase: U.S. Monetary Policy Normalization and Russia-Ukraine Conflict

The report categorizes the main factors driving the exchange rate increase into short-term and long-term factors, identifying short-term factors as monetary policy normalization, the Russia-Ukraine conflict, deterioration of the international balance of payments, and global recession concerns.

During the gradual normalization of the accommodative monetary policies implemented by various countries in response to COVID-19, the U.S. Federal Reserve raised the benchmark interest rate four times starting in March this year. Notably, in June and July, the rate was increased by 0.75 percentage points each time, bringing the benchmark rate to 2.25?2.50%. U.S. monetary policy affects the global dollar value, influencing exchange rates worldwide. The recent consecutive rate hikes have intensified the dollar's strength, causing the won-dollar exchange rate to rise.

The U.S. monetary policy stance is also expected to maintain a tightening approach focused on price stability until the end of next year. The U.S. FOMC dot plot, released quarterly, shows the Federal Reserve members' projections for appropriate benchmark interest rates. The dot plot published in June indicated a median rate of 3.4% by the end of this year and 3.75% by the end of next year.

Federal Reserve Chair Jerome Powell also hinted that the September FOMC would update these figures, raising the appropriate rate by the end of next year to just below 4%. This suggests that the upward trend in the won-dollar exchange rate, along with U.S. monetary policy, is likely to continue at least until the first half of next year.

The ongoing Russia-Ukraine conflict since February is also related to the exchange rate increase. Global risk-related news tends to immediately affect market sentiment, causing the exchange rate to react swiftly in the short term. Additionally, the conflict has disrupted global supply chains, strengthening the preference for the safe-haven dollar.

Next, the report stated that deterioration in the international balance of payments, one of the macroeconomic fundamental indicators, acts as a factor for exchange rate increases. The international balance of payments consists of the current account, representing exports and imports of goods and services, and the capital account and financial account, representing capital inflows and outflows. In other words, if foreign exchange outflows resulting from trade and capital transactions with other countries exceed inflows, causing the balance of payments to worsen, the exchange rate may rise. If the rising exchange rate continues to increase the burden of raw material imports, as seen recently, the trade deficit may accumulate, further pushing up the exchange rate. In the first half of this year, despite exports increasing by 15.6% compared to the same period last year, imports rose even more significantly (up 26.2%), resulting in a trade deficit of $10.3 billion (approximately 14.0389 trillion won).

Furthermore, the report assessed that the depreciation of the won is intensifying due to global inflation, including international oil and raw material prices, and the resulting recession concerns. International crude oil prices (WTI) surpassed $120 per barrel in June, reaching the highest level since the financial crisis, maintaining a high level for a considerable period before recently declining amid global recession fears. The U.S. consumer price index (CPI) rose 9.1% in June, the highest since 1981. The IMF forecasted global economic growth at 4.4% in January but revised it downward to 3.2% in July.

Long-term Factors for Exchange Rate Increase: ① Demographic Changes ② Increase in Overseas Investment

The report identified demographic changes and increased overseas investment as factors influencing the long-term trend of the exchange rate.

South Korea is experiencing rapid population aging. The proportion of the population aged 65 and over increased significantly from 5.1% in 1990 to 15.7% in 2020, and the average age rose from 27 to 43.7 during the same period. Due to the rapidly progressing aging trend, the economic burden of supporting the elderly population that the working-age population must bear is expected to increase.

The problem is that increased expenditures due to the support burden are likely to lead to reduced savings and increased imports. Increased household consumption reduces saving capacity, and increased consumption can induce higher imports from an overall economic perspective. If these phenomena accumulate over the long term, they may negatively affect the current account balance, causing excess demand for foreign exchange and influencing exchange rate increases.

Additionally, the report pointed out that the continuous expansion of overseas investments, such as direct investment and securities investment, is also related to the exchange rate increase. As of the first quarter of this year, the overseas financial assets held by Korean nationals amounted to approximately $2.2 trillion (about 2,998 trillion won). The net external financial assets, calculated by subtracting foreign financial liabilities invested domestically, have remained positive and increased since the third quarter of 2014. This trend can increase demand for dollars, contributing to exchange rate increases.

‘Exchange Rate Increase → Export Growth’ Expectation Difficult... Measures Needed Such as Crude Oil Tariff Reduction, Currency Swaps, and Trade Finance

The report noted that although the Korean economy has grown based on trade surpluses through exports, the recent exchange rate increase driven by the global dollar strength is unlikely to lead to export growth and increased corporate profits. It also pointed out concerns that rising interest burdens on corporate foreign currency debts could suppress investment. Furthermore, the rise in import prices due to the exchange rate increase may lead to domestic inflation, and if expectations of continuous won depreciation form, foreign investment may decrease, potentially causing capital outflows.

Therefore, to mitigate the negative impacts of the exchange rate increase and ease foreign exchange market instability, the report recommended ① reducing crude oil tariffs, ② currency swaps, ③ reducing corporate financial costs and expanding exchange rate fluctuation insurance limits, and ④ measures to stimulate consumption, investment, and exports.

Currently, South Korea is the only non-oil-producing country among OECD members that imposes tariffs on imported crude oil. Although the government expanded the reduction of oil tax rates until the end of the year (from 30% to 37%) to alleviate the burden of high oil prices, the effect has been difficult to feel due to the large increase in oil prices and the slow reflection of reductions in field prices. Although international oil prices have recently shown a downward trend amid growing global recession concerns, if prices rise again due to global factors such as the Russia-Ukraine war, it will be necessary to consider reducing crude oil tariffs along with the current oil tax reduction measures.

Next, it is necessary to expand foreign currency funding supply through currency swaps with major countries such as the U.S. Considering that currency depreciation is also occurring in countries like the UK, Switzerland, and the EU, which have standing currency swaps with the U.S., and that the current won-dollar exchange rate increase is not due to a shortage of foreign currency liquidity, the role of currency swaps may be limited. Nevertheless, currency swaps can help prevent excessive market concentration and prevent the fixation of expectations for further exchange rate increases. In 2020, the announcement of the Korea-U.S. currency swap agreement eased concerns about dollar procurement, leading to a decline in the exchange rate.

It is also necessary to review trade finance interest rates supporting export SMEs. The government announced an expansion of trade finance supply by about 90 trillion won this year (from approximately 261 trillion to 351 trillion won as of August 31) to alleviate corporate cost and logistics burdens. Trade finance is a system that loans funds in won to export companies for production and raw material purchases, with loan interest rates set by adding a premium based on the company's credit rating to the benchmark interest rate. Considering the recent interest rate hikes, loan rates are expected to rise further, so reviewing and adjusting loan interest rates to alleviate corporate burdens caused by exchange rate increases will be necessary to preserve the original purpose.

Kim Hyun-soo, head of the Economic Policy Office at the Korea Chamber of Commerce and Industry, said regarding measures to stimulate consumption, investment, and exports, "To prevent the exchange rate increase from leading to a decline in overall economic vitality, measures that can reduce high-cost burdens, such as income tax and corporate tax cuts, expansion of corporate investment tax credits, and increased export finance support, must be implemented promptly." He added, "Cooperation between the government and the National Assembly is urgently needed."

Min Kyung-hee, SGI Research Fellow at the Korea Chamber of Commerce and Industry, evaluated, "The issues our economy faces, such as exchange rate, inflation, and interest rate increases, are interconnected and influence each other, making it difficult for macroeconomic policies targeting each to have independent effects." She added, "In a situation where the possibility of a global economic recession is increasing, it is necessary to actively implement policy measures to stabilize the market and prevent risk factors from spreading to financial and real economic crises, and efforts to reduce exchange rate sensitivity, such as corporate foreign exchange hedging and diversification of settlement currencies, are required."