[King Dollar's Bombardment] Foreign Exchange Reserves: Sufficient vs Insufficient... Heated Adequacy Debate

Record High Exchange Rates Yet Government and Bank of Korea Say "Sufficient"
Experts Warn "No Room for Complacency... Heightened Vigilance Needed"

Despite the recent global trend of a ‘King Dollar,’ the Korean won has experienced a notably sharp decline, and South Korea’s foreign exchange reserves are also rapidly decreasing. As the foreign exchange reserves, which serve as a safety net for external payment settlements and crisis response during national economic emergencies, have shifted to a downward trend, debates over the adequacy of the reserve size have intensified. Currently, there are opposing views: one argues that South Korea’s foreign exchange reserves fall short of the appropriate level estimated by major institutions such as the Bank for International Settlements (BIS), while the other contends that the current strong dollar phenomenon is a global issue and should be viewed differently from the 1997 foreign exchange crisis. In response, Asia Economy has gathered opinions on both sides of the debate regarding the appropriate level of foreign exchange reserves.

"External soundness indicators are stable... foreign currency procurement is smooth" (Choo Kyung-ho, Deputy Prime Minister and Minister of Economy and Finance)

"Our foreign exchange reserves rank 9th worldwide... the ranking itself is meaningless" (Lee Chang-yong, Governor of the Bank of Korea)

Despite the won-dollar exchange rate rising to its highest level in 13 years and 5 months, the government and the Bank of Korea confidently assert that there is no problem with foreign exchange soundness, largely because the size of the reserves is not insignificant. According to the Bank of Korea, as of the end of last month, South Korea’s foreign exchange reserves stood at $436.43 billion, ranking 9th globally after Saudi Arabia and Hong Kong. This is 20 times larger than the $20.4 billion during the 1997 foreign exchange crisis and more than double the amount during the 2008 financial crisis. The reserves have shown steady growth, reaching $200 billion in 2004, $300 billion in 2010, and $400 billion in 2017. Typically, the won’s value is determined by the market, but if fluctuations threaten market stability, foreign exchange authorities intervene by buying or selling dollars using reserves to stabilize the market. However, if reserves decrease, policy flexibility diminishes, making it difficult to defend against volatility during rapid exchange rate surges or drops. Although foreign exchange reserves have decreased by more than $30 billion from their peak in November last year due to the strong dollar, the Bank of Korea and the government reassure the market because they judge that the current reserves are more than sufficient to fulfill this role.

Economic Fundamentals Differ from the Foreign Exchange Crisis... Divergent Views on Adequacy Standards

The foreign exchange authorities also focus on the fact that the fundamental strength of the Korean economy today is clearly different from that during the past foreign exchange crisis.

Although the won-dollar exchange rate has risen sharply, domestic external soundness indicators remain stable, unlike during past crises. The credit default swap (CDS) premium, an indicator of national credit risk, has been declining since July, and on August 1, the Korea Development Bank successfully issued $2 billion worth of dollar and euro bonds at interest rates lower than expected, which serves as evidence. The current account balance, which plummeted by over 80% year-on-year during the 2008 financial crisis, recorded a surplus of $24.8 billion in the first half of this year, maintaining a healthy level.

There is also a significant difference in perspectives regarding the adequacy standards for foreign exchange reserves. Since there is no internationally accepted standard, academia and markets generally refer to recommendations from the International Monetary Fund (IMF) and the Bank for International Settlements (BIS). According to a recent analysis by the Hyundai Research Institute, South Korea’s foreign exchange reserves are significantly insufficient compared to the 2013 IMF standard (150%) and the 2003 BIS standard. However, the Bank of Korea holds the view that these standards themselves are difficult to assign meaningful significance to. At a press conference last month, Governor Lee Chang-yong emphasized, "I came from the IMF," and added, "No IMF staff member would tell you to accumulate 150% of the IMF standard as foreign exchange reserves." A Bank of Korea official stated, "The BIS recommendation is not based on precise design or research, so it is inappropriate to use it as a current adequacy standard," and "Even if the IMF recommendation falls below 100%, it is not a major problem."

Foreign exchange authorities warn that overreacting to risks and increasing foreign exchange reserves beyond necessity could lead to opportunity costs and side effects. The Bank of Korea explained, "The appropriate scale of foreign exchange reserves should be evaluated from a long-term and dynamic perspective."

Short-term External Debt Hits 10-Year High... Should Be Judged by Ratio to GDP

While foreign exchange authorities caution against excessive interpretation of the decline in foreign exchange reserves, there is considerable counterargument that the recent trend, combined with a sharp rise in the exchange rate and sluggish exports, could plunge the Korean economy into a crisis.

Although there is no definitive answer to the appropriate size of a country’s foreign exchange reserves, it is difficult to judge the current size of South Korea’s reserves as sufficient from the perspective of reserve adequacy. Recently, voices in academia have suggested that the appropriate level of foreign exchange reserves should be assessed not by absolute amount but by the ratio to gross domestic product (GDP). Professor Kim Dae-jong of Sejong University’s Department of Business Administration emphasized, "As of the end of July this year, South Korea’s foreign exchange reserves to GDP ratio is 27%, which is much lower than Switzerland (129%), Hong Kong (129%), and Taiwan (91%). Since Taiwan did not face a sovereign default crisis during the 1997 foreign exchange crisis due to sufficient reserves, it is necessary to accumulate more foreign exchange reserves to serve as a safety net against sudden capital outflows."

Some experts also point to the low proportion of liquid assets within the foreign exchange reserves as a risk factor. As of the end of last month, South Korea’s deposits, which are liquid assets, amounted to $17.9 billion, accounting for only 4.1% of the total reserves. This is a decrease from $23.2 billion (5.3%) at the end of July. Professor Shin Se-don of Sookmyung Women’s University’s Department of Economics noted, "This means there are not many assets that can be immediately liquidated within the foreign exchange reserves," and added, "A significant portion of the managed foreign exchange assets is tied up in bonds, making it difficult to respond to capital outflows."

The short-term external debt ratio, which has risen to its highest level in 10 years, is also cited as a factor increasing concerns about foreign exchange reserves. The short-term external debt ratio in the second quarter of this year was 41.9%, the highest in 10 years since the second quarter of 2012 (45.5%). Professor Kim Dae-jong said, "Short-term external debt refers to debts with maturities of less than one year, which can be quickly withdrawn. The 1997 foreign exchange crisis also began with the rapid outflow of Japanese short-term external debt," and added, "To prevent a recurrence of the foreign exchange crisis, the resumption of Korea-US and Korea-Japan currency swaps is necessary."

The fact that emerging countries have faced domino defaults due to the King Dollar shock is also cited as a reason to raise the level of caution. Sri Lanka, which declared default in April, is currently negotiating a $3 billion bailout with the IMF, and Pakistan and Bangladesh have also requested IMF bailouts. If the won’s depreciation due to the King Dollar and the domino defaults in emerging countries coincide, leading to a global credit crunch and rapid dollar repatriation by foreign investors, South Korea’s financial market cannot be assured of safety.

Professor Emeritus Kim Jung-sik of Yonsei University’s Department of Economics said, "South Korea’s foreign exchange reserves returned to a downward trend in August, and a sharp decline in reserves is not desirable as it signals a foreign exchange crisis," and added, "Since exchange rates are heavily influenced by psychology, the Korea-US currency swap is necessary also for its psychological effect."