[Seungseop Song's Financial Light] How Does a Currency Swap Lower Exchange Rates?

Asset Exchange in Financial Markets: 'Swap'
Currency Swaps Enable Foreign Currency Acquisition at Low Cost
Currency Swaps Discussed to Supply Dollars Amid Soaring Exchange Rates
Criticism Grows That "There Is Little Effect in the Current Situation"

Finance is difficult. It is entangled with confusing terms and complex backstories. 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, basic financial knowledge must be the foundation. Accordingly, Asia Economy selects one financial issue each week and explains it in very simple terms. Even if you know nothing about finance, you can immediately understand these 'light' stories that turn on the bright 'light' of finance for you.

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[Asia Economy Reporter Song Seung-seop] The exchange rate is soaring fearfully. On the 30th of last month, the won-dollar exchange rate closed at 1,430.2 won in the Seoul foreign exchange market. During the day, it surpassed 1,400 won for the first time in 13 years and 6 months. The monthly record high changed 11 times just last month. The government is considering the currency swap card with the United States, but how can a currency swap calm the exchange rate?

First, you need to understand the concept of a swap. Swap is an English word meaning 'to exchange' or 'to trade.' Let's imagine Mr. A, who owns a nice luxury sedan. Mr. A plans to go camping deep in the forest with his family for a month. He needs a camping vehicle, but buying one is wasteful and renting one is costly. However, his neighbor Mr. B owns a camper van. Mr. A proposes to Mr. B, "Let's freely use each other's vehicles whenever we want." Mr. B accepted the proposal because he sometimes needed a sedan too. Thanks to the agreement, Mr. A was able to go camping with his family.

Conveniently Bringing Foreign Currency with 'Currency Swap'

As such, a swap is a contract to exchange one asset with another party. Mr. A and Mr. B essentially entered into a kind of car swap. If they had exchanged computers instead, it would have been called a 'computer swap.' There are many assets in the financial market, such as foreign exchange, bonds, and stocks. There are also derivatives created from these. Contracts to exchange these assets are also swaps. If it is a contract to exchange interest payments to be received later, it is called an 'interest rate swap.' A currency swap is literally a contract between two countries to exchange their respective currencies.

[Image source=Yonhap News]

So why do countries enter into currency swaps? Think of Mr. A and Mr. B exchanging vehicles conveniently. By entering into a currency swap, a country can easily obtain the foreign currency of the other country. It is especially beneficial if the currency swap contract secures currencies widely used worldwide. If Korea enters into a currency swap with the United States, it can defend against a foreign exchange crisis caused by a shortage of dollars.

The cost is also low. What if you need the other country's money but there is no currency swap? You would have to exchange money or borrow money from the other country, which is a very cumbersome process. Borrowing money would also incur higher costs. If you borrow from the International Monetary Fund (IMF), you face interference, but currency swaps do not require that. Also, since the exchange rate is predetermined when the currency swap is made, you can avoid the risk of exchange rate fluctuations. For financial institutions, it is not considered debt, so it is exempt from financial regulations such as debt ratio limits.

Korea's first currency swap with the United States was in 2008 during the global financial crisis. The validity period was until April 30, 2009, and through this contract, the Bank of Korea could use up to 30 billion dollars (about 39 trillion won at the time). On December 31 of the same year, Korea also signed currency swaps with China and Japan, expanding the scale to about 30 billion dollars each. In March 2020, when COVID-19 began, the Bank of Korea signed a 60 billion dollar currency swap with the United States and drew up to 18.8 billion dollars.

Due to the sharp decline in the U.S. stock market, the domestic stock market also started lower on the 30th. Dealers are busy working in the dealing room of Hana Bank in Euljiro, Seoul. Photo by Moon Honam munonam@

Can Currency Swaps Lower the Soaring Exchange Rate?

Currently, the currency swap contract with the United States has ended, so why is the currency swap being discussed now as the won-dollar exchange rate rises? The rise in exchange rate basically has two reasons: supply and demand. People want too many dollars, or the market is severely short of dollars. Right now, the U.S. Federal Reserve (Fed) is tightening monetary policy and withdrawing dollars. Accordingly, the Bank of Korea is trying to increase supply by selling its dollar holdings. In the second quarter of this year, it net sold 15.49 billion dollars, the largest scale since the statistics were first disclosed in 2019.

Even though the Bank of Korea released a large amount of dollars in the second quarter, the exchange rate continued to rise, so the currency swap was brought up. If Korea signs a currency swap with the United States, it can easily bring dollars into Korea. The argument is that if the supply of dollars increases, the exchange rate can stabilize. In fact, when the news of currency swap agreements with the United States was announced in 2008 and 2020, the upward trend of the won-dollar exchange rate stopped. The exchange rate fell by 12.4% in 2008 and 3.3% in 2020.

Bank of Korea Governor Lee Chang-yong is attending the plenary meeting of the Planning and Finance Committee held at the National Assembly in Yeouido, Seoul, on the morning of the 26th, responding to questions from lawmakers.

The government and authorities are also moving urgently. On the 30th of last month, Deputy Prime Minister and Minister of Economy and Finance Choo Kyung-ho had a conference call with U.S. Treasury Secretary Janet Yellen. They discussed economic issues and agreed to cooperate closely to implement 'liquidity supply measures' if liquidity tightens and financial instability worsens. The representative liquidity supply measure is the Korea-U.S. currency swap. Bank of Korea Governor Lee Chang-yong also stated that they are "exchanging opinions with the U.S. Federal Reserve regarding the Korea-U.S. currency swap."

However, there are also claims that the effect of currency swaps will be limited. Looking closely at the current sharp rise in the exchange rate, it is said that it is caused not by a shortage of dollars but by inflation and events such as Russia's invasion of Ukraine overlapping. Therefore, even if a currency swap is signed, it is difficult to expect a significant effect. In fact, when the currency swap was signed in 2008, the exchange rate fell but hit a new high again after about 20 days. Governor Lee also said, "The Korea-U.S. currency swap is theoretically unnecessary," and "The situation is different from the crises in 1997 or 2008 when there was a shortage of dollars."