[BOK Focus] Is 'Won Weakness = Export Increase' Wrong? ... Is It Time to Change the Textbook?

When the Dollar Weakens, Financing Conditions Improve, Leading to Increased Exports

Shin Hyun-song, BIS Economic Advisor and Director of the Research Department, is delivering the keynote speech at the 1st Bank of Korea-Korea Chamber of Commerce and Industry Joint Seminar held on the 1st at the Korea Chamber of Commerce and Industry in Jung-gu, Seoul, on the theme of "Changes in the Economic Paradigm and Korea's Economic Response Measures." Photo by Kim Hyun-min kimhyun81@

[Asia Economy Reporter Seo So-jeong] "If the dollar weakness (won strength) trend continues, South Korea's trade balance could improve faster than expected."

Shin Hyun-song, Economic Advisor and Head of Research at the Bank for International Settlements (BIS), made this remark during the keynote speech at the joint seminar held by the Bank of Korea and the Korea Chamber of Commerce and Industry on the 1st, quietly stirring waves in the academic community. The traditional economic formula of "won depreciation = export increase," long accepted like a textbook principle, has recently stopped working in the market, prompting a flood of analyses on the causes.

According to the Mundell-Fleming theory, when the Korean won weakens against the dollar, exports increase and imports decrease, improving the trade balance and aiding economic growth. However, recent studies argue that with the expansion of the US dollar's dominance in international trade and the advancement of global value chains, the depreciation of individual currencies may not improve the trade balance.

Park Yang-soo, President of the Bank of Korea Economic Research Institute, explained, "Since exports are mainly traded in US dollars, despite the depreciation of the exporting country's currency, there is little change in import prices, so export volumes do not increase significantly." He added, "Especially when the US dollar is strong due to US monetary tightening, countries other than the US experience no increase in exports despite currency depreciation, while import prices rise, leading to inflation." Although export and import volumes remain similar, in a strong dollar situation, export profits (in won) increase while import costs rise. This leads to reduced demand in countries outside the US, potentially causing a global economic slowdown.

Shin Hyun-song of BIS analyzed that in the context of dollar dominance and strengthened global value chains, the demand for trade finance and working capital increases, and the strong US dollar?i.e., worsening dollar funding conditions for companies?tends to shrink global production activities and reduce exports. Shin stated, "A significant portion of global trade is settled in dollars, and dollar flows affect trade finance and working capital, ultimately impacting manufacturing exports." He argued, "When the dollar is strong, it worsens companies' dollar funding conditions, suppressing production activities and eventually reducing exports. Conversely, when the dollar weakens, funding conditions improve, allowing exports to increase." He explained that a strong dollar can increase working capital burdens, negatively affecting exports. Shin emphasized, "Since October last year, the dollar's weakening, i.e., improved dollar funding conditions, could actually help South Korea's exports."

In South Korea's case, even as the COVID-19 situation was calming down in the fall of 2022, trade volume decreased due to the dollar's shift to strength. In contrast, South Korea's exports performed best in 2021 when supply chain disruptions were severe, during a period of dollar weakness. This suggests that dollar strength may have a more negative impact on our exports than supply chain disruptions.

Recently, heated discussions have taken place within the Bank of Korea regarding Shin's claims, which contradict conventional economic wisdom. Generally, the 'J-curve effect' shows that the trade balance initially worsens when the exchange rate rises (won depreciation) but improves after some time. However, this effect has become less evident recently, leading to increasing analyses that the formula "won depreciation = export increase" is cracking. Min Jwa-hong, Deputy Governor of the Bank of Korea, said, "Currently, most currencies are weak compared to the dollar, and the currencies of export competitors are also low, so the advantage of won depreciation is not significant, making it difficult to uniformly apply past theories."

Recently, the Bank of Korea Economic Research Institute published a paper suggesting that won depreciation may not significantly increase exports from the perspective of anchor currency price setting. Park said, "Contrary to past beliefs, won depreciation may not greatly help exports," adding, "It implies the need to carefully identify the causes of depreciation." Professor Ha Jun-kyung of Hanyang University's Department of Economics diagnosed, "Korea's exports tend to respond more sensitively to the global economy than to exchange rates," noting, "The negative effect of increased raw material import costs appears immediately, while the positive effect of increased demand for Korean goods is not sufficiently evident." Professor Ha said, "Although exchange rates remain a key variable in trade analysis, the past formula is less likely to apply in an environment where global supply chains are being reorganized and the low interest rate regime is shifting to a high interest rate regime."