[Insight & Opinion] How to Survive the East Asian Currency War

High Interest Rates Deepen Global Recession
China and Japan Boost Economies by Raising Exchange Rates
South Korea Urgently Needs Policies to Maintain Appropriate Exchange Rates

Due to sticky inflation caused by rising wages, the U.S. Federal Reserve (Fed) is increasingly likely to raise interest rates further in the second half of the year. Even if interest rates are held steady, high rates are expected to persist for some time, raising concerns that the global economic recession will deepen.

As the recession is expected to be prolonged, concerns are also growing over the East Asian currency war, where countries raise exchange rates to boost exports and stimulate their economies. To raise exchange rates, intervention in the foreign exchange market is necessary, but Japan and China can increase their exchange rates without such intervention, thereby avoiding U.S. currency manipulation regulations. Japan, which holds international currency reserves and has low inflation, has responded to the U.S.'s high interest rate policy with a low interest rate policy, raising its exchange rate through domestic monetary policy that the U.S. cannot interfere with. Meanwhile, China has adopted a basket exchange rate system where the People's Bank of China determines the exchange rate daily.

Recently, the yen-dollar exchange rate has surpassed 144 yen per dollar, and the Chinese yuan-dollar exchange rate has also risen above 7.2 yuan. In contrast, the won-dollar exchange rate is hovering around 1,300 won due to inflows of foreign stock investment funds, and the won-yen exchange rate has fallen to around 900 won. There are concerns that exports, already struggling due to the global economic recession and falling semiconductor prices, will decline further because of the currency war.

To respond to the East Asian currency war, South Korea should also raise the won-dollar exchange rate, but this is not easy. First, rising import prices could cause inflation, which has recently stabilized, to rise again. Capital outflows are also a problem. If the interest rate gap with the U.S. widens and the exchange rate rises, capital outflows may increase. Considering inflation and capital outflows, the foreign exchange authorities should lower the exchange rate, but taking into account exports and the East Asian currency war, they face a dilemma of needing to raise the exchange rate.

The solution available to policymakers is to maintain an appropriate exchange rate through intervention in the foreign exchange market. When capital liberalization and a floating exchange rate system are chosen, market exchange rates often fall below appropriate levels, causing crises. Excessive capital inflows lower the exchange rate below appropriate levels, reducing exports. For this reason, Hong Kong, Singapore, and China have adopted basket exchange rate systems, and Singapore's monetary authorities periodically announce appropriate exchange rates. However, such fixed exchange rate systems have the disadvantage of making independent monetary policy difficult, so most stable advanced economies choose floating exchange rate systems.

South Korea, with higher growth rates and interest rates than advanced countries, has chosen capital liberalization and a floating exchange rate system, resulting in market exchange rates often being lower than appropriate levels due to foreign investment inflows, and exchange rate volatility is also high. Therefore, although the foreign exchange authorities cannot raise the exchange rate as much as Japan, they need to manage the won-dollar exchange rate at an appropriate level through market intervention to prevent the won-yen exchange rate from falling below the 900 won level.

Additionally, excessive exchange rate volatility caused by inflows of foreign stock investment funds must be reduced. Increasing exports to maintain a current account surplus will help prepare for additional U.S. interest rate hikes in the second half of the year and reduce the risk of capital outflows. Preventing excessive economic recession through domestic demand stimulation is also important to avoid sudden outflows of foreign stock investment funds.

The Korean economy is exposed to risks both externally and internally. Externally, it faces the risk of additional U.S. interest rate hikes and the East Asian currency war involving Japan and China; internally, the possibility of financial instability due to inflation and high interest rates is increasing. With additional U.S. interest rate hikes expected, cautious policy choices by policymakers are more necessary than ever.

Jungsik Kim (Emeritus Professor, Department of Economics, Yonsei University)