[Insight & Opinion] The Need to Be Cautious About an Exchange Rate Crisis

Recently, the rapid surge in the exchange rate has heightened concerns about a currency crisis. Some argue that there is no need to worry because other countries are also experiencing delayed interest rate cuts by the United States, which is the cause of the exchange rate increase, and the rise in crude oil prices due to the Middle East situation is temporary. Additionally, they emphasize that the current account balance remains in surplus, lowering the risk of a foreign exchange crisis caused by a shortage of foreign currency.

However, the U.S. economy is performing well enough for the International Monetary Fund (IMF) to revise its growth forecast upward this year. Given the high likelihood of inflation reemerging in the U.S., a high exchange rate is likely to persist. The Israel-Iran conflict, currently in a lull, may escalate again after the U.S. presidential election in November. South Korea’s economy, which has a high dependence on external energy, experiences a larger increase in the exchange rate compared to other countries. Although the current account surplus reduces the risk of a foreign exchange crisis, the exchange rate crisis should be cautiously monitored due to inflationary instability and the possibility of currency speculation caused by the rapid rise in the exchange rate.

In fact, the exchange rate is an Achilles' heel for the Korean economy right now. While an increase in the exchange rate has the advantage of boosting exports, it raises import prices, which can trigger a resurgence of inflation. If prices rise again, the Bank of Korea will have no choice but to delay interest rate cuts, and the prolonged high interest rates could worsen the already sluggish domestic economy, spread financial instability, and deepen the public discontent revealed in the recent general election. Furthermore, concerns exist about the outflow of foreign investment funds due to increased foreign exchange losses and financial market instability. It is urgent for policymakers to devise measures to mitigate the rapid rise in the exchange rate and its side effects.

First, the domestic economy must be stimulated. When the exchange rate rises, the increase in import prices raises the cost of all goods and services, which can further depress the economy. This may lead to more closures of self-employed businesses and small merchants, making life harder for ordinary citizens. Since it is difficult to lower interest rates now, policymakers need to utilize fiscal policy to revitalize the domestic economy. Maintaining fiscal soundness is important, but economic recovery is more critical.

The government reduced the fiscal deficit as a percentage of GDP from a high of 5.8% in 2020 to 3.9% last year. Although below 3% is desirable, considering the lingering effects of the COVID-19 pandemic, this level is not alarming. Policymakers should be cautious of excessive populism but must expand fiscal spending for low-income groups to restore the domestic economy and reduce the side effects of the rapid exchange rate increase.

Measures to stabilize prices are also important. To curb inflation caused by rising import prices, it is necessary to postpone increases in energy and public utility charges during periods of rising exchange rates. Increases in energy and electricity prices raise the costs of all products and services, including agricultural products, thereby pushing up prices. Price increases, in turn, lead to wage hikes with a time lag, potentially trapping the Korean economy in a vicious cycle of wage-price inflation. Even if the government temporarily compensates energy companies’ losses caused by rising oil prices through fiscal measures, increases in energy prices and public utility charges should be postponed until the exchange rate stabilizes.

Intervention in the foreign exchange market to stabilize the exchange rate is also necessary. South Korea’s foreign exchange reserves peaked at $469.2 billion in 2021 but have since declined to $419.2 billion due to continuous market interventions. To prevent reserves from falling from the $400 billion range to the $300 billion range, excessive intervention that depletes reserves is undesirable. However, intervention to maintain an appropriate exchange rate and reduce excessive volatility is needed.

The exchange rate signals the soundness of a country’s economy. The rapid rise in the exchange rate is increasing uncertainty in the Korean economy. Political instability following the general election could further destabilize the exchange rate. To stabilize the Korean economy by reducing the rapid rise in the exchange rate and its side effects, the economic team’s correct policy choices are more important than ever.

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