[Insight & Opinion] Concerns Rise Over Sharp Surge in Exchange Rate

The upward trend in the exchange rate is becoming serious. Initially, it was expected that if the U.S. cut interest rates sharply by 0.5 percentage points, the Korean won exchange rate would fall to the high 1200 won range. This was because the rise in the exchange rate from the 1000 won range before the COVID-19 pandemic to the 1400 won range was seen as purely due to the U.S. interest rate hikes. However, contrary to expectations, the exchange rate has surpassed 1380 won. Considering the side effects of the sharp rise in the exchange rate, it is urgent for policy authorities to devise countermeasures.

First, the rising exchange rate increases import prices, which can reignite inflation and deepen domestic demand stagnation due to high interest rates. Before lowering interest rates, the Bank of Korea was paying attention to rising housing prices and increasing household debt but was cautious about the rising exchange rate. If the exchange rate rises, import prices increase, making it difficult to lower interest rates due to the risk of inflation resurgence. Moreover, high interest rates increase interest burdens, reducing consumption capacity and deepening domestic demand stagnation, while also potentially spreading financial instability. If the interest rate gap with the U.S. widens and the exchange rate rises, capital outflows are also a concern. Although a rising exchange rate can increase exports, the losses may outweigh the gains.

Another issue is the high likelihood that the current high exchange rate trend will continue. The main reason for the rising exchange rate is the possibility of a sustained U.S. economic boom. We are currently in an era of industrial revolution where new technologies are developed and new industries are fostered. New industries such as electric vehicles, autonomous vehicles, biotechnology, and drones are emerging due to advances in artificial intelligence (AI) and semiconductors, with the U.S. leading investments in new technologies. This underpins forecasts that the U.S. potential growth rate will remain high for a considerable period. Additionally, regardless of whether Donald Trump or Kamala Harris wins the U.S. presidential election in November, strong support for domestic manufacturing production in the U.S. is expected. Due to the U.S. economic boom and concerns about inflation resurgence, the pace of U.S. interest rate cuts is slowing, and the won exchange rate is surging amid expectations of a strong dollar.

Unstable global geopolitical factors and the difficult situation of the Korean economy are also factors behind the high exchange rate. Despite Hamas's recent weakening, the Middle East situation remains unstable. The conflict between Ukraine and Russia also heightens global economic uncertainty. Recently, North Korea’s deployment to Ukraine and strengthened military cooperation with Russia have further destabilized the Korean Peninsula situation. These uncertainties increase demand for the safe-haven U.S. dollar, pushing up the exchange rate.

To respond to the sharp rise in the exchange rate, increasing foreign exchange market intervention to lower the exchange rate could further reduce the already significantly diminished foreign exchange reserves. While foreign exchange authorities should intervene to reduce exchange rate volatility, they must be cautious about excessive intervention aimed at lowering the exchange rate. Instead, policy focus should be on mitigating the side effects caused by the rising exchange rate. To stabilize living costs, agricultural imports should be expanded, and the distribution and logistics system should be digitized to reduce transaction costs. Additionally, the increase in electricity rates, which greatly affects agricultural product prices, should be restrained. Next, active stimulation of domestic demand is necessary. To revive domestic demand, temporary increases in fiscal spending and increased housing supply with established transportation infrastructure should be implemented to boost the construction industry closely linked to domestic demand. It is also important to brighten the future vision of the Korean economy through new industrial policies.

The sharp rise in the exchange rate is the Achilles' heel of the Korean economy. Relying solely on the current account surplus from the semiconductor boom and becoming complacent could expose the Korean economy to crisis. With the exchange rate surging now, careful policy choices by authorities are more important than ever.

Kim Jeong-sik, Professor Emeritus, Department of Economics, Yonsei University