The Highest Exchange Rate in 26 Years Caused by Low Growth... Concerns Over 1400 Won Fixation [The Fall of the Won]①

The won's value falls to its lowest level since the IMF crisis
Political turmoil pushes the won-dollar exchange rate even higher after economic decline
Without structural reform, low growth will become entrenched and high exchange rates cannot be prevented

The value of South Korea's currency has fallen to its lowest level since the 1997 foreign exchange crisis. It is also the first time since the crisis that the won has depreciated for three consecutive years, a phenomenon interpreted as a result of the increasingly difficult economic situation. There are concerns that without economic improvement, the high exchange rate around 1,400 won will become entrenched in the long term.

On the 7th, stock prices and exchange rate indices were displayed on the status board of the Hana Bank dealing room in Jung-gu, Seoul.

The average won-dollar exchange rate soars to levels similar to those during the IMF crisis

According to the Bank of Korea on the 10th, last year's average won-dollar exchange rate was about 1,364 won, the highest in 26 years since it recorded 1,395 won in 1998. The won's value fell to a level comparable to the period of the worst economic crisis in history, when the foreign exchange crisis led to a downgrade of the country's credit rating and corporate bankruptcies.

The annual average won-dollar exchange rate has risen for three consecutive years from 2021 to last year. This is the first time since 1996 to 1998 that the exchange rate has increased for three consecutive years. The upward trend continues this year as well, with the average won-dollar exchange rate in January rising to 1,455 won.

Even when calculated using the real effective exchange rate, which takes into account the prices and purchasing power of comparison countries rather than the nominal exchange rate shown in figures, the won's depreciation was among the lowest worldwide. According to the Bank for International Settlements (BIS), as of the end of December last year, South Korea's real effective exchange rate index was 91.03, the second lowest among 64 BIS member countries after Japan. This indicates that the won's real value is considerably low, not just nominally.

The rising won-dollar exchange rate that has continued for several years is partly due to recent political reasons such as martial law and impeachment, but a deeper analysis shows that the fundamental causes are South Korea's economic low growth and weakening competitiveness.

According to the Korea Institute of Finance, periods when the won's value sharply declined always coincided with times when South Korea's economy was sluggish due to deteriorating domestic and external conditions. These include the 1997 foreign exchange crisis, the 2000 dot-com bubble burst, the 2008 global financial crisis, and the 2020 COVID-19 pandemic. In particular, in 2008, the fourth-quarter economic growth rate plunged to -3.4%, the largest drop since the foreign exchange crisis, and the won-dollar exchange rate surged by more than 50% from the 1,000 won range to the 1,500 won range within half a year, experiencing a rapid depreciation of the won.

South Korea's economic growth rates have been on a general downward trend, with 2.7% in 2022, 1.4% in 2023, 2.0% in 2024, and 1.6% this year (Bank of Korea forecast), which is analyzed as a significant cause of the sustained depreciation of the won over the past few years.

The Korea Institute of Finance diagnosed that the recent rise in the won-dollar exchange rate continues due to the slowdown in South Korea's economic growth, the strong U.S. economy, and the global dollar strength resulting from high interest rate policies. It added that political uncertainties such as presidential impeachment can cause temporary sharp rises in the exchange rate, but after political uncertainties ease, the exchange rate tends to fall significantly, indicating that political uncertainty is not a fundamental factor driving the exchange rate upward.

Jang Min, a senior researcher at the Korea Institute of Finance, explained, "There are various causes of instability in the foreign exchange market, but the magnitude and speed of the won-dollar exchange rate increase are greatly influenced by the domestic economic conditions and vulnerabilities at the time. Political uncertainty can temporarily cause sharp exchange rate spikes or increase volatility, but it does not act as a fundamental factor for a sustained rise in the exchange rate."

Without structural reform, low growth will become entrenched and high exchange rates cannot be prevented

Ultimately, to prevent further depreciation of the won, a rebound in the growth rate through economic recovery in South Korea is essential. However, since South Korea's economic growth rate continues to decline, it is likely to take considerable time for the exchange rate to stabilize.

The government forecasts that South Korea's economic growth rate will be only 1.8% this year, and the Bank of Korea is expected to lower its economic outlook to 1.6-1.7% in this month's report. Major foreign investment banks (IBs) are also lowering their growth forecasts for South Korea one after another. Citi recently lowered its growth forecast for South Korea this year from 1.5% to 1.4%, and JP Morgan also cut it from 1.3% to 1.2%. If these forecasts materialize, it will be the lowest level since the negative growth recorded during the 2020 COVID-19 pandemic.

Choi Ye-chan, a researcher at Sangsangin Securities, argued, "Considering structural undervaluation factors such as demographic structure and division, domestic political stability issues, and the U.S.'s protectionism and anti-China policies, the won's position will continue to weaken, and after 2029, a won-dollar exchange rate of 1,500 won could become the new normal."

The downward trend in potential growth rate, which can predict South Korea's future economic growth rate, is also serious. According to the Bank of Korea's economic modeling office, the potential growth rate, which was around 5% in the early 2000s, fell to the low to mid-3% range in the 2010s, then dropped to the mid-2% range from 2016 to 2020, and currently stands at 2%. The potential growth rate refers to the maximum economic growth rate achievable without causing inflation when all production factors such as capital and labor are fully utilized. It is the maximum growth achievable with the highest effort using available resources.

The main reasons for the trend decline in South Korea's potential growth rate are structural factors such as population decline, productivity slowdown, and decreased investment, which have reduced overall economic vitality. A bigger problem is that due to low birth rates and aging, South Korea's potential growth rate is expected to fall to the low 1% range in the 2030s and plunge to the 0% range in the 2040s. There are serious concerns that long-term low growth will become entrenched, accompanied by high exchange rates, weakened national competitiveness, and stagnation in per capita national income.

The Bank of Korea emphasized that to effectively raise the potential growth rate, structural reforms to improve productivity across the economy are necessary. Lee Eun-kyung, head of the Bank of Korea's economic modeling office, stressed, "To effectively raise the potential growth rate, structural reforms are needed, such as improving inefficiencies in the labor market, inducing efficient allocation of resources, improving the corporate investment environment, and fostering innovative companies to enhance productivity." She added, "To mitigate the slowdown in labor supply caused by low birth rates and aging, active responses through policies such as easing concentration in the metropolitan area and promoting work-family balance are required."