[Economic Insight] Excessive Fiscal Expansion Inevitably Weakens the Won

The high exchange rate is a hot issue. This is due to the structural factor of a surge in overseas securities investments by so-called "Seohak Ants" (Korean individual investors in foreign stocks). Although there is talk that the National Pension Service's overseas investment amount is greater than that of Seohak Ants, the National Pension Service has always maintained a large volume of overseas investments. While the overall increase in the National Pension Service's fund management scale has had some effect, the recent surge and concentration of investments by Seohak Ants is much more pronounced. Some point to the annual $20 billion investment cap in the United States, imposed due to tariff negotiations, as another factor, but since this has not yet materialized and it remains uncertain how much will be invested next year, its impact is likely limited.

Another noteworthy factor is the government's monetary expansion. Despite the fact that under President Yoon Suk-yeol, the quarterly economic growth rate fell from 1.2% in the first quarter to -0.2% in the second quarter last year, the 2025 budget proposal announced at the end of August did not pursue aggressive expansionary fiscal policy, citing fiscal soundness. The managed fiscal deficit stood at 74 trillion won, or 2.8% of gross domestic product (GDP). The conventional wisdom is that whether in deficit or surplus, fiscal management should keep the ratio within 3% of GDP. While fiscal soundness may have been maintained, the economy was not. The third quarter growth rate last year was just 0.1%, and the fourth quarter was also limited to 0.1%. In the first quarter of this year, it dropped to -0.2%.

Ultimately, a supplementary budget had to be drawn up, and after two rounds of supplementary budgets, the managed fiscal deficit expanded to 112 trillion won, or 4.2% of GDP. While the effects of the new administration's launch played a role, fiscal policy, together with two base rate cuts (in February and May this year), clearly acted as a pump-priming measure, leading to a rebound in growth rates to 0.7% in the second quarter and 1.3% in the third quarter of this year.

The problem lies ahead. In the 2026 budget proposal announced at the end of August, the Ministry of Economy and Finance set the managed fiscal deficit at 109 trillion won, or 4.0% of GDP. The final budget bill passed by the National Assembly on December 2 set the deficit at 108 trillion won, or 3.9% of GDP. It made me wonder if they simply wanted to change the leading digit of the deficit-to-GDP ratio from 4 to 3, just for appearances. According to the Ministry's medium-term fiscal plan, the deficit-to-GDP ratio is projected to be 4.1% in 2027, 4.4% in 2028, and 4.1% in 2029.

No matter how much the Lee Jaemyung administration emphasizes the role of fiscal policy, maintaining fiscal deficits exceeding 4% every year and pursuing excessive expansionary policy is not desirable. If the government continues to inject so much money into the economy, it is only natural for the value of the won to decline. Looking at recent exchange rate trends: a year ago, due to the declaration of martial law, the won-dollar rate soared to around 1,480 won, but after the impeachment ruling in early April, it dropped dramatically, reaching around 1,350 won by the end of June. After the announcement of the 2026 budget and the medium-term fiscal plan through 2029 at the end of August, the exchange rate, which had remained below the 1,400 won mark, has been on a steady upward trend since then.

The Bank of Korea's growth forecast for next year is 1.8%, which is at the level of potential growth. On November 27, Bank of Korea Governor Rhee Changyong stated at a press briefing following the Monetary Policy Board's base rate decision that the GDP gap (actual GDP minus potential GDP) could turn positive as early as late 2026 or early 2027.

Despite this recovery in growth, the government still plans to pursue excessive fiscal expansion, with a deficit-to-GDP ratio exceeding 3% and even reaching the 4% range-measures typically reserved for times of economic downturn. While it is unclear exactly how much the Lee Jaemyung administration's excessive expansionary fiscal stance has contributed to the recent rise in the won-dollar exchange rate, it is certain that it has had a significant impact.

In its "Economic Outlook" released on December 2, the Organisation for Economic Co-operation and Development (OECD) stated, "The two rounds of supplementary budgets, amounting to about 1% of GDP (actually 1.4%), have had a temporary but direct effect in boosting growth." However, it also pointed out, "There are no measures to strengthen fiscal soundness, and despite increased corporate tax revenues, the government plans to maintain the managed fiscal deficit above 4% of GDP for the next several years." This is a stark contrast to the advice previously given by international organizations such as the International Monetary Fund (IMF) and the OECD, which had said, "Since Korea's national debt-to-GDP ratio is much lower than that of other countries, there is ample fiscal space, so it is acceptable to use fiscal policy during economic downturns."

The government has introduced various measures to stabilize the exchange rate and is likely considering new ones. However, the top priority should be to announce, "Once the economy recovers, we will return to a neutral fiscal stance."