[Q&A] Lee Chang-yong: "If High Exchange Rate Persists, the Divide Between Winners and Losers Will Sharpen... The Situation Is Not Reassuring"

Lee Chang-yong, Governor of the Bank of Korea, Holds Briefing on Inflation

On the 17th, Lee Chang-yong, Governor of the Bank of Korea, stated, "Although the current high exchange rate does not constitute a financial crisis in the traditional sense, its impact on inflation and the polarization of economic growth is significant," adding, "In that respect, it is a crisis, and I do not believe the situation is one where we can be at ease."

Lee Chang-yong, Governor of the Bank of Korea, is speaking at the briefing session on the status of inflation targeting held at the Bank of Korea in Jung-gu, Seoul on the 17th. Photo by Yonhap News Agency Joint Press Corps

Governor Lee made these remarks at a press briefing on the status of inflation target management held at the Bank of Korea headquarters in Jung-gu, Seoul, on the same day. He said, "It can be called a crisis, but its nature seems to be very different from the past."

He continued, "People tend to think of an exchange rate crisis in terms of the 1997 IMF crisis or the 2008 financial crisis, but we are now a net creditor nation, so there are actually many who benefit from a weaker won due to our significant overseas assets. I do not fully agree that this is a financial crisis in the traditional sense."

However, he pointed out, "The impact on inflation is considerable, and when the exchange rate rises, there is a sharp divide between those who benefit and those who lose domestically. The widening gap caused by the rising exchange rate could create a social environment where social cohesion becomes even more difficult," adding, "In this sense, it can be called a crisis, and my concerns are substantial."

The following is a Q&A session.

(From left) Lee Chang-yong, Governor of the Bank of Korea, Kim Woong, Deputy Governor, and Lee Jiho, Director of the Research Department, are speaking at the briefing on the status of inflation target management held on the 17th at the Bank of Korea in Jung-gu. Photo by Yonhap News Agency Joint Coverage Team

- There seem to be differing views on whether the recent high exchange rate constitutes a crisis. What is the Bank of Korea's perspective?

▲It can be called a crisis, but its nature is very different from the past. In previous crises, such as the 1997 IMF crisis or the 2008 financial crisis, the won depreciated due to an inability to cover foreign debt, leading to financial institutions collapsing and the country facing the risk of national default. However, as we are now a net creditor nation, there are actually many who benefit from a weaker won due to our significant overseas assets. I do not fully agree that this is a financial crisis in the traditional sense. In that respect, my concerns are lessened, but in other respects, it can still be considered a crisis, and I am quite concerned.

▲Simply put, the impact on inflation is not insignificant. When the exchange rate rises, there is a sharp divide between those who benefit and those who lose domestically. While our economy is being sustained by strong exports in sectors like semiconductors and shipbuilding, importers are struggling, and there are domestic sectors such as construction and self-employed businesses. The rising exchange rate could further widen this gap, creating a social environment where social cohesion becomes even more difficult. Considering the polarization of inflation and growth caused by the exchange rate, I do not believe the situation is one where we can be at ease.

- Regarding the recent discussions by the foreign exchange authorities on stabilizing the exchange rate, and the swap with the National Pension Service, are these measures aimed at reducing volatility or at lowering the exchange rate level itself?

▲Of course, we monitor volatility, but as we see it, despite the exchange rate starting in the low 1,400 won range and the US dollar stabilizing, the won has continued to depreciate for some time due to significant domestic factors. We believe that unnecessary increases in the exchange rate have occurred due to these internal factors, so we are considering whether there are aspects we can manage not only in terms of volatility but also in terms of the exchange rate level itself.

▲Additionally, in December, trading volume decreases, which can lead to greater exchange rate volatility due to supply and demand factors. We are responding by adjusting these supply and demand factors through various internal discussions. As announced yesterday, the National Pension Service and the Ministry of Health and Welfare have agreed to coordinate policies, considering the macroeconomic impact of the National Pension Service's activities, for which we are very grateful.

▲One more point: since we keep talking only about supply and demand factors regarding the exchange rate, there may be misunderstandings that we are blaming others or ignoring medium- to long-term factors. The significant depreciation of the won is, of course, also influenced by the large gap in economic growth rates and interest rates between Korea and the US, as well as the so-called Korea Discount in our stock market. We do not deny these are important factors, but it will take considerable time to address them. As policymakers, we cannot only talk about issues that take a long time to resolve, so we need to adjust short-term supply and demand factors as well. I hope this is not seen as blaming any particular group.

▲There are also claims that the 20 billion dollars in Korea-US investment is a persistent factor in the depreciation of the won, but the investment is structured so as not to affect the foreign exchange market. According to the bill submitted to the National Assembly, the Bank of Korea is to provide funds through interest and dividend income from foreign reserves, and we have no intention of providing funds at a level that would threaten the foreign exchange market. As the Bank of Korea is responsible for this, the notion that US-bound investments are causing a long-term depreciation is, in our view, excessive. We will manage this appropriately.

- Is the focus on the exchange rate level related to inflation management?

▲The focus on the exchange rate level is not solely for inflation management. The current level may be due to internal issues, so it is necessary to monitor it. The National Pension Service's overseas investment tools are operated with such transparency that the timing and amount of outflows are widely known, including when hedging will be discontinued. As a result, there are expectations that the exchange rate will move in that direction, and investors act accordingly. Therefore, I suggested that the internal tools should be less transparent. At yesterday's National Pension Service meeting, it was announced that strategic currency hedging would be made less transparent, which I consider significant progress. If such issues did not exist, monetary and foreign exchange policy should, of course, focus on volatility rather than the level itself.

- If the won-dollar exchange rate remains in the 1,470 won range next year, by how much could inflation rise?

▲Lee Jiho, Director of the Research Department / If the current exchange rate level continues, we expect inflation to rise by 0.2 percentage points. The forecast for next year is 2.1%. So it could rise to 2.3%. Since there may be some fluctuation, we are expressing it as the low-to-mid 2% range.

- If the exchange rate stabilizes or falls further, could next year's inflation rate drop to the 1% range?

▲Kim Woong, Deputy Governor / We currently see core inflation as stable at 2%. While we cannot guarantee it, we set next year's inflation forecast at 2.1% based on this assessment.

- The government has stated that expansionary fiscal policy will be unavoidable until 2027. From the perspectives of inflation stability and economic stimulus, what is your view on the continued use of expansionary fiscal policy?

▲When we set interest rate policy, we do not consider fiscal policy as a direct variable. Instead, we look at how fiscal policy affects inflation and price stability. The medium- to long-term fiscal soundness itself is not a direct consideration. Earlier this year, when there was an exceptional need for a supplementary budget, the growth rate was close to 1% and inflation had fallen significantly, so an expansionary policy was necessary. As for how such fiscal policy will affect our monetary policy, we will have to see whether next year's growth rate of 1.8% and inflation rate of 2.1% are achieved, and how growth will develop thereafter. It is too early to make a judgment now.

- When do you expect the outline of the National Pension Service's new framework to become clear?

▲We are continuously holding meetings with policymakers. Many expect quick results, but while the issues are recognized, each ministry has different views on how changes should be made, and the Ministry of Health and Welfare and the National Pension Service headquarters, as the main authorities, must make the final decision, which could take time. We are making every effort to expedite the process, but it cannot be resolved in just a day or two. Therefore, even before the new framework is introduced, we are working to stabilize the market through policy measures. The Bank of Korea plans to provide theoretical support and research to the Ministry of Health and Welfare during the process of developing the new framework.

▲In my view, there are three things I hope the new framework will address. First, the timing and decision-making process for initiating and discontinuing currency hedging are currently too transparent, making it easy to form a trading range and creating a risk of one-sided moves. It would be helpful if the process were less transparent, so we are not revealing all our strategies. Second, the National Pension Service's performance and returns are currently evaluated entirely in won. When funds are sent overseas, this acts to depreciate the won, and although the returns may appear high in accounting terms, if the won appreciates when the funds are brought back, the returns fall. We need to discuss how much to hedge, how to flexibly adjust returns, and what kind of returns should be used for incentives, taking into account the long-term impact on the exchange rate. For reference, I believe the case of Taiwan in May and June offers many lessons. Taiwanese insurance companies made significant overseas investments without hedging, but as Taiwan's exports increased and the Taiwan dollar appreciated, insurance companies suffered huge foreign exchange losses, which became a major burden on Taiwan's domestic market. The authorities and insurance companies are now reconsidering the rules for managing currency risk. There is no guarantee that we will not face similar circumstances. This is an issue that individual investors should also consider. Third, the National Pension Service has become a major player. The assets to be increased through parametric reforms will be large, and the macroeconomic impact is now very different from ten years ago. It is no longer desirable for the National Pension Service to ignore the macroeconomic impact when making overseas investments. Ten years ago, the diversification of the overall national portfolio was an advantage, but now, with the National Pension Service also investing abroad, we must consider the macroeconomic effects on the domestic stock market, employment, and so on, when managing assets.

- Will the high exchange rate seen throughout this year continue to affect next year or even the year after, and what is the long-term impact on inflation? When it comes to core inflation, it seems that supply-side pressures on service prices are greater than demand-side pressures, and the core inflation rate remains relatively high. Could this be due to expansionary fiscal policy, and if so, should we expect this effect to persist next year?

▲Lee Jiho / At the last inflation briefing, we explained that companies have been reflecting accumulated cost pressures from the COVID-19 crisis and its aftermath, and that this has had a lagged effect. Looking at next year and the year after, we believe much of the accumulated cost pressure has already been reflected. If this continues into this year, there could be a long-term impact, but that would require the current exchange rate level to remain unchanged. In fact, Brent crude oil has fallen below $60 for the first time since the COVID-19 crisis. In our forecast period, oil prices are weaker than initially expected, while the exchange rate is higher. Since these factors offset each other to a significant extent, we do not expect excessive inflation as a result.

▲Although the economy has not been strong, core inflation has remained at 2%. Some may argue that this is due to fiscal policy, but the puzzle this year has been why core inflation is so high relative to the level of economic activity. Our understanding is that when processed food companies face higher raw material costs, they do not reflect 100% of the increase at once, as that would mean ceasing business. Thus, the accumulated cost pressures have been reflected gradually, leading to a moderate increase in pressure.

▲At least until this year, we do not believe that expansionary fiscal policy has had an impact on core inflation. In the first quarter, growth was negative, and even combining the first and second quarters, growth was close to zero. There is, of course, a lag between growth and economic activity, but we do not believe the high core inflation this year was due to expansionary fiscal policy.

- Should we consider the possibility of the exchange rate reaching 1,500 won next year? If it does, how much would inflation rise? Conversely, what if it falls to the low 1,400 won range?

▲Kim Woong / On average, we estimate that a 10% increase in the exchange rate leads to a 0.3 percentage point rise in inflation. However, this must be considered alongside whether companies actually change their prices in response.

- In December, despite a significant decline in investments by overseas retail investors and purchases by the National Pension Service, the exchange rate has continued to rise. How do you assess this?

▲Rather than trading volume and outflows directly affecting the exchange rate, expectations about the exchange rate are shaped by ongoing trends. Even if trading volume decreases slightly, its relative share does not diminish. Moreover, expectations about future trading also influence exchange rate forecasts, so it is difficult to draw conclusions based on monthly changes in trading volume. Every December, there is a capital gains tax exemption limit for overseas stock investments-about 2.5 million won-so investors tend to realize gains up to that amount. Although activity has decreased this December, the decline is not large compared to usual, so the scale of domestic investors’ overseas investments remains significant. We are not blaming anyone, but rather discussing what can be done to change this trend. For now, our focus is on stabilizing this trend.

- Next year, the growth rate is expected to approach the potential growth rate, but you have previously stated that domestic demand and consumption are unlikely to exert significant upward pressure on inflation. Does this view remain valid for next year?

▲Lee Jiho / As stated during the November economic outlook briefing, next year’s economic growth rate is projected at 1.8%, but there is a large gap between IT and non-IT sectors, and the recovery is slow. If we look only at non-IT sectors, the growth rate is 1.4%. In this situation, it is unlikely that there will be strong inflationary pressure. Even if growth reaches 1.8% next year, we do not expect a broad-based inflationary phase.

- If the exchange rate remains at the current level and inflation stays in the low-to-mid 2% range after the first quarter of next year, how might this affect the current monetary policy path?

▲The textbook answer is that inflation is the first thing to watch. We will consider whether inflation remains at 2.3% and all related factors. I cannot comment on changing interest rate conditions at this point; we will monitor inflation and make decisions accordingly. However,when the interest rate decision was made in November, there was no mention of the possibility of a rate hike by the Monetary Policy Board for the next three months. Whether this situation will continue will be discussed again soon, and we will make a judgment based on the data at that time.