Is the High Exchange Rate Due to Excessive Liquidity?…Bank of Korea Says "Not True, Needs Correction"

Bank of Korea Posts on Exchange Rate Two Days in a Row
This Time: "Misconceptions and Facts About Recent Liquidity and Exchange Rate Conditions"
Money Supply-to-GDP Ratio Differs Across Countries Due to Financial Structure
Recently Stabilized...

The Bank of Korea has firmly refuted claims from some quarters that the recent rise in the won-dollar exchange rate was caused by an excessive supply of Korean won in the market. The central bank publicly criticized such logic, warning that if these arguments are amplified and reproduced as fact, they could actually trigger a further decline in the value of the won.

On January 20, the Bank of Korea posted an article titled "Misunderstandings and Facts about Recent Liquidity and Exchange Rate Conditions" on its official blog, making its stance clear. This follows International Department Director Yoon Kyungsoo's statement the previous day that "there is sufficient dollar liquidity in the market, but the exchange rate is rising because investors are only looking to buy dollars rather than sell." For the second consecutive day, the Bank of Korea has published blog posts to correct public misconceptions about the exchange rate.

In a Q&A format, Lee Goodgeon, Director of the Monetary Policy Department at the Bank of Korea, and other authors systematically refuted the argument that excessive growth in won liquidity has driven up the exchange rate.

Is the Money Supply Growth Rate Excessively High? "About Average Among Top 10 Economies, Lower Than the U.S."

The Bank of Korea first dismissed the claim that the recent growth rate of the money supply (M2) has been excessively high. The M2 growth rate surged to 11-12% during 2020-2021 in response to COVID-19, but has since fluctuated in the 4-5% range. The Bank of Korea pointed out that while there has been a slight rebound since 2024, the current level remains lower than the historical average. Even compared to the top 10 major economies, Korea's recent M2 growth rate is about average. Some argue that Korea's growth rate is higher than that of the United States, but the Bank of Korea noted that the U.S. has experienced the largest fluctuations among major economies. The U.S. saw its growth rate swing from a high of 27% to a low of -5% due to quantitative easing and tightening, indicating significant volatility.

In response to claims that the Bank of Korea supplied an excessive 488 trillion won in liquidity last year through repurchase agreement (RP) purchases, the central bank strongly countered that this is a misunderstanding arising from simply accumulating the RP purchase amounts, which greatly exaggerates the scale and reflects a lack of understanding of RP transaction mechanisms. RP purchases typically have a maturity of about two weeks, after which the reverse transaction automatically occurs and the funds are withdrawn. The Bank of Korea explained, "For example, if you borrow and repay 100,000 won every week for a year, your wallet doesn't hold 5.2 million won (100,000 won x 52 weeks), but only 100,000 won at a time." The central bank added that its open market operations, such as issuing monetary stabilization bonds and selling RPs, actually absorb a large amount of market liquidity (reserve balances).

The Ratio of Money Supply to GDP Has Stabilized Recently..."Simple Cross-Country Comparisons Are Inappropriate Due to Financial Structure Differences"

The Bank of Korea also assessed that the ratio of money supply to gross domestic product (GDP) has stabilized recently. Since the fourth quarter of 2022, this ratio has declined slightly and has since remained steady. This is attributed to the ongoing reduction in household debt and a slowdown in corporate lending. The Bank of Korea explained that, while the ratio has risen over the long term, this is a result of the steady expansion of the domestic banking sector as the financial industry has developed, and of increased financial support by banks during the COVID-19 response.

The central bank also pointed out that, due to differences in financial structures across countries, it is inappropriate to simply compare the money supply-to-GDP ratio between nations. Specifically, since the money supply represents cash-like assets deposited with deposit-taking institutions by economic agents, Asian countries with a high reliance on banks tend to have a higher ratio, while the United States, which relies more on capital markets, tends to have a ratio about half that of Korea.

The Bank of Korea categorically stated that there is no statistical basis for the argument, based on the purchasing power parity theory, that an increase in the money supply leads to higher inflation and, subsequently, a rise in the exchange rate. Purchasing power parity theory posits that if domestic prices rise relatively, demand for domestic goods shifts overseas, increasing demand for the dollar and thus raising the won-dollar exchange rate.

Upon analyzing data since 2005, the Bank of Korea found that the correlation between the difference in money supply growth rates between Korea and the U.S. and the rate of increase in the won-dollar exchange rate was only 0.10%. The central bank stated, "Some emphasize a connection by selectively using data from specific periods, but over the long term, there is almost no correlation, and recently, the relationship has even moved in the opposite direction. Nevertheless, claims not based on actual data are spreading through various channels in the market and are influencing expectations of a further rise in the exchange rate," expressing concern.

If Not Money Supply Growth, Why Has the Exchange Rate Risen?..."Result of Market Sentiment and Supply-Demand Imbalances"

The Bank of Korea analyzed that the recent rise in the exchange rate is not due to an increase in the money supply, but is largely the result of market sentiment and supply-demand conditions. In fact, from January to November last year, the current account surplus was 101.8 billion dollars, but residents' securities investment surged to 129.4 billion dollars, far exceeding the surplus and exerting upward pressure on the exchange rate. In other words, more dollars flowed out than came in. This trend has continued into this year.

The Bank of Korea stated, "The claim of excessive liquidity growth does not match objective facts, and the recent exchange rate situation also appears somewhat disconnected from economic fundamentals. The government and the central bank have implemented various market stabilization measures, and their effects are expected to appear with a time lag. We will continue to closely monitor market conditions and make efforts to mitigate excessive expectations and supply-demand imbalances."

However, the central bank dismissed calls from some quarters to respond directly to exchange rate stabilization through monetary policy measures such as interest rate hikes. The Bank of Korea said, "We do not operate monetary policy with the exchange rate as a direct target, but instead consider its impact on inflation indirectly. If monetary policy were to target the exchange rate directly, it could have significant side effects on the economy, negatively impacting various economic agents, and could even undermine exchange rate stability."