Where can one obtain the necessary data to understand the movements of exchange rates? Even if one understands the theory, what use is it without the necessary data? Firstly, it is essential to know about the balance of payments announced by the government. The balance of payments is a summary of the amount of foreign currency flowing in and out of the country over a certain period, divided into the “current account” and the “capital account.” In simple terms, the current account is related to PPP (Purchasing Power Parity), and the capital account is related to IPP (International Price Performance).
The current account primarily refers to the state of foreign currency resulting from the export and import of goods, services, and labor due to a country’s production activities. Advanced countries like the United States and Japan see a significant impact of economic growth rates on exchange rates, whereas empirical analysis shows that the current account is crucial for countries like South Korea. The capital account, on the other hand, refers to the state of pure capital inflow and outflow, not related to production activities. These two accounts move independently, but their sum, the balance of payments, affects the exchange rate. Thus, understanding the movements of exchange rates requires connecting all of the above points.
The Effect of Exchange Rate Changes on the Economy
For ordinary people who rarely deal with foreign currency, exchange rates may seem like a distant concern. However, due to the characteristics of its industrial structure, no one in South Korea is immune to their effects. Let’s consider how changes in exchange rates impact the economy.
How do movements in foreign exchange affect the economy?
Many will remember the surge in the dollar following the 1997 financial crisis, peaking at 1,800 KRW at the beginning of 1998. By the end of that year, the exchange rate had dropped to 1,200 KRW, showing a rapid decline of about 30% in just one year. Following this period of volatility, from March 2008, factors such as foreign investor withdrawal and a cumulative deficit in the current account, compounded by a global financial crisis, led to fluctuations between 940 KRW and 1,440 KRW until February 2009. The exchange rate has since stabilized, fluctuating between the 1,000 KRW and 1,300 KRW ranges up to today.
Firstly, it affects the currency. The influx of foreign exchange domestically is equivalent to the government increasing the money supply through the central bank. For example, if exports increase and dollars come in, the dollars could theoretically be used as currency. However, in reality, the influx of foreign currency eventually leads to an increase in the domestic currency supply, as banks purchase the foreign currency from the central bank, which in turn increases the money supply by buying government bonds from the banks.
The movement of foreign money into and out of Korea can increase or decrease the money supply, ultimately affecting economic indicators like inflation. According to the Bank of Korea’s “Analysis of the Impact of Exchange Rates on Prices Using the 2005 Input-Output Tables,” a 10% rise in the exchange rate in 2005 would increase consumer prices by 1.8% and producer prices by 3.0%. The greater impact on producer prices is due to Korea’s dependence on imports for most raw materials.
Secondly, it affects trade and capital movement. Intuitively, if the value of the won increases, imports increase, or, as seen during periods of yen appreciation in Japan, outflows of foreign currency due to the purchase of overseas assets increase. It’s a natural regulatory function at work.
Thirdly, it impacts corporate profits. For example, if the exchange rate rises from 900 KRW to 1,000 KRW per dollar, export companies benefit because they earn 1,000 KRW for every dollar earned without extra effort, increasing their sales revenue in won for the same dollar amount of exports. While a higher exchange rate may reduce the value of the country’s currency, it can increase sales and profits for exporters.
Fourthly, exchange rates ultimately affect real and financial assets. The return on stocks and bonds is influenced by exchange rate decisions. Conversely, changes in exchange rates can affect asset values. Typically, when the exchange rate rises, stock and real estate prices fall, and vice versa when the exchange rate falls, due to changes in supply and demand driven by the flow of foreign capital.
Korea, with exports accounting for about half of its GDP (45% in 2023), is heavily dependent on trade, making it particularly susceptible to the effects of exchange rates. While generalizations are difficult, exchange rates also represent the price of currency and thus form a cycle based on changes in supply and demand. For example, if an increase in exchange rates boosts exports and improves the current account balance, the expected profits for companies rise, attracting foreign investment funds. This leads to a rise in stock prices and bond values. As foreign capital increases, the value of the won appreciates, causing the exchange rate to fall. A decrease in the exchange rate is linked to an increase in imports and a decrease in exports. When the current account worsens, stock and bond prices fall, prompting foreign capital to leave. This situation can continue until the cycle returns to the beginning, with an increase in exchange rates.
Most countries are tempted to manipulate exchange rates, for instance, preferring a higher rate to boost exports. However, in the case of floating exchange rates, there is an inherent ability to self-adjust as demonstrated in the cycle described above. Inappropriate intervention in the foreign exchange market can distort market flows. Yet, there are countries where policies related to exchange rates constitute the entirety of their monetary policy because exchange rates significantly influence their economies. This is the case for countries with small economic scales and large degrees of openness to the outside world, such as Hong Kong and New Zealand.
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