Corporation of South Korea and Exchange Rates
Exchange rates are essentially prices that move according to supply and demand. If an item becomes common, its price falls; if many people want it, the price rises. The same goes for foreign currencies: if there’s an ample supply, its value decreases; if demand is high, its value increases. Thus, the USD/KRW exchange rate falls when dollars are abundant in Korea, and rises when there are fewer dollars.
Supply and demand reflect the intrinsic value of the products being traded. For example, while stock prices are determined by the supply and demand at any given time, these in turn reflect the fundamental value of the company. In this sense, a country’s currency behaves similarly to company stock prices. Simply put, ‘a country’s currency is like its stock.’ However, since each stock has a different face value just as each country’s currency does, absolute numbers alone do not matter; what is important is the change in ratios.
The value of a stock is theoretically the present value of future earnings. Thus, a company’s value represents both its current and future income, which is reflected in its stock price. A company’s revenue is determined by its product competitiveness. Similarly, a country’s income is determined by its export competitiveness, and competitive countries record trade surpluses.
A nation’s currency value increases with a larger trade surplus. For instance, if exports increase and more dollars flow in, the dollar’s value will drop and conversely, the value of the Korean won will rise. If imports grow, leading to a dollar shortage or the need to borrow dollars, the dollar’s value will naturally increase.
Why can exports occur? Because, like businesses, a country can sell good products cheaply. Good products might be those not available in other countries or those of superior quality. Alternatively, it might be about the ability to produce the same goods more cheaply. The sum of these competitive factors constitutes a country’s export competitiveness. Therefore, the more competitive firms there are exporting numerous goods, the higher the currency value of that country will inevitably be.
However, there’s another variable. If risks are equal, stocks with higher returns or bonds with higher interest rates issued by one company will attract more investors. The same applies to a country’s currency value. Considering the risks, a currency expected to offer high returns will appreciate. Therefore, if a country’s interest rates rise, its currency value is also expected to rise.
How can such future earnings be reflected in exchange rates? Here too, adjustments are made through arbitrage in currency markets, a concept known as Interest Rate Parity (IRP). In practice, if a country’s interest rates increase, its currency value is presumed to rise. An example is the early 1980s in the USA when interest rates rose, attracting foreign capital and consequently increasing the dollar’s value—this refers to the period of the US twin deficits.
However, for interest rate parity to function, two conditions are necessary. First, the efficiency of the foreign exchange market is a prerequisite, so either futures or spot currency markets must be active. Second, the political and social risks of the countries involved must be similar. Political risks include the possibility of central bank intervention in the forex market, constraints on capital and currency exchanges, and potential changes in tax rates on interest payments to foreign investors. The creditworthiness of each country’s financial products is rated based on risk, one measure of which is the CDS premium.
A CDS (Credit Default Swap) can be translated into Korean as ‘신용부도스와프,’ essentially an insurance premium against risk, a new type of financial derivative traded on the market that isolates a company’s credit risk. For example, a bank in Korea might engage in a CDS transaction with a financial company in London to hedge against the default risk of a specific company. If the contracted company defaults, the London financial company will repay on its behalf.
Such CDS transactions can also occur with Korean government bonds, thus CDS premiums exist for them as well. A CDS premium essentially being an insurance fee, a high premium indicates increased risk, suggesting a depreciation in the related currency value. This logic is straightforward. Therefore, just because someone predicts a decline in value due to rising CDS premiums does not qualify them as an economic expert.
As the risk levels of financial products vary between countries, it is difficult to believe that exchange rates are determined solely by interest rates. However, it is undeniable that changes in interest rates do affect exchange rates.
A country’s currency value is influenced by the amount of money it issues. Changes in the money supply affect interest rates. Particularly, issuing new currency is similar to a company conducting a bonus issue—increasing the number of shares without increasing capital, theoretically not increasing overall value while increasing the number of shares. If currency issuance exceeds actual production, the value of the currency will inevitably fall.
Inflation means that, relatively speaking, the value of currency declines. If the value of goods remains the same, but more money is required to purchase them, this is an instance of rising prices. Thus, inflation is reflected in the market as a decrease in the currency value or ‘purchasing power.’
Let’s use the Big Mac as an example. Assume the current exchange rate is 1000 KRW/USD, and in both Seoul and Los Angeles, a Big Mac costs 1000 won. If the price in the U.S. suddenly rises to $2 while it remains 1000 won in Korea, there would be pressure to adjust the exchange rate to 500 KRW/USD.
The most immediate effect on exchange rates is liquidity. Just as a company can go bankrupt in a surplus, a lack of foreign exchange liquidity can destabilize a country’s currency value. If there is an anticipated shortage of foreign currency needed to repay debts, the currency value might drop. Ideally, in an efficient currency market, such a situation shouldn’t occur. In practice, however, even profitable companies can face immediate cash shortages, similar to the situation during Korea’s 1997 financial crisis and the global financial crisis at the end of 2008 and early 2009, which emphasized the importance of securing dollars due to liquidity issues.
The international financial market is highly sensitive to even small interest rate differences, showing that international capital can move based on minor rate changes. In Korea, there is a call rate for short-term interbank money transactions, while internationally, the LIBOR (London Inter-bank Offered Rate) applies. It is the benchmark short-term interest rate among highly regarded banks in London’s financial market.
When borrowing abroad or securing loans, financial institutions typically use the LIBOR rate. Korean financial institutions usually add about 0.125% to the LIBOR rate to fund themselves, then add a margin of 1-1.5% when supplying these funds to domestic companies. Consequently, domestic companies can access funds at rates around 5% annually, cheaper than domestic loans. However, indiscriminately increasing foreign borrowing due to low interest rates can lead to side effects like increased external debt and domestic currency supply.
There are alternatives to simply borrowing dollars, such as through currency swaps (CRS-Currency Rate Swap). For example, the 2008 currency swap between Korea and the U.S. resembles a bilateral currency swap agreement between financial institutions. Typically, a currency swap involves exchanging won for dollars, paying interest on the dollar based on LIBOR, while receiving a fixed interest on the won. This allows our financial institutions to obtain dollars and the counterparties to invest in Korean financial products like government bonds. The interest received on the swapped won is the currency swap rate.
If the CRS rate decreases, it means there is high demand for dollars even if it involves receiving less interest on the won. Further, if this rate turns negative, it means paying extra interest on the dollar on top of not receiving interest on the provided won. Therefore, a falling CRS rate suggests a devaluation of the currency. Thus, saying the currency value will decrease as the CRS rate falls does not necessarily qualify one as an economic expert.
In volatile markets with liquidity issues, exchange rates cannot be determined by interest rates alone. When liquidity is scarce, cash, especially the highly liquid dollar, is preferred. This is evident as 76% of the world’s foreign exchange reserves are in dollars, highlighting the dollar’s importance as the world’s primary reserve currency.
Moreover, since most international transactions are contracted in dollars, there’s a natural preference for the dollar in trade. In a financial crisis, currencies close to being reserve currencies appreciate in value, while the won may depreciate more significantly.
Lastly, the existence of speculative forces aiming for exchange rate differentials cannot be ignored. The NDF (Non-Deliverable Forward) market, notably in Hong Kong and Singapore, serves as a speculative arena where futures are traded, and the physical currencies are not exchanged. Instead, the difference between the contracted forward exchange rate and the spot rate at maturity is settled in the designated currency. This market is particularly active in trading the won in Singapore and Hong Kong, where hedge funds predominantly operate.
To recap, if the supply of dollars from foreign transactions exceeds the demand, the exchange rate falls; conversely, if the supply is less than the demand, the exchange rate rises. For instance, if foreigners import many South Korean cell phones, more dollars will be supplied to Korea, causing the exchange rate to fall and the won’s value to rise. If our country’s interest rates are higher than abroad, foreign investors seeking higher returns will bring more dollars into Korea, similarly increasing the dollar supply and lowering the exchange rate. Conversely, if international oil prices soar, the need to buy dollars for oil payments will push up the exchange rate. Additionally, if our country’s banks and businesses have substantial foreign debt, the potential for a sharp rise in the exchange rate increases.
