- USDKRW has been driven by relative trade surpluses and deficits
- Interest rate differentials appear to have little influence on USDKRW
- High private sector debt, low inflation explain why South Korean rates remain low
- Low government debt gives public sector substantial borrowing capacity
Since the beginning of 2021 the Korean won (KRW) has fallen by about 7% versus the U.S. dollar (USD), and has been trading within a relatively narrow 20% range against the USD since 2010. Currently, it is almost exactly in the middle of that range.
USDKR has not always been such a docile currency pair. From 1995 to 2010, USDKRW made a series of extremely significant moves. From the end of 1995 to the end of 1997, USD rose by 160% versus KRW during the Asian crisis. KRW spent the next decade rebounding, rising 110% versus USD, peaking at the end of 2007. The dollar soared 77% versus KRW during the onset of the Great Recession in 2008.
Investors’ initial reaction to the 2008 global financial crisis was to fear a repeat of the 1997 Asian crisis. Late in 2008, however, well before the equity market hit bottom in 2009, currency investors concluded it was different this time, at least in so far as South Korea was concerned. The factors that had led to the crash of KRW in 1997 were largely absent in 2008.
Prior to KRW’s 1997 slide, South Korea had spent years running trade deficits that were similar in size to those of the U.S., and sometimes even larger. Persistent trade deficits for the U.S. reflect, in part, the dollar’s status as the primary global reserve currency. This creates a substantial capital account surplus for the U.S., which on the other side of the ledger means running a current account (trade) deficit of a similar size. While the market appears to tolerate the persistent U.S. trade deficit for this reason, investors show less tolerance of persistent trade deficits from other countries.
The 1997 KRW bear market worked its magic. A weaker KRW made Korean exports extremely competitive. The country moved from running trade deficits to notching trade surpluses as it exported its way to recovery (Figure 1). The recovery in South Korean exports facilitated the 1998-2007 rebound in KRW. The only time since 1998 that South Korea had come close to running a trade deficit was in 2008, at the onset of the global financial crisis. The consistency of trade surpluses in South Korea and trade deficits in the U.S. may explain why USDKRW has been so stable since (Figure 2).
Figure 1: South Korea ran trade deficits pre-1997 and has mostly run surpluses since
Figure 2: Persistent Korean trade surpluses & U.S. deficits has kept USDKRW rangebound since 2010
A similar but less pronounced difference between the U.S. and South Korea relates to budget deficits. While the U.S. has run budget deficits, including large ones at times, since 2002, South Korea has mostly run budget surpluses in the 0-2% of GDP range, with occasional exceptions including a 3.6% of GDP budget deficit in 2020 that was a fraction of the U.S. fiscal deficit of nearly 20% of GDP last year.
USDKRW appears to be relatively impervious to other factors that typically drive exchange rates. For example, pre-2009, the interest rate differential between the South Korean Official Bank Rate and the U.S. Fed funds rates moved roughly in tandem with USDKRW (Figure 3). Since 2009, the currency pair no longer appears to take much direction from changes in short-term interest rate differentials between the two countries.
Figure 3: Interest rate differentials appear to have little influence on USDKRW recently
The lack of focus on short-term rate differentials may stem from the fact that investors in both South Korea and the U.S. see both central banks as having the credibility to keep prices stable over long periods of time. As such, investors showed little reaction on Bank of Korea’s (BOK) recent rate hike. That said, the prospect of potentially tighter Fed monetary policy in the U.S, may be attracting funds to U.S. dollar bonds and may explain some of the recent weakness in KRW.
Another reason why interest rate differentials don’t appear to explain the USDKRW exchange particularly well is that South Korean interest rates have converged towards zero over time. Even after the BOK’s recent rate hike, South Korean rates are still only at 0.75%. The low level of South Korean interest rates reflects stable inflation (Figure 4) as well as the substantial growth in South Korea’s total level of debt (public + private). South Korea’s total level of debt has risen from around 150% of GDP in 2000 to nearly 260% by early 2021. As such, South Korea is discovering like Japan, Europe and the U.S. that the easiest way to finance large levels of debt is through near zero interest rates. As such, currency investors might remain more focused on trade and fiscal deficits/surpluses as well as growth differentials.
Figure 4: South Korea’s inflation rate has been low and stable for the past two decades
South Korea has a low level of government debt but quite high levels of private sector debt (Figure 5). High levels of private sector debt usually don’t pose problems until there is substantial monetary tightening by the central bank. Should South Korea ever experience financial stress in its private sector, the country’s public sector could likely step in by cutting taxes, raising spending or otherwise bailing out the private corporations. Doing so would likely weaken KRW but for the moment that seems like an unlikely prospect.
Figure 5: South Korean debt levels have risen, especially in the private sector
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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.