This blog post examines whether a rising exchange rate directly signals a crisis for the Korean economy and calmly explains how exchange rates, base interest rates, and government policies interact.
Does a rising exchange rate really shake the economy?
From summer 2022 to fall 2023, the won-dollar exchange rate surged significantly. While exchange rates are inherently volatile indicators, during this period, it skyrocketed from the 1,250 won range to the 1,450 won range, then fell back, only to rise again to around 1,350 won, repeating this pattern. Regarding these exchange rate movements, many have argued that “since the exchange rate is rising sharply, the South Korean economy is in crisis, and the Bank of Korea should raise the base rate to lower the exchange rate, but its failure to do so is the root of the problem.”
At this point, three main questions warrant consideration. First, does a rising exchange rate immediately mean the economy is in crisis? Second, is the exchange rate necessarily something that must be lowered, and is it actually possible to lower it? Third, is raising the benchmark interest rate an appropriate choice to achieve this? Starting from a basic understanding of exchange rates, it is necessary to carefully revisit the discussion on the benchmark interest rate.
Daily Fluctuations in Exchange Rates
An exchange rate refers to the exchange ratio applied when converting currencies between two different countries. Since each nation uses its own currency, trading with other countries requires exchanging domestic currency for foreign currency via exchange rates. The most commonly encountered won-dollar exchange rate indicates how many won are equivalent to one dollar. Therefore, if 1 dollar goes from 1,000 won to 1,200 won, it means the dollar’s value has risen, and conversely, the won’s value has fallen.
Exchange rates are fundamentally determined by the demand and supply of currency. For example, if foreigners increase their investment in South Korea, demand for the won rises, causing the won’s value to increase and the exchange rate to fall. Similarly, when South Korean exports increase, foreign currency inflows occur, causing the exchange rate to move downward. Furthermore, when South Korea’s base interest rate rises, foreign capital anticipating interest income from the Bank of Korea flows in, increasing demand for the won and acting as a factor lowering the exchange rate.
Does a rising exchange rate then immediately signal reduced investment in the country and weak exports? While there is some correlation, it is difficult to conclude this solely based on that factor. The frequently cited won-dollar exchange rate is, as the name implies, the exchange ratio between the US dollar and the South Korean won. Consequently, it is significantly influenced not only by changes in the South Korean economy but also by shifts in the US economy. For instance, if funds concentrate in the US for specific reasons, the won-dollar exchange rate can rise even if there are no significant changes in the South Korean economy.
A simple way to verify this is to examine the exchange rate trends between South Korea and the US alongside those with other countries. From early 2022 through 2023, the won-dollar exchange rate rose sharply, yet the won-yen rate actually trended downward during the same period. While the won-euro rate also increased, it showed different movement patterns compared to the won-dollar rate. If the won’s value plummets sharply, causing its exchange rate to surge significantly while exchange rates with other currencies remain largely stable, this could be interpreted as a signal of a potentially severe economic crisis.
Indeed, during the 1997 IMF foreign exchange crisis, the won-dollar exchange rate skyrocketed from the 800 won range to the 1,900 won range within a few months. However, the exchange rate fluctuations observed in 2022 and 2023 were distinctly different from that level of extreme volatility. Furthermore, while foreign exchange reserves once fell to around $2 billion during the IMF crisis, subsequent consistent management has maintained South Korea’s reserves at approximately $400 billion as of 2024. This signifies that the defensive capability to respond to foreign exchange market fluctuations has strengthened incomparably compared to the past.
What happens if exchange rates are intentionally adjusted?
So, would artificially lowering the exchange rate help the economy? If the government absorbs won circulating in the market, controls won supply, or utilizes foreign exchange reserves, it could influence the exchange rate in the short term. However, excessive intervention in the foreign exchange market is highly likely to cause serious side effects.
Intentionally lowering the exchange rate artificially inflates the value of the domestic currency. While this may create the superficial appearance of a robust economy, it carries the risk of rapidly depleting foreign exchange reserves in the process. Indeed, the 1997 IMF foreign exchange crisis was decisively triggered by the reckless use of foreign exchange reserves to maintain a low exchange rate.
Conversely, intentionally raising the exchange rate can provide some benefit to exporting companies. However, this also means selling goods to foreign markets at relatively lower prices, effectively offering favorable conditions to foreign buyers. Moreover, recent observations show that as the dollar strengthens, South Korean exports actually slow down, making it difficult to conclude that a rising exchange rate always leads to increased exports. Thus, the relationship between exchange rates and exports is far more complex than commonly assumed.
For these reasons, opinions on raising or lowering exchange rates vary widely between countries and individuals. However, many market economies adopt an approach of minimizing direct intervention in foreign exchange markets, respecting market trends, and intervening only in a limited manner when sudden, sharp fluctuations occur in the short term. The desirable approach is to strengthen the economy’s fundamental health, naturally attracting foreign investors, which in turn leads to an appreciation of the won. The method of artificially adjusting the won’s value to make the economy appear healthier carries significant risks. Ultimately, it is more appropriate to view the exchange rate as a result of policy rather than a policy tool itself.
The Division of Roles Between the Government and the Central Bank
Another crucial factor influencing the exchange rate is the base interest rate. To simplify, when banks exist in both the US and South Korea, an increase in South Korea’s interest rates triggers capital flows driven by the interest rate differential. Consequently, some funds move from the US to Korea, increasing demand for the won and pushing the exchange rate downward.
One major reason for the won-dollar exchange rate’s rise since 2022 is that the US Federal Reserve’s rapid and substantial interest rate hikes significantly boosted the dollar’s appeal. When the U.S. raises its benchmark rate, demand for the won relatively decreases, putting upward pressure on the won-dollar exchange rate. As such, when the gap between South Korea and the U.S. benchmark rates widens, it inevitably places greater strain on the overall economy. Bank of Korea Governor Lee Chang-yong’s remark that “The Bank of Korea is independent from the government, but not from the U.S. Federal Reserve” reflects this reality.
However, adjusting the benchmark interest rate is not a simple solution. When determining the benchmark rate, the Bank of Korea must comprehensively consider various factors beyond just the exchange rate, including inflation management, economic fluctuation adjustment, and financial market stability. While action is needed if the exchange rate rises excessively and destabilizes financial markets, within a certain range of fluctuation, the Bank of Korea prioritizes inflation suppression and preventing economic downturn as its primary policy goals.
Raising the base rate can alleviate inflationary pressures, but it simultaneously increases the likelihood of higher unemployment. Conversely, lowering the base rate may stimulate the economy, but it risks reigniting inflation or causing excessive price increases in stock and real estate markets. Furthermore, excessively lowering the base rate when the economic situation is relatively stable may yield limited stimulus effects. Therefore, adjusting the base rate solely for exchange rate reasons is undesirable; its broader impact on the entire economy must be considered.
The base rate is determined through deliberation by the Bank of Korea’s Monetary Policy Board members. With only three options—increase, hold, or decrease—adjusting the base rate alone cannot solve all economic problems. Consequently, other economic policies must accompany base rate policy, which falls under the government’s role, not the central bank’s. For instance, while some advocate raising interest rates to stabilize the exchange rate and lower apartment prices, the base rate has broad implications for the entire economy. To address real estate price issues, one must examine excessive real estate stimulus measures, the housing supply structure, and the overall tax system, including the comprehensive real estate tax. Limiting this solely to the base rate issue has clear limitations.
The shock left by the 1997 foreign exchange crisis on Korean society was so profound that certain economic indicators still trigger public anxiety. This includes an excessive fixation on fiscal balance or overly sensitive reactions to exchange rate increases and declines in foreign exchange reserves. However, over the long period since then, the resilience of the Korean economy has significantly strengthened. The nation’s credit rating remains high, and foreign exchange reserves are also at a sufficient level. The Bank of Korea’s benchmark interest rate decisions are centered not solely on the exchange rate but on more crucial economic stability objectives. While some turbulence may appear in the Korean economy, there is no need to immediately interpret this as a crisis. It is equally important to remember that, as significant as benchmark interest rate policy is, government fiscal and industrial policies sometimes play an even greater role.
