This blog post explains the impact of exchange rate fluctuations on exports and imports, covering the underlying principles and real-world examples in an easy-to-understand manner.
Why do exchange rates rise and fall?
How are exchange rates determined? The financial sector closely monitors daily exchange rate fluctuations. Articles expressing concern that significant exchange rate movements could negatively impact the national economy are also common. However, just because it’s a frequent topic in the media doesn’t mean people fully understand exchange rates. Few people accurately understand why a rise in the won’s value causes the exchange rate to fall, or why a falling exchange rate is expected to reduce exports. The opposite scenario—where the won’s value falls and the exchange rate rises—is equally misunderstood. This chapter examines the fundamental principles governing exchange rate determination and the impact a nation’s exchange rate has on its economy. We’ll also explore why a rising exchange rate boosts exports and a falling exchange rate reduces them.
Why the U.S. is sensitive to exchange rates
Before explaining exchange rates, it is necessary to briefly review an important economic issue that occurred in 2018. Most people may not even know this happened, but it was a significant event that could have had a major impact on the Korean economy. On April 13, 2018, the U.S. Treasury Department released its report evaluating the exchange rate policies of 13 countries, including South Korea, China, Japan, Germany, India, and Switzerland. This report is published twice a year, in April and October, since 2016.
What is the purpose of the U.S. releasing such a report? It is precisely because the exchange rates of other countries have a significant impact on the U.S. economy. It is to warn countries that adjust their exchange rates to increase exports to the U.S. and reduce imports of American products into their own countries. By designating such countries as currency manipulators and imposing disadvantages, the intent is to increase exports of American products worldwide. From the U.S. perspective, increasing exports of American goods is essential for the revival of its manufacturing sector, making this issue highly sensitive.
In 2017, the U.S. ran a trade deficit of $466.2 billion, nearly 500 trillion won in Korean currency, with other nations. More precisely, it incurred this deficit in its current account balance. Facing such massive annual deficits in international trade, voices grew louder among the American public, politicians, and businesses demanding reduced imports of foreign goods and increased exports of American products. Consequently, President Donald Trump has intensified protectionist measures since taking office, including imposing high tariffs on imported goods. This is also why the U.S. has willingly risked trade disputes with traditional allies to raise tariff barriers and has strengthened intervention in the exchange rate policies of major trading partners.
Fortunately, South Korea was not designated a currency manipulator in the report released in April 2018. In fact, no country has been designated a currency manipulator since the reports began (as of the October 2018 report). During his Republican presidential campaign, President Trump stated, “I will designate China as a currency manipulator.” Yet China, too, has not been designated as such. Even amid the fierce US-China trade war, the US has refrained from playing the “currency manipulator designation” card.
However, South Korea has been placed on the monitoring list consecutively since the first report in 2016. In April 2018, it was again placed on the monitoring list alongside China, Japan, Germany, India, and Switzerland. Monitoring list countries can be simply understood as “nations that are not intervening in foreign exchange markets severely enough to warrant designation as currency manipulators, but which the U.S. government must consistently monitor and watch.”
The criteria for designation as a currency manipulator are threefold: ‘a U.S. trade surplus exceeding $20 billion,’ ‘an annual current account surplus exceeding 3% of GDP,‘ and ‘dollar-buying intervention in foreign exchange markets.’ From July 2017 to June 2018, South Korea recorded a $21 billion, approximately 24 trillion won, surplus in trade with the United States. Its current account surplus also reached 4.7% of GDP. This means it met two of the three criteria the U.S. has stated for labeling a country a currency manipulator. Consequently, suspicions have arisen that South Korea’s substantial profits from trade with the U.S. might be due to the government artificially manipulating the exchange rate.
The Impact of Exchange Rates on Exports
How can an exchange rate, seemingly just a number, have such a massive impact on a country’s exports and imports? Economics distinguishes three types of exchange rates: the nominal exchange rate, the real exchange rate, and the effective exchange rate. This chapter will focus solely on the most familiar to us: the nominal exchange rate. The nominal exchange rate refers to the rate expressed as the won-dollar ratio, such as ‘1,100 won per dollar’ or ‘1,200 won per dollar’. The won-dollar rate, won-yen rate, won-euro rate, etc., that we check when preparing for overseas travel all fall under the nominal exchange rate.
The exchange rate is the ‘price of money’ that indicates how much of another country’s currency you can buy with your own currency. Economically speaking, it can be described as the ‘exchange ratio between two different countries’ currencies’. Like other goods, the price of each country’s currency is determined by the principles of supply and demand. The more people want to buy it, the higher the price rises; the more people want to sell it, the lower the price falls.
Today, with deepening globalization, most countries export their manufactured goods abroad and import necessary products from other nations. Within this international trade process, why would a country’s currency value rise? Recalling the principle of supply and demand makes it simple: if more people want to buy an item than sell it, the price goes up. Similarly, if more people want to buy a currency than sell it, its value increases. When the traded commodity is money itself, we simply use the term exchange rate, or currency value, instead of price.
For example, suppose a smartphone made in Korea becomes hugely popular, with orders pouring in from all over the world. To buy these Korean-made smartphones, other countries need Korean won. This ultimately increases demand for the won, and as more people want to buy it, the price of Korean money rises. For simplicity, we’ve described a foreign company directly purchasing Korean products with won. However, in international trade, both buyers and sellers mostly transact in dollars. Yet, when Korean companies bring the dollars earned from selling goods to foreign firms back into Korea, they must convert them into won. Even when trading in dollars, it effectively increases demand for the won. Therefore, saying Korean products are exporting well is equivalent to saying demand for the Korean won has grown.
Conversely, imagine Korean-made products (smartphones, cars, washing machines, etc.) are unpopular in overseas markets. With no foreign consumers seeking Korean goods, foreign companies lose the need to acquire Korean money. As demand for Korean money decreases, the won’s value naturally falls. This is why strong exports boost the won’s value, while weak exports cause it to depreciate.
However, many people get confused about the relationship between the won’s value and the exchange rate. Let me pose a question. Suppose the exchange rate, which was 1,000 won per dollar, changes to 800 won per dollar. How have the won’s value and the exchange rate changed, respectively? The correct answer is: “The won’s value has risen by 20%, and the exchange rate has fallen by 20%.” Previously, you needed 1,000 won to buy 1 dollar, but now you can buy 1 dollar with just 800 won. The value of Korean money increased by 200 won, so it rose by 20%. The won-dollar exchange rate decreased by 200 won, so it fell by 20%. Simply put, when the value of the won rises, the exchange rate falls; when the value of the won falls, the exchange rate rises.
During the 1997 IMF foreign exchange crisis, the exchange rate, which started the year around 840 won, surged to as high as 1,964 won at one point. This means the value of Korean money fell by more than half in less than a year. As the Korean economy faced a severe crisis, the value of the Korean currency naturally had to fall. When a country’s economy deteriorates, the value of its currency declines, ultimately causing the exchange rate to rise. Recalling the case of the IMF foreign exchange crisis helps us understand the relationship between the value of the won and the exchange rate.
How does the exchange rate affect exports?
Earlier, we explained why a strong won and a low exchange rate occur when exports are strong, and why a weak won and a high exchange rate occur when exports are weak. Now, let’s look at the reverse: how the exchange rate affects exports. If all other conditions remain the same—such as the performance and production costs of domestically produced goods—how would an increase or decrease in the exchange rate affect exports and imports respectively?
For example, imagine a company that manufactures and sells frozen tteokbokki. The price of each pack of frozen tteokbokki produced by this company is 10,000 won. They also export this product overseas at this price, with the current exchange rate being 1,000 won per dollar. Therefore, they receive 10 dollars for each pack of tteokbokki exported overseas. But what if the exchange rate drops by 50%, making 1 USD equal 500 KRW? Would exports increase or decrease? If the exchange rate falls by 50% like this, exports will likely decrease significantly in most cases. Previously, foreign buyers only needed 10 USD to obtain 10,000 KRW, since the KRW/USD rate was 1,000 KRW per USD. But if the won-dollar exchange rate becomes 500 won, they now need 20 dollars to get 10,000 won. From the overseas consumer’s perspective, the price of Korean tteokbokki suddenly jumps from 10 dollars to 20 dollars—a doubling. With the sudden price hike, they eat less tteokbokki than before, and naturally, exports decline.
Conversely, what if the won-dollar exchange rate rises by 500 won to 1,500 won? Such an appreciation would benefit exports. Previously, 10 dollars were needed to obtain 10,000 won, but with the exchange rate rising, only about 6.6 dollars are now required to get 10,000 won. Overseas consumers who previously paid $10 for a pack of frozen tteokbokki can now buy it for $6.60 after the exchange rate rises. Therefore, a falling exchange rate is unfavorable for exports but favorable for imports, while a rising exchange rate is favorable for exports but unfavorable for imports.
Fluctuations in the exchange rate affect the performance of countless companies, from large corporations like Samsung Electronics to small and medium-sized enterprises in regional small cities. The domestic securities industry estimates that a 10 won drop in the won-dollar exchange rate reduces Samsung Electronics’ operating profit by approximately 200 billion won. This is because Samsung Electronics generates about 80-90% of its sales overseas. Indeed, if the exchange rate continues to fall for an extended period, securities firms lower their projected operating profit for Samsung Electronics by hundreds of billions of won. Of course, Samsung Electronics is not alone. Many large Korean corporations with high overseas sales ratios have a structure where profits immediately decrease when the exchange rate falls. SK Hynix also stated in its audit report released in early 2018 that a 10% drop in the won-dollar exchange rate could reduce its net profit before corporate tax expenses by approximately 690 billion won.
However, a falling exchange rate doesn’t only have negative effects on all sectors of the Korean economy. When the won appreciates, the prices of imported goods become relatively cheaper. There is also a positive aspect: the lower prices of imported daily necessities reduce the burden on citizens. Furthermore, the reduced import prices of various overseas raw materials lower companies’ production costs. Typically, when the exchange rate falls, companies like airlines, travel agencies, and food manufacturers see improved performance. A lower exchange rate reduces the cost of overseas travel, leading to an increase in outbound travelers, which naturally boosts the performance of airlines and travel agencies. Food manufacturers that import various raw materials from abroad can also reduce their raw material import costs, enabling them to generate greater profits.
