Korea's currency weakness

By Peter S. Kim

About halfway through the year, battered investors globally are struggling to see the end of the tunnel due to the relentlessly rising inflation and interest rates. Over the past few weeks, financial markets have been bracing for an imminent global recession after losing faith in the ability of central banks to rein in runaway inflation.

There is even talk of stagflation, the ultimate doomsday scenario that we have not seen since the 1970s. Doubts over the effectiveness of central bank policy responses have arisen from the current inflation surge driven by the pressures from the supply side more than the demand side. The restriction of the supply of goods and services concurrently as a result of COVID-19-induced restrictions and distribution difficulties, the Russia-Ukraine war and China's withdrawal from global trade are factors that cannot be fixed by higher rates alone.

In the United States, labor shortages have been exacerbated by the anti-immigration movement that began with the Trump administration. Admittedly, the demand side of the equation is also responsible, given the unprecedented fiscal and monetary stimulus since the outbreak.

Nevertheless, the inflation caused by the pausing or even reversal of globalization is arguably the most critical factor driving prices up for essential goods, which hurts everyday consumers. In particular, the U.S.-China standoff has suddenly halted dividends from the spread of international free trade, which the world has taken for granted for decades.

For South Korea, the aggressive interest rate hike has caused the Korean currency to weaken to its lowest level since the subprime crisis of 2009. Besides making overseas travel more expensive for those earning salaries in Korean won, many broader issues need to be considered.

Historically, the Korean financial system has had a crisis of some kind whenever the currency showed severe volatility. The last one was during the global financial crisis in 2009 when Korea's shipbuilding companies took currency bets on their backlog of orders, causing massive losses for the entire industry. This time, thanks to vigilant banking oversight and prudent financial management, there are no signs of systemic risks arising from the weakening currency.

The Korean financial system could finally get credit for being robust enough to weather rising interest rates which invariably exposes the weak links among the emerging economies. The usual candidates to get into systemic crises during times of rising interest rates and the U.S. dollar are trade deficit-prone economies with chronic foreign debt like those in Latin America or Southeast Asia.

This time, however, due to high commodity prices, countries like Brazil and Indonesia show no signs of stress. Amazingly, even the Russian economy is enjoying stability despite growing sanctions amid its war with Ukraine. So far, the most notable victims seem to be limited to investors of cryptocurrencies.

Another outdated notion is that Korea's central bank, the Bank of Korea, regularly intervenes to support its currency to defend its export competitiveness. That may have been a valid thesis in the 1990s, but much has changed over the past decade. When Korea Inc. was competing for market share versus its Japanese counterparts, Korea's products began by penetrating low-end segments where pricing advantage was key. Since then, Korean products have established their mid- to high-end positioning, where pricing is no longer vital to their business models.

Notably, Korea's largest export destination, China, has been declining for Korea Inc. The decline in exports to China is symbolic of China Inc.'s rapid transition from customer to competitor for Korea Inc. It also reflects Korea's move up the value chain from manufacturing to higher-end services.

Therefore, Korea's reputation as an export-dependent economy is increasingly misleading, given its rightful status as a developed economy. Koreans' rising income and stable financial system equate to an economy that deserves a developed market status. The growing sophistication of the consumer class and the solid financial system make South Korea one of the stronger economies to weather the continuing COVID-19 storm.

There are a couple of other positives in Korea's favor for the next 12 months. First, the central bank had the good fortune of hiking rates from last year. Even though Korea's inflation path remains high, much of the inflationary drivers are from imported energy and goods, making higher rates only partially effective. Understanding the limitation, the Bank of Korea should show a relatively dovish approach, especially against the U.S.

The second positive is President Yoon and his pro-business policies. A couple of weeks ago, the Yoon government announced comprehensive tax reforms to boost business and consumer sentiment. It is a first step to restoring business confidence by providing incentives for businesses to grow and expand. Also, the Yoon administration relaxed taxes on property after five years of tightening by the Moon government.

Further, the overall election promise of deregulation is in motion, with over 100 regulations earmarked for unwinding. However, external risks need to be addressed before Korea's pro-business policies translate to stock market performance. But at least we can sleep easy in the knowledge that the volatility in global financial markets may not get a chance to arrest South Korea as one of its victims this time.

Peter S. Kim (peter.kim@kbfg.com) is a managing director at KB Financial Group.