Why does a country have foreign currency reserves?
At least, you have probably seen the words “foreign reserves” splashed across newspapers.
Some of you already know that a foreign reserve refers to the sum of other countries’ currencies held by Korea, for example U.S. dollars, yen or euros.
But why is it so important for a country to retain foreign reserves?
That’s why the foreign currency that companies and commercial banks keep is not regarded as foreign reserves.
Even in an emergency, when there is a foreign currency shortage, a country has no right to order companies and banks to make their foreign currencies available to the rest of the country.
Accordingly, foreign reserves refer specifically to the foreign currency held by a government and its central bank. In Korea’s case, that is the Bank of Korea.
What kind of emergencies are we talking about?
One example is when the local currency weakens sharply against other countries’ currencies, especially the U.S. dollar, which is the situation today.
A crisis can arise when the exchange rate between the Korean won and another country’s currency changes so sharply that people need a lot more won to buy foreign currency.
Take imports for example. Korea imports many goods from other countries and pays for them in foreign currencies. If the exchange rate is 1,000 won per dollar, Korea pays 10,000 won to import a $10 product from the United States.
If the won’s value weakens so the exchange rate becomes 1,250 won per dollar, Korea pays 12,500 won for the same product.
So if the local currency weakens against foreign currencies, the price tags of imported goods go up. This situation can cause inflation.
If this occurs, Koreans will feel poorer because they have to pay more to buy goods and they cannot buy as much as they did before.
And if prices rise too sharply, low-income households will suffer.
To prevent such cases, when the Korean won weakens too sharply against the dollar, the government sells dollars from its foreign reserves on the foreign exchange market.
Based on the principle of supply and demand, if the supply of dollars increases, the price of a dollar - the amount of Korean won exchanged for a dollar - will decline.
Foreign reserves are used also to pay back money that a country borrowed from another country, or when creditors want their loans paid back in dollars or euros, currencies used in many countries worldwide.
If a country has too little foreign currency, countries that lent money to it start worrying that the debtor country will not be able to honor its outstanding loans.
In this situation, some countries might refuse to give that country any more credit and instead urge the country to repay its existing debts.
Korea was in this position in the 1997 Asian financial crisis. Korea had to borrow dollars from the International Monetary Fund to pay down its debts.
In exchange, Korea had to accept the IMF’s request to restructure its financial institutions and companies.
Korea currently has about $240 billion in foreign currency, about 30 times more than it had prior to the 1997 crisis.
How did Korea raise such a large sum over the last decade?
Korean companies exported many goods and were paid in dollars. They kept a part of the dollar earnings and exchanged the rest for Korean won.
In addition, many foreign investors bought Korean companies’ stocks, owing to their good performances.
Meanwhile, foreign investors put their dollars on the market to exchange them for Korean won.
This meant that there was a large amount of dollars on the local foreign exchange.
Again, on the principle of supply and demand, the oversupply of the dollar caused a sharp decline in its value against the won, which allowed the Korean currency to strengthen against the dollar.
As you know, problems occur if the won weakens too sharply against the dollar.
But it is also a problem if the won strengthens too sharply against the dollar, because this raises the prices of Korean exports.
In turn, this lowers the competitiveness of Korean companies.
To keep the won in check, the government can buy dollars on the foreign exchange market to reduce the dollar supply.
So, the dollars that the government bought have been turned into the large foreign reserves that Korea now has stashed away.
So is Korea holding its $240 billion of foreign currency in cash?
The simple answer is no.
You might know that most people don’t keep all their money entirely in cash. They put the money in deposits, buy stocks or invest money in other products to earn interest, income or dividends.
A country is similar to an individual in terms of asset management. Korea has bought relatively safe products, such as U.S. government-issued securities and government bonds from other developed countries in order to earn interest.
Some people say that even if Korea has large foreign reserves, the amount the government can get its hands on immediately is actually much smaller.
Some even say that U.S. Treasury securities are no longer as safe as originally believed, as the country is suffering in the current financial crisis.
In response, the government says it can use most of its foreign reserves by selling the bonds and argues that U.S. Treasury securities are still one of the world’s safest assets.
The government also emphasizes that Korea has the world’s sixth largest foreign reserves.
By Kwon Hyuk-joo JoongAng Ilbo/ Moon So-young Staff Reporter [symoon@joongang.co.kr]
with the Korea JoongAng Daily
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