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Why did the currency swap with the U.S. help Korea?

It gave the country an ample supply of dollars and enhanced its credibility.

Nov 25,2008

There is a lot of gloomy news about the economy these days. The won is nosediving against the dollar and stocks have been plunging.

But at the end of last month, some upbeat news came out - Korea signed a currency swap deal with the United States.

Immediately after the news broke, the stock market shot up and the won surged versus the greenback.

So what is a currency swap deal?

A currency swap is, literally, an exchange of a specified amount in one country’s currency with that of another. It is a foreign exchange transaction.

The swap is done in cash. In the swap deal between Korea and the United States, the two countries are exchanging Korean won and U.S. dollars. This does not mean that they hold the money exchanged forever. At some point, they give the currencies back to each other.

Currency swaps are contracts made between the central banks of both nations.

So the swap deal this time was between the Bank of Korea and U.S. Federal Reserve Board.

The amount of money that the two countries promised to exchange was $30 billion.

That means Korea can give $30 billion worth of Korean won to the U.S. in exchange for $30 billion whenever necessary.

The arrangement necessitates that you have a certain amount of Korean currency to swap for dollars. But that is not a problem because the Bank of Korea can issue the currency whenever needed.

What made the swap deal necessary was a shortage of dollars in the Korean financial market. Dollars are essential because they are the currency of international trade.

But recently, more people began wanting to buy dollars while fewer wanted to sell them. That’s why demand for dollars went up and the Korean won lost value.

For those in need of dollars - such as companies that buy overseas goods and parents whose children study abroad - this is a problem because it takes more Korean won to buy items priced in dollars.

But that’s not all.

When the won falls sharply in a very short time span, people think that there is something wrong with the national economy. This creates problems both within and outside Korea’s borders.

As fear spreads, people start selling stock or real estate, putting downward pressure on market prices.

Other countries become reluctant to lend dollars to Korea because they have less confidence in its financial security.

The supply of dollars shrinks and the won loses even more value - a vicious circle.

To avoid this situation, the nation will have to increase its dollar supply.

Of course, there is a solution: borrowing dollars from international financial markets.

But that is not as easy as many think because the United States is in the grip of its own financial crisis and the consequences are weighing on other developed economies as well.

Unable to predict when the crisis will affect them, these countries just hold on to their dollar reserves.

Even if they have more than sufficient levels of currency, they won’t lend them, which is why Korea’s financial companies are experiencing a shortage of greenbacks.

The situation pretty much explains why the won regained so much value and stocks skyrocketed on news of the Korea-U.S. currency swap.

But the deal has another meaning as well.

The United States does not sign currency swaps with just any country.

Before the contract with Korea, the U.S. had swap deals with 10 countries - developed countries such as Britain, Japan and Switzerland.

Brazil, Singapore and Mexico, countries that clinched currency swap deals with the U.S. along with Korea, are well-off among emerging markets. They actually serve as regional centers for the global financial market.

The simple fact that a country has a currency swap contract with the U.S. gives global investors the impression that it is stable.

Another crucial point of the Korea-U.S. deal is that the two countries may increase the swap pool when the situation worsens.

In fact, Britain, Japan and Switzerland, which now have no limits for the volume of the swaps, had small pools at the beginning.

Switzerland started at $4 billion.

So how can a limitless pool become possible?

It is because the United States can issue as many dollars as necessary.

In that sense, the swap deal could serve as a “dollar pipeline” when the market here gets bad.

The scenario of Korea facing a sovereign bankruptcy due to a dollar crunch is no longer valid.

Citibank said in a recent report that the probability of Korea going bankrupt has become virtually zero.

The Bank of Korea will be bringing in dollars from its U.S. counterpart and supplying it in volume to commercial lenders in return for interest.

Lenders will bid competitively and those proposing higher rates will win.

In return, the central bank will be given Korean won equivalent to the borrowed dollars, which provides additional liquidity for another swap.

Other than the U.S., Korea has swap deals with Japan, China and four Southeast Asian countries (Thailand, Malaysia, the Philippines and Indonesia).

The pool with Japan is $13 billion, while that with China stands at $4 billion.

With Japan, $3 billion is exchangeable between yen and won and the rest can be done in dollars and won.

The deal is only good for yuan with China.

The Korean government is currently seeking to raise the swap pool with those two countries.

As has already been suggested, bilateral swap deals have a symbolic effect in that Korea maintains close financial ties with those countries.

Recently the International Monetary Fund developed a dollar swap program as well.

Member countries can be given up to five times the amount of money that they hold in the fund in dollars.

The services will only be open to countries that have solid fundamentals but are in temporary trouble because of a dollar squeeze.

Although the currency market is still volatile, the Korean government has decided not to take advantage of the program.

Korea already has several currency swap deals with other nations and national sentiment here about the IMF is not that positive because of the conditions that Korea was forced to accept for a rescue package during the financial crisis of the late 1990s.

The experience gave Koreans the impression that intervention by the international organization signifies unhealthy national economic conditions.


By Lee Sang-ryeul JoongAng Ilbo [spring@joongang.co.kr]



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