[VIEWPOINT]Hedging beats tinkering any day

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[VIEWPOINT]Hedging beats tinkering any day

Over the past few months, the won has appreciated sharply against the U.S. dollar. Yet only late last year, the won was moving sharply in the opposite direction. A number of other currencies, including those of many of Korea's trading partners, have experienced similar movements. These developments highlight a fact of life in countries like Korea with flexible exchange rates: Short-term rates can be volatile.

In response to these developments, many in Korea have called on the government to "do something." Surprisingly, these calls have recently been joined by a prominent bank, which argued for government intervention in the foreign exchange market to weaken the won. We at the IMF think this is the wrong approach.

We believe the right approach is to deepen the foreign exchange market. This comes about when government action is limited to "smoothing operations" to moderate exchange rate volatility, a larger class of players is allowed into the market, and most importantly, companies -- particularly large, sophisticated ones -- protect themselves against sharp currency movements by hedging. While the first two criteria are being met, the third is not. Even though the won was floated in late 1997, many companies are still not hedging.

What really matters is what Koreans think. A full-fledged debate on the costs of not hedging would be beneficial. These costs -- which include reduced foreign investor confidence, increased uncertainty and continued market underdevelopment -- could be substantial.

First, should there be concern about the exchange rate? Of course. The level of the won affects the competitiveness of Korean exports, and as an open economy, Korea depends on strong exports for healthy growth. While the won has lost some competitiveness over the past few months, this loss has been relatively modest. But let us leave that debate aside and focus on how the foreign exchange market works.

Since the foreign exchange market can be volatile, there is a case for government smoothing. In periods of volatility the market becomes one-sided -- there are only buyers or only sellers. An outside party, the government, can ensure that orderly trading takes place. This does not mean that the government targets a particular exchange rate; it just seeks to moderate the rate of change. We agree with this approach. Also, the government is moving to deepen the market by allowing insurance and securities companies to begin trading later this year.

Although smoothing is appropriate under certain conditions, it does have a downside. Volatility creates profit opportunities, which spurs trading and hence market development. When the government undertakes its smoothing operations it dampens volatility, retards market development, and keeps trading thin. This appears to be a vicious circle. What to do?

Attempts to deepen the market are being complicated by the actions of some companies. By not trading to protect themselves from future changes in the won, these companies, in effect, keep the market underdeveloped. For example, many exporters could have sold their dollars on the forward market when the exchange rate was over 1,300. However, they decided to not hedge, lost the bet and ended up with lower profits. Now they are calling for help.

Which firms are complicating the process? Banks have protected themselves against currency risk, and it is difficult to believe that small and medium enterprises have much influence. Therefore, the source of the pressure most likely comes from large, non-bank companies. These otherwise sophisticated businesses should, arguably, protect themselves and not run to the government every time the exchange rate moves against their positions. Hedging should not be mandatory, of course. Companies may take on currency risk, but then they should face the consequences of their decision. They cannot have it both ways.

We are concerned because of the costs for Korea. First, the world is watching. Potential foreign investors still wonder whether Korea has truly moved away from a government-jaebol dominated economic system; the present situation at least partially validates their suspicions that it has not. Second, unhedged companies face increased uncertainty, which reduces investment and consumption. Finally, as noted, government action -- even in the form of smoothing operations -- retards development of Korea's still small foreign exchange market. These are all negatives for a country aspiring to become a regional financial hub.

Should the government "do something"? Yes. Government has a role to play in making sure the foreign exchange market functions smoothly in periods of turbulence and in deepening the market over time. But the public debate should be broadened to ask why some firms are not hedging and what costs this entails. Those firms may respond that hedging is expensive. That may be, but not hedging carries costs for Korea that are surely larger.


The writer is the International Monetary Fund's resident representative in Korea.

by Paul Francis Gruenwald

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