Confidence is the best tonic

Panic continues to wash through South Korean financial markets despite moves by the authorities to reverse investor sentiment. After the recent fall of the benchmark stock price index and Korean won, confidence in the domestic market is now worse than it was three years ago, when it was struck by the meltdown on Wall Street.

The cost of buying protection against a sovereign credit default is more expensive here than in France, which saw its banks’ ratings plunge amid credit concerns in Europe. The Seoul market may be geographically removed from the two epicenters of the crisis - Europe and the United States - but, in some ways, it risks being the hardest hit. Authorities were forced to aggressively intervene recently to bolster the won by selling an estimated $5 billion. They wanted to rein in bets on the declining won because such bets can trigger a mass dumping of won-denominated assets that would further batter stock prices and accelerate the already weakening currency.

But such quick-fix solutions risk causing greater disruption further down the road.

Right now, the Korean market is undergoing a period of readjustment after witnessing excessive foreign investment in the last couple of years. European and U.S. funds are pulling out to compensate for their losses at home, resulting in a sudden dumping of the won. Investors usually respond to global economic jitters by exiting emerging markets and turning to safer assets such as U.S. Treasury bonds and the greenback.

But Korea’s economic fundamentals are strong, and the country’s economy will not likely retain these losses for long. Foreign reserves stand at $312.2 billion and short-term debt takes up just 37 percent of the country’s total external debt. The economy is still growing at 4 percent and has recorded a trade surplus for 19 straight months. The sell-off of won-denominated assets was sparked by a sense of group panic rather than problems with the Korean economy.

Still, experts are mixed about the prospects of the world economy and there is a general consensus that problems will persist for a significant time yet. The global economy is unlikely to pick up unless Europe resolves its credit crisis and the U.S. economy escapes the risk of a double-dip recession. Moreover, these countries have used up their fiscal and monetary ammunition to quickly get their economies up and running again. China and the Middle East also seem to be playing a game of wait-and-see.

For its part, Korea should focus on bolstering confidence instead of openly intervening in the market or using pension funds to prop up the stock market until the Group of 20 economies come up with answers.