A good swap

Korean and Japanese leaders agreed to radically expand their currency swap arrangements to $70 billion from the current $13 billion to help build in shock absorbers for both economies to cope with global financial instability.

The hike in the ceiling of the short-term loans in case of sharp volatility in the foreign exchange market will be effective until the end of October 2012. The won gained on the news of the deal, which came during a visit to Korea from Japanese Prime Minister Yoshihiko Noda.

As in any business deal, there’s a price. South Korean exports will no longer enjoy price competitiveness against Japanese counterparts as the won’s value is likely to strengthen with the yen added to its reserve coffers. Some suspect the yen loans were part of a bargain to deflect attention from the fact that Noda refused to discuss sensitive issues from the two countries’ history during the summit meeting or accelerate long-stalled bilateral free trade deal.

We cannot exactly know the diplomatic backstory, but expanded currency swaps are a boon for the country. The global financial markets trembled when the sovereign credit rating of the U.S. was downgraded two months ago. Our currency sharply lost ground amid real worries about Europe’s fiscal and debt crisis and the vulnerability of large international banks with exposure to troubled European countries.

Despite reserves in excess of $300 billion, jitters in the local market continued because of our heavily export-reliant economic structure and wide-open financial market. Authorities cannot suddenly restrict foreign capital as it would harm our credibility with overseas investors.

A safety net - which is what the expanded swap arrangement is - is the best answer, as it can send a message to speculative forces that the local currency has strong backing from neighboring economies.

The global financial market is currently in a calm before the storm. The European credit crisis cannot be solved overnight. It could spill over to the banking sector. The won is likely to suffer.

Authorities need not explain every detail of their foreign deals. The latest move may suggest that the Bank of Korea is concerned about its dollar reserves. What’s more important is reinforcing the safety net. Authorities must employ the swaps only as a last ditch weapon.