How to respond to the strong dollar

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How to respond to the strong dollar

Suh Kyoung-ho

The author is an editorial writer of the JoongAng Ilbo.

The Wall Street Journal last Monday carried an article “Dollar’s Rise Spells Troubles for Global Economics” with quotes from Raghuran Rajan, a professor at the University of Chicago’s Booth School of Business and former governor of the Reserve Bank of India, projecting the strong dollar trend was just beginning. “We’re going to be in a high-rates regime for some time. The fragilities will build up,” he said.

Rajan, also a former chief International Monetary Fund economist, complained about the impact of U.S. monetary policy and a strong dollar on the rest of the world.

Rajan worried that debt stress for emerging economies would deepen as a stronger dollar makes U.S. dollar debt more expensive. According to the Institute of International Finance (IIF), governments of emerging economies have $83 billion in U.S. dollar-denominated debt due by the end of next year. The World Bank last week warned that the global economy was heading toward a recession and “a string of financial crises.”

The International Monetary Fund (IMF) is busy as a result. Sri Lanka has sought a bailout, followed by Pakistan. Serbia joined the list last week. Since the Russian invasion of Ukraine, the IMF has received 20 requests for relief from 16 member countries. Since the pandemic in 2020, the international lender of last resort has doled out $268 billion to more than 90 member countries.

South Korea has been doing relatively well so far because it has the world’s ninth largest foreign exchange reserves and an economy running above the potential growth rate. The country is also a net creditor. South Korea and other Asian countries in the emerging category were weathering the exceptionally strong greenback thanks to their richer forex reserves, according to Bloomberg.

But how much longer they can hum along is uncertain. The won has been falling faster than other currencies. The won also has been weighed down due to growing current-account deficits, the down cycle for the chip industry, and a slowdown in the Chinese economy. The dollar has been hovering around 1,400 won.

There could be three theoretical solutions to stabilize the dollar-won exchange rate. One is to dig into Korea’s forex reserves. Financial authorities can use some of the dollar reserves for a smoothing operation when the market bias bends excessively in a certain direction. They can refer to the U.S. Dollar Index, which tracks the value of the greenback against a basket of six major currencies, if the won’s depreciation is too steep compared to other exchange rates.

Another option is to raise the base interest rate of the won, as higher rates can prop up a currency’s value. Interest rates in the U.S. have accelerated. The U.S. Federal Reserve has delivered the third hike in 75 basis points. The Fed Funds rate rose to the 3 percent to 3.25 percent range, above the Korean base rate of 2.50 percent. The forward market has already bet on U.S. rates at 4.2 percent by the year-end and 4.5 percent by March next year. To keep the gap at a minimum, the Bank of Korea (BOK) would have to raise interest rates continuously. Raising rates to stabilize the value of the won is a disputable decision because the step won’t likely help to defend the won’s value under a global strong dollar trend and because monetary policy should be used to help stabilize prices.

Then there is the third option of leaving the won up to the market under a flexible rate system. Unlike in the past, Korea does not suffer a dollar drought. Price variants should best be respected as long as dollar supplies are sustainable. Cho Dong-chul, a professor at the Korea Development Institute (KDI) School of Public Policy & Management who used to serve on the monetary board of the government, thinks that laisse-faire could be the best policy for now. Authorities could run shy of condoning a weak won, which can aggravate import prices and unnerve financial markets. But doing so could be the best thing for the economy. Maneuvering room for policymakers could widen if people are not too fearful of the dollar at 1,400 won from the traumatic memory of the 1997-98 foreign currency crisis and the 2007-08 global financial crisis. Yet it won’t be easy for the financial authorities to endure criticism about doing nothing about the won dip.

The three options usually are employed in a reasonable mix. Authorities have been doing so in the past and will likely continue with such a balancing act. They keep watch when the won-dollar exchange rate is at a certain bias, without trying to reverse the trend. They can interfere with a dollar-buying action as they did on Sept. 15-16.

The BOK monetary board may have to deliberate hard at its next rate-setting meeting in October. BOK Governor Rhee Chang-yong gave a heads-up about an increase of 25 basis points, but a bigger lift of 50 basis points cannot be ruled out to keep up with giant steps by the U.S. and other countries.

If the BOK chooses a raise of 25 basis points in October, it could forewarn of a bigger increase at this year’s final meeting in November. Although the move saves ammunition for the central bank, it could be faced with public and political disgruntlement over the won’s weakening.
 
The Korean won-U.S. dollar exchange rate jumped over 1,400 won per dollar on Thursday last week for the first time in 13 years and six months. [YONHAP] 

Some of the board members could argue for a hike of 50 basis points as it could be more effective in taming inflation and the strong dollar. The board has turned more hawkish, or inclined to tightening, after it has been pressured by the government to keep interest rates supportive of growth.

But if the rate is raised by half a percentage point in October, a hike of the same scope would be inevitable at the year-end because the current account could shift to a deficit in the fourth quarter — and because the yuan could weaken further from protracted lockdowns in China and a real estate market slump. Foreign capital regards the Korean won as a proxy to the Chinese yuan. If the yuan shakes, so would the won.

In a recent report, the Peterson Institute for International Economics warned that “uncoordinated monetary policies” around the world could risk a historic economic slowdown. That does not mean central banks need to discuss their currency policy with others. But if they could accurately weigh others’ monetary moves, they could avoid a crisis, the report said. Fast tightening of the U.S. and other advanced economies could deepen a global economic slowdown and hurt trading countries like South Korea. Financial authorities must consider the risk in monetary policymaking to stabilize inflation and exchange rate without harming the economy too much.

The BOK in its revised outlook for next year’s growth to slow to 2.1 percent. But many think the estimate is too sanguine with some even warning of a contraction. If the economy slows and corporate revenues worsen, foreign capital would abandon the local markets.

When the won falls too steeply and the forex market turns volatile, there are calls for authorities to seek a currency swap with the U.S. But a currency swap is not a panacea. After the two central banks entered a swap agreement in 2008, the won rose sharply the following day. But after 20 days, it returned to the previous level. The U.S. central bank usually strikes a currency swap deal with several allies at the same time, as it did in 2008 and 2020. Washington also won’t be able to understand Korea’s obsession with the swap deal as the country is not in a liquidity crisis. If Korea really becomes dollar-short, the U.S. mostly likely will come to the rescue.
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