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Falling exchange reserves invite another financial crisis

Published: 06 Jan. 2025, 00:00

Ha Hyun-ock
The author is an editorial writer of the JoongAng Ilbo.

Koreans share a collective anxiety rooted in a traumatic past: the “foreign exchange crisis.” The 1997 Asian Financial Crisis, when Korea’s foreign exchange reserves dwindled to $3.9 billion forcing the nation to accept an International Monetary Fund (IMF) bailout, left a deep scar. So too did the 2008 global financial crisis, when massive dollar outflows threatened the economy, only to be stemmed by a Korea-U.S. currency swap agreement. In both cases, rapid won depreciation signaled an impending crisis, with foreign currency outflows shaking the economy and financial markets. It is no wonder Korea has focused so intently on building up its “foreign exchange breakwater.”

Korea’s foreign exchange reserves, built as a hedge against uncertainty, are substantial. Though they have declined from their record high of $469.21 billion in October 2021, the reserves stood at $415.39 billion as of November 2023, ranking ninth globally. Yet, fears of another currency crisis are resurfacing. Ongoing political turmoil, including martial law and the impeachment of both the president and acting president, has caused the won to plummet in value. As authorities appear to have intervened in the market to stabilize the currency, concerns are growing that foreign exchange reserves may have fallen sharply. There is heightened vigilance that reserves could dip below the psychologically critical $400 billion threshold.

Opinions vary on what constitutes an adequate level of foreign exchange reserves. Traditionally, reserves equivalent to three months’ worth of imports were considered sufficient. With increasing capital transactions, the benchmark expanded to include three months of current account imports plus short-term external debt maturing within a year. The Bank for International Settlements (BIS) sets the strictest criteria, incorporating 30 percent of resident foreign currency deposits and foreign investments in domestic securities. By this measure, Korea would require over $600 billion in reserves.

According to the IMF, the adequacy of reserves for emerging markets is calculated using a formula: 30 percent of short-term external debt, 15 percent of other external liabilities (such as foreign investment in domestic stocks), 5 percent of broad money (M2) and 5 percent of annual exports. By this metric, Korea’s reserves in 2022 fell to 97 percent, below the IMF’s recommended range of 100 percent to 150 percent. However, this benchmark primarily applies to emerging markets. In July 2023, the IMF reclassified Korea as a “mature market” subject to qualitative, rather than quantitative, assessments. Bank of Korea Gov. Rhee Chang-yong has stated that Korea’s reserves should not be judged as insufficient based on outdated metrics.

While ample reserves can serve as a financial buffer, endlessly piling up reserves is not a panacea. Maintaining excessive reserves comes at a cost. Foreign exchange reserves are essentially foreign assets purchased and held by the government. To fund these purchases, the government and Bank of Korea issue bonds, such as Foreign Exchange Stabilization Fund bonds and monetary stabilization securities. Increasing reserves means higher interest payments on these bonds. Moreover, returns on reserves are often lower than borrowing costs, as reserves are typically invested in low-risk, low-return assets to ensure liquidity and stability. This creates a national and social burden: borrowing expensive money to invest in low-yield assets.

Building a robust breakwater to withstand external shocks is critical and justifies certain social costs. However, Korea’s foreign exchange reserves are currently being depleted not by external waves but by internal political turbulence. The imposition of martial law, a seismic shock to Korea’s democracy, necessitated substantial reserve spending. The impeachment motion against acting President Han Duck-soo, spearheaded by opposition parties with brute force, further escalated exchange rate volatility, driving up the won-dollar rate to levels unseen since the global financial crisis and depleting reserves even further.

Both the ruling and opposition parties bear responsibility. The ruling party, incapable of effective governance, and the opposition, lacking accountability as a potential ruling party, have drained Korea’s reserves in their political chess game. Resources meant to prevent real crises have been squandered in a war of attrition. To put it bluntly, political infighting is inviting a currency crisis. Politics is meant to manage the nation and improve livelihoods. Yet, politicians have taken the economy hostage, amplifying risks instead of mitigating them.

Rhee emphasized the importance of separating the economy from political processes and fostering cooperation between the ruling and opposition parties. His pointed remarks came as acting President Choi Sang-mok, also deputy prime minister and finance minister, faced bipartisan pressure over his appointment of two Constitutional Court justices. If political factions continue to prioritize infighting over national interest and public welfare, Korea’s foreign exchange reserves — a critical breakwater — could crumble like a sandcastle.

Translated using generative AI and edited by Korea JoongAng Daily staff.