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KDI - Korea Development Institute

KDI - Korea Development Institute



KDI Economic Outlook 2022-1st Half Impact of External Uncertainty on Exchange Rate and Capital Flow May 12, 2022

KDI Economic Outlook 2022-1st Half Impact of External Uncertainty on Exchange Rate and Capital Flow

May 12, 2022

  • KDI
    CHOI, Woo jin
■ Rising external uncertainty increases the capital outflows and depreciates exchange rates, but the magnitude has decreased after 2014.

- We have shown that, after Korea transitioned to a net creditor position in 2014, the extent of the exchange rate depreciation and capital outflows decreased.

- This change can be attributed to positive feedback from foreign investors on Korea’s business competitiveness and macro-policy management.

- The total Korean government bonds held by other countries as foreign exchange reserves are approximately $81 billion as of the end-2020. The magnitude is higher than other currencies except for the US dollar and the euro.

■ In the short term, we suggest that the financial market be closely monitored and prepare for sudden market disruption.

- Ongoing global uncertainty expansion could possibly be very devastating; with sudden outlfows being realized, proactive policy measures, including foreign exchange prudential regulations, should be called for.

■ In the mid-to-long term, consistent efforts should be made for stable inflation, and the overall level of the public debt needs to be managed. Also, improvement in access to the forex market is highly recommended.

- Policies to rein in recent high inflation and burgeoning sovereign debt are at the core of macroeconomic stability and maintaining external debt soundness.

- For business competitiveness, it is necessary to upgrade Korea’s macroeconomic fundamentals, the basis of the won currency, by enhancing economic dynamics through regulatory system reforms and infrastructure investment.

- At the same time, mid-to-long-term efforts should continue to strengthen the status of the won currency.
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|   Related information   |
High inflation, interest rate hikes, Russia's invasion of Ukraine, rising oil prices...
With a lot going on in the recent global economy, is it possible that even our country, heavily dependent on external factors, might be shaken, and a crisis similar to the past could be on the horizon?
|   Script   |

The 2008 Global Financial Crisis depreciated the Korean won by more than 25% against the US dollar amid the hiking external uncertainty index.
And the dollar-won exchange rate depreciated by 13% following Greece's sovereign debt crisis.

We are now facing global instability again, and there are rising concerns over another crisis with unexpected capital outflows and currency depreciation in Korea.
Against this backdrop, KDI examined Korea’s economic fundamentals.
2014 was the year when Korea switched over to a net external creditor.
Using 2014 as the base year that Korea's overseas investment outstripped foreign investment in Korea,
KDI analyzed how external uncertainty influenced exchange rates and capital flows before and after that year.

According to the analysis, as external uncertainty escalated, the exchange rate depreciated by nearly 8% until 2013, but it only did by 2.6% after 2014.
Capital outflow to GDP increased by 3%p until 2013, but there were no statistically significant changes after 2014.

In the breakdown of international capital flows, it was portfolio investment in particular that reduced the outflow.
The impact of external uncertainty shocks on the currency and capital outflow tends to diminish starting from 2014 and 2016, respectively.
There may be several reasons for the diminishing impacts.
Among them, what appeals to foreign investors seems to be sustained low inflation and debt-to-GDP ratio, coupled with its ICT-driven global competitiveness.
And their positive feedback plays a major role in cushioning the shock.

The total amount of Korean government bonds in foreign exchange reserves of other countries is quite high except for the US dollar and the euro in reflection of the changing environment.
Indicators of the investment environment for sovereign bonds also show improving investor-friendliness in Korea, as seen in better transparency in its asset market and enhanced accessibility and convenience in the settlement and liquidation process.

As explained already, Korea's economic fundamentals stemming from the global competitiveness of its firms have entered a virtuous cycle that feeds into a chain reaction of stable asset value, less policy intervention, better transparency, and greater credibility among foreign investors.
(Interview with the author, CHOI, Woo jin)
Korea's external debt soundness has been steadily improving, and its currency value and capital flow appear less volatile.
However, given mounting global uncertainty in recent months, it is necessary to closely monitor them both in the short run.
If the situation evolves into a crisis with unexpected capital outflows, strong macroprudential policy actions are required to cope with short-term foreign exchange fluctuations.
Consistent efforts over the mid-to-long term should not be overlooked to sustain sound external stability. In particular, the focus should be on price stability through steady exchange rates and managing the overall level of public debt needs. Also, international investors should have better access to the forex market.
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