hankyoreh

Displays in the trading room of KB Kookmin Bank in Seoul show the KOSPI dipping below 1500 and the value of the Korean won plummeting against the US dollar on Mar. 19. (Kim Jung-hyo, staff photographer)

The reason the South Korean financial market has reached a state of panic is because of difficulties acquiring the US dollar due to fears in the international short-term capital market. It’s succumbing to a vicious cycle in which a soaring exchange rate leads to foreign investors selling off their shares, which leads in turn to stock prices plunging and the exchange rate rising further.

On the Seoul foreign exchange market on Mar. 19, the won-to-dollar exchange rate climbed to the same level it reached in July 2009, when the effects of the global financial crisis were still being felt. Amid the loss of funds from foreign investors seeking to avoid exchange losses, the KOSPI plummeted to its lowest level in 10 years and eight months. This sends the message that South Korea’s US$400 billion in current foreign exchange reserves -- the world’s ninth highest level -- may no longer function as a safety valve for the financial market.

During the 2008 financial crisis, the value of the won nosedived amid losses of short-term capital, despite external soundness factors such as foreign exchange reserve holdings and external debt being relatively favorable. Another factor in won’s drop in value and share prices being larger than in other major Asian countries has been the relative abundance of liquidity in the South Korean stock market -- functioning as a “cash machine” of sorts for international buyers desperate for dollars.

The dollar index, which represents the value of the US dollar compared to six other major currencies, had passed 100 as of Mar. 18, marking its highest level in the three years since March 2017. On the New York financial market the same day, prices plummeted for all assets, including government bonds and gold, as companies and financial institutions rushed to acquire dollars as a last refuge amid fears of an economic recession.

Reductions in the interest rate, which represents the value of money, lead to weakness in the worth of the currency in question. Yet even after the US Federal Reserve lowered the benchmark interest rate twice by a total of 1.5 percentage points this month alone, dollars have only become more difficult to secure on the market. The situation has been called the “dollar smile” phenomenon: when the US economy is relatively strong, it shows a rise like the corner of a smiling mouth, but a rise also occurs on the opposite side in cases of extreme risk avoidance scenarios like the current one. Goldman Sachs described this as a reflection of the US dollar’s stature as a benchmark currency within the global economy and financial system.

The reason for the explosive demand of the dollar has to do with liquidity drying up in the short-term capital market owing to the novel coronavirus pandemic. In particular, fears have risen over repayment of the principal on non-investment grade bonds issued by US energy companies amid plummeting global oil prices, which has translated into a liquidity crunch across the corporate bond market. The risk is that with an economic recession, even bonds at the last level of investment suitability (BBB) will be downgraded to a non-investment grade. According to the Korea Center for International Finance, US insurance companies and pension funds possess around half (49%) of US corporate bonds. If those institutions’ soundness is threatened, the situation could escalate into a financial crisis.

The rise in interest rates on the US capital market is a danger sign for emerging economies, which have a large amount of dollar-denominated foreign loans. The growing interest burden for emergency economy countries that obtained funds through the issuance of dollar-denominated bonds could leave them unable to repay their debts. As if to reflect this, the spread (EMBI+) for emerging market bonds -- indicating the level of credit risk associated with emerging as opposed to advanced economies -- has also been rising steeply.

International foreign exchange traders see the safety valve for financial markets now as lying not in foreign exchange reserves, but in dollar swap agreements. The interest for cross currency swaps (CRS) in which won are loaned out in exchange for borrowed dollars, has recently reached a minus level. This means that additional interest has to be paid to acquire dollars due to the lack of foreign currency liquidity. This is also being impacted by the rising demand for dollar borrowing among some securities companies. A foreign exchange dealer at Hana Bank said, “Some of the export companies are not letting go of dollars because they’re predicting the exchange rate will rise further.”

But many believe the likelihood of the exchange rate rising beyond 1,500 won to the dollar as it did during the financial crisis is slim.

“In 2008, there was the combination of a sharp rise in pressure to repay short-term borrowings and the sale of South Korean bonds by speculative foreign investors,” explained Lee Seung-hoon, an analyst for Meritz Securities. “It’s a different situation now.”

By Han Gwang-deok, finance correspondent

Please direct comments or questions to [english@hani.co.kr]