The South Korean won (KRW) is the official currency of South Korea, and one of the most traded currencies in the world. The exchange rate of the won against other currencies, especially the US dollar (USD), has a significant impact on the country’s economy, trade, and financial stability. In this article, we will explore how the won exchange rate is determined, what factors influence it, and what are the implications for South Korea’s economic performance and outlook.
How the Won Exchange Rate Is Determined
The won exchange rate is determined by the supply and demand of the currency in the foreign exchange market. The supply and demand are influenced by various factors, such as trade flows, capital flows, interest rates, inflation, monetary policy, political events, market sentiment, and speculation. The Bank of Korea (BOK), the country’s central bank, also plays a role in managing the won exchange rate by intervening in the market when necessary to smooth excessive volatility or to achieve policy objectives.
The won exchange rate is expressed as the number of won per unit of another currency, such as USD/KRW or EUR/KRW. For example, as of late 2020, the USD/KRW exchange rate is 1107.12 – approximately 1100 KRW = 1 USD. Although high, the exchange rate has been remarkably stable for the past decade, primarily fluctuating between 1100 and 1200.
What Factors Influence the Won Exchange Rate
The won exchange rate is influenced by a combination of domestic and external factors. Some of the most important factors are:
– Trade flows: South Korea is a major exporter of goods and services, such as electronics, automobiles, machinery, petrochemicals, and semiconductors. The country also imports raw materials, energy, and intermediate goods. The balance of trade (the difference between exports and imports) affects the supply and demand of the won in the market. A trade surplus (when exports exceed imports) increases the demand for won, while a trade deficit (when imports exceed exports) increases the supply of won. Therefore, a trade surplus tends to appreciate the won, while a trade deficit tends to depreciate it.
– Capital flows: South Korea is also a recipient and a source of foreign direct investment (FDI), portfolio investment (such as stocks and bonds), and other financial flows (such as loans and remittances). The balance of capital account (the difference between inflows and outflows of capital) affects the supply and demand of the won in the market. A capital account surplus (when inflows exceed outflows) increases the demand for won, while a capital account deficit (when outflows exceed inflows) increases the supply of won. Therefore, a capital account surplus tends to appreciate the won, while a capital account deficit tends to depreciate it.
– Interest rates: The interest rate differential between South Korea and other countries affects the attractiveness of holding or borrowing won-denominated assets. A higher interest rate in South Korea relative to other countries increases the demand for won-denominated assets, while a lower interest rate decreases it. Therefore, a higher interest rate in South Korea tends to appreciate the won, while a lower interest rate tends to depreciate it.
– Inflation: The inflation differential between South Korea and other countries affects the purchasing power parity (PPP) of the won. PPP is a theory that states that the exchange rate between two currencies should equalize their price levels. A higher inflation rate in South Korea relative to other countries reduces the PPP value of the won, while a lower inflation rate increases it. Therefore, a higher inflation rate in South Korea tends to depreciate the won, while a lower inflation rate tends to appreciate it.
– Monetary policy: The BOK conducts monetary policy by setting the base rate (the interest rate at which it lends to commercial banks) and using other tools such as open market operations (buying or selling government securities), reserve requirements (the percentage of deposits that banks must hold as reserves), and foreign exchange interventions (buying or selling foreign currencies).
