Stabilizing Korean Financial Market

The Korean financial market showed instability after the outbreak of the Lehman Brothers incident in September, 2008. The financial market claimed the currency swap between Korea and the US was good news. Stock prices, the foreign currency exchange rate and bond prices all rose.

On the day of the announcement of the currency swap, the Korean won-US dollar exchange rate closed at 1,250 won, a drop of 177 won from the previous day. The drop was the biggest since 338 won on December 26 of 1997. The KOSPI soared by 115.75 points (a growth rate of 11.95%), its highest-ever jump.

Thanks to the stability of the foreign currency market, the interest rate of three-year government and public bonds dropped 0.15% points to 4.39%. At that time, the Korean financial market was suffering from severe instability as foreign investors withdrew money from the Korean stock market.

As the current account deficit from July to September in 2008 reached US$3.981 billion and foreign exchange authorities began to defend the local currency, Korea’s foreign currency reserves fell sharply by US$63.740 billion to US$200.5 billion in November that year from US$264.24 billion in March. At that time, US$200 billion in foreign currency reserves was regarded as the Maginot Line to prevent a national default.

The Korean financial market stabilized as the Ministry of Finance and Planning and The Bank of Korea announced the Korea-US currency swap agreement. The announcement meant that not only did the Korean financial market secure US$30 billion, but also the US would protect the Korean economy.

“The agreement enhanced the nation’s international credibility as the US would guarantee Korea’s capability to pay foreign debt,” said an official at the Ministry of Finance and Planning, adding, “This is similar to the situation that just the presence itself of about 4,000 US troops in Korea is getting rid of the concerns over our national security,”

Recently, the value of the Korean won fell sharply and people began to worry about a foreign currency crisis due to the European financial crisis and the bankruptcies of global banks. Korea felt it was walking on thin ice even though the nation had more than US$300 billion in foreign reserves.

This is because the Korean economy depends heavily on exports and imports and its financial market is widely open to foreigners. However, despite this, Korea cannot toughen its financial regulations. This is because the Korean economy may face a bigger crisis when it fails to earn trust from the international financial market. As a way to decrease anxiety over a crisis and financial instability, Korean President Lee Myung-bak agreed to expand a currency swap to US$70 billion with Japanese prime minister Noda Yoshihiko who visited Korea recently.

In addition, on October 26, Korean Prime Minister Kim Hwang-shik and Li Keqiang, the first-ranking vice-Premier and deputy party secretary of the State Council of the People’s Republic of China, signed an MOU and agreement to increase the volume of currency swap bet-ween Korea and China at the Central Government Complex in Seoul.

The Bank of Korea and the People’s Bank of China announced that they renewed a contract to increase the volume of Korean won-Chinese yuan currency swap to 360 billion yuan (64 trillion won or US$56 billion) from 180 billion won (38 trillion won). The agreement will be valid for three years and can be extended with a bilateral agreement.

In addition, the two parties agreed to review the possibility of turning swap currencies into reverse currencies and the size of such a change. This agreement aims to maximize the supply of foreign currency liquidity by making it possible to supply dollars instead of Korean and Chinese currencies when necessary.

With the currency swap between Korea and China increasing to US$56 billion, foreign currencies that Korea can now use totaled US$448.6 billion: US$303.4 billion in the currency reserve (as of September), US$70 billion in the currency swap with Japan, US19.2 billion in the fund of CMIM (Chiang Mai Initiative Multilateralization). This is expected to help stablilize the Korean financial market.

“Korea’s signing of currency swaps with Japan and China will reinforce a financial safety network within the Asian region,” said Choi Jong-gu, an assistant vice minister of the Minister of Finance and Planning. “Both countries agreed to strengthen a global financial safety net after expanding regional financial safety nets amid the European crisis, said Kim Jae-cheon, a deputy vice chancellor of The Bank of Korea. “This decision will reduce negative effects on the financial markets of the two countries.”

Experts say that China’s and Japan’s currency swaps with Korea signals that the competition to win the hegemony in East Asia has restarted. As the status of the US dollar fell after the financial crisis, countries in East Asia felt the need to establish Asian Financial Funds or create a single currency. In particular, China is pushing to globalize the yuan and is active in signing currency swap agreements with neighboring countries. Japan, a rival of China, is also strengthening financial cooperation in East Asia.

Of late, such movements hit a snag with international distrust of the Euro Zone System after the outbreak of the financial crisis in Europe. Instead, some people insist that the size and functions of the CMIM should be expanded to the level of the IMF.

China’s and Japan’s currency swap agreements with Korea are aimed at strengthening a financial safety net for the East Asian region in the long-term. This is because if a country secures financial cooperation with neighboring countries through a currency swap, the country can exert its influence during the expansion of the CMIM or the establishment of the AMF.

“China is wary of the possibility that the nation’s influence will become weaker than that of Japan. China also wants to take the lead in discussing a regional financial safety net in the future,” said Jeong Yeong-shik, a senior research fellow at the Samsung Economic Research Institute. “Currency swaps among Korea, China and Japan will be a matter of who will take the lead in this region, going beyond aiming to simply secure foreign currency liquidity.”

Many experts say that Korea’s expansion of currency swaps with China and Japan is a real benefit for Korea to gain amid the competition between the two contestants. In fact, Japan showed a lukewarm attitude about signing the agreement in 2008. But this time, Japan became very active about such an agreement. The volume of the swap increased to US$70 billion that was more than originally expected.

“Korea is able to play the role of the casting vote that can make either China or Japan stronger. Utilizing this fact, we will be able to set an agenda in East Asia,” said Jeong Dae-seon, a senior research fellow at the Samsung Economic Research Institute.

Some analyze that the expansion of currency swap by China and Japan has domestic political and economical reasons in addition to the goal of realizing financial stability. Some say that Japan’s expansion of a currency swap is a gambit to cover up very politically tough problems, such as a discussion on past affairs between Korea and Japan at the Korea-Japan summit meeting or a scheme to push for a Korea-Japan Free Trade Agreement.

Some say that the currency swap between Korea and China is also a strategic move by China to break through its tough domestic situations diplomatically. Recently, China has been suffering difficulties, such as a decrease in exports due to the European financial crisis and a drop in its trade balance surplus. In addition, the ratification of the Korea-US FTA is not far away.

The limits of the currency swaps are clear, as Jang Ha-jun, professor of economics at Cambridge University said in 2008, “Korea’s signing of a currency swap agreement with the US in 2008 is like securing an umbrella when a big storm is coming.” At that time, with the real economy in a slump, many unfavorable factors such as the liquidity crisis of small and medium-sized companies occurred due to the aftermath of a global credit crunch, although the national default crisis had disappeared. In fact, the won-dollar exchange rate closed at 1,497 won, higher than the level before the signing of the currency swap agreement.

In the same context, “The linkage of finance and real sector is very important,” Kim Jung-su, chancellor of The Bank of Korea said about the European financial crisis’ impact on the real Korean economy. “We need to carefully judge what impact the crisis will have domestically and internationally.”

People at The Bank of Korea have various opinions about whether the financial crisis in the Euro Zone moved to the Korean real economy after it hit the Korean financial market. According to the BSI in September announced by The Bank of Korea, business sentiment among big companies was the lowest in two years and three months.