Concerns are growing over increasing volatility of won-dollar exchange rates due to escalating trade tensions between the United States and China and rising U.S. interest rates. If the volatility continues and the Korean won gets excessively weaker, more and more foreign capital could leave the country.
According to the Bank of Korea (BOK) on October 22, the local currency closed at 1,128.4 won against the U.S. dollar, down 3.7 won from last weekend. The exchange rate fell on the day but it has been on the rise in the second half of this year, which means a weakening of the won. The won-dollar exchange rate remained at below the 1,100 won level in the first half but surpassed the 1,120 won level in the second half and recently reached the 1,140 won level for a while.
The volatility of exchange rates is also likely to grow further. This is largely due to the intensifying trade war between the U.S. and China. The Donald Trump administration has again decided not to brand China a currency manipulator but there is growing concern in the market over the prolonged trade war. Some say that the U.S. has decided not to label China as a currency manipulator to use it as a weapon for the prolonged trade war in the future.
When the trade war is prolonged and intensified, there will be strong preference for U.S. dollar, which is a risk-free asset. The fact that the U.S. Federal Reserve System continuously sticks to the tight monetary policy is another factor behind the weaker won.
If the exchange rate gradually goes up toward the end of the year and the volatility grows further at the same time, an increasing amount of foreign capital can flow out of the South Korean bond market. Currently, the policy interest rate gap between South Korea and the U.S. stands at 0.75 percentage point. When the Fed raises the interest rate in December once again and the BOK decides to freeze the rate by the end of the year, however, the rate gap between the two countries will go up to 1 percentage point.
With the continuous expansion of the interest rate gap and lower arbitrage trading gains owing to a stronger dollar, foreign investors are highly likely to withdraw money from the domestic market.
According to the Financial Supervisory Service, the foreign ownership of South Korean bonds increased to 114.28 trillion won (US$100.96 billion) at the end of August but then decreased to 112.09 trillion won (US$99.02 billion) at the end of September and 111.08 trillion won (US$98.13 billion) as of October 18.