Bank of Korea’s steady hand on Won

The Korean Won Nominal Effective Exchange Rate has appreciated 4.7% since the 41-month low recorded on 12th August to a six-month high, with the Won up against the currencies of Korea’s largest trading partners, namely the Yen, Euro, Renminbi and Dollar.

A common view is that, with China accounting for about a third of Korea’s total trade, day-to-day speculative flows searching for a proxy to USD/CNY drive the Won. However, in the past 11 weeks USD/KRW has fallen 4.6% whereas USD/CNY has been broadly unchanged, suggesting that other balance of payment flows are driving the Won.

Foreign portfolio inflows into Korean equities and bonds have in recent years often closely correlated with USD/KRW. However, this correlation broke down between mid-March and early October and the Won NEER has been far more stable than volatile portfolio inflows into Korea, trading in a 9.5% range since March 2016.

We see a number of explanations for these dislocations, including the FX-hedging of local-currency bond purchases. Moreover, historically sizeable Korean trade and current account surpluses, which have shrunk sharply in the past 12 months on the back of slowing trade with China, have had a material impact on the Won’s medium-term trend.

However, in the past 108 months, the average Won NEER has rarely appreciated or depreciated by more than 2–3% mom (see Figure 13). Moreover, these moves have tallied with changes in the (adjusted) $-value of the Bank of Korea’s FX reserves, suggesting that the BoK intervenes in the FX market to smooth the Won NEER.

The BoK is probably not overly concerned with (modest) intra-day or even monthly moves in USD/KRW and its FX intervention has been light-handed, particularly in recent years. But it has shown a willingness to keep the Won NEER in a narrower band than if left to its own devices, with a bias towards selling Won/buying Dollars.

With the Won having made sizeable gains in recent months, BoK interest rate policy tight relative to CPI-inflation, GDP growth volatile and the outlook for US-China trade still murky despite recent developments, we expect the BoK to cut rates further and at the very least slow any Won appreciation in coming months to maintain currency competitiveness.

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