Budget Deficit Leads to Risk of Greater Exchange Rate Volatility

The Finance Ministry is using the exchange rate stabilization fund to fill the hole in the budget.

Budget Deficit Leads to Risk of Greater Exchange Rate Volatility

Photo: Chu Gyeong-ho, Minister of Strategy and Finance (right).  Credit: Ministry of Strategy and Finance.

The post-COVID reduction in liquidity has led to persistently poor exchange rates for the South Korean won. Despite the longstanding and commonly used rule of thumb that KRW 1,000 roughly equals USD 1, the exchange rate has deteriorated since mid-2022, reaching over KRW 1,300 to USD 1.

A major reason for the slide is that the Bank of Korea 한국은행 has kept its benchmark interest rate lower than the Federal Reserve of the United States, leading to a capital outflow. South Korea’s central bank has been under pressure to keep the interest rate relatively low in order to protect real estate owners with variable interest rate mortgages. (See previous coverage, “The Triple Quandary.”)

To prevent the KRW-USD exchange rate from spiraling out of control, the Bank of Korea has shored up the KRW’s value by steadily drawing from its USD reserves, resulting in an overall decline of South Korea’s USD reserves from USD 429.9B at the beginning of this year  to USD 418.3b as of August 31. Over the same time period, the South Korean won has been the second most volatile currency of all major economies, trailing only the Japanese yen.

The won’s ride is about to get even bumpier. The South Korean government has been facing down a record budget deficit caused by the slowing economy and declining real estate values. On September 3, the Ministry of Strategy and Finance 기획재정부 proposed filling the budget gap by appropriating up to KRW 20t (USD 15b) from the Exchange Equalization Fund 외국환평형기금, the fund earmarked for stabilizing the exchange rate.

The MSF said the Exchange Equalization Fund’s exchanges of USD for KRW mean that it currently holds an excess of Korean won. The Democratic Party 민주당 criticized the proposal, calling it “repaying debt with more debt.”

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