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Structural Factors Behind Foreign Exchange Rate and Current Account Balances And Policy Directions Financial policy, Exchange Rate

Author Minsoo Han, Sungbae An, Hyosang Kim, Subin Kim, Jinhee Lee, Soyoung Kim, and Ju Hyun Pyun Series 20-17 Language Korean Date 2020.12.30

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   The goal of this study is twofold. On the one hand, when the Korean won is weak, we provide an empirical basis and response logic to the pressure of appreciation. On the other hand, when the won is strong, we analyze the effect of the exchange rate on the competitiveness of Korean exporting firms, thereby providing relevant policy directions. 
   Korea’s current account has generally maintained a surplus since 2000. However, the current account surplus did not immediately lead to an increase in net foreign assets. Indeed, Korea has become a net foreign asset country only since 2014. Korea’s continuous current account surplus and investment in safe but low-return foreign assets can be attributed to the rational choice of Korean investors who take into account that Korea has traditionally been a country with certain characteristics (e.g. the absence of a key currency, relatively less developed domestic financial market, and low accessibility to the international financial market). In Chapter 2, building on the important study by Chinn and Parasad (2003) and considering these additional determinants, we empirically analyze the determinants of current account. Our analysis shows that the more the domestic financial market develops or the access to the international financial market improves, the less the current account surplus tends to be. Therefore, for example, if accessibility to international financial markets is not taken into account, the current account gap—actual current account net of appropriate current account—can be overestimated. Our results imply that if the domestic financial market develops or access to the international financial market is strengthened, the current account imbalance will decline gradually in the long run.
   However, in reports on external statements of the IMF and the US Treasury Department, a country’s current account imbalance is occasionally interpreted as a sign of market distortions that stem from the foreign exchange interventions. Fortunately, according to their recent report, these institutions have assessed that Korea’s current account and exchange rate are generally consistent with economic fundamentals, and that, if any, the Korean policy authorities’ foreign exchange interventions are conducted in both directions to improve the disordered market situation. Nevertheless, in the future, pressures for appreciation of the Korean won will increase. Therefore, it is necessary to show empirically that Korea’s foreign exchange market intervention policy has a limited effect on the exchange rate in order to further reinforce the logic of responding to the pressure of exchange rate appreciation. In Chapter 3 we analyze the impact on exchange rates by explicitly considering the interaction of two policies—monetary policy and foreign exchange market intervention policy—in the model. Our main result is that the foreign exchange interventions have a statistically significant effect only in the short term. We also show that the result is robust even if we use alternative empirical methods. The results imply that the foreign exchange interventions could temporarily stabilize the exchange rate, but could not change the exchange rate level or the long-term trend.
   Furthermore, if the foreign exchange interventions are structurally only having a limited effect on the exchange rate, in order to address the pressure to appreciation the value of the Korean won, it will be useful to empirically identify the factors that determine the exchange rate. The recent empirical studies have already pointed out a weak correlation between the exchange rate between two countries and the economic fundamentals of the two countries, which is as opposed to the predictions of previous theoretical studies. In Chapter 4, observing the co-movement of the exchange rates of many countries, we extract common factors of exchange rate movement and empirically analyze the determinants of exchange rates, using financial and trade variables. First, we find that the dollar’s influence on individual exchange rates is found to be quite large. However, the sensitivity of individual exchange rates to dollar factors differed from country to country, and the sensitivity is highly related to the similarity between the capital inflow and outflow of individual countries and the global financial cycle, but the association with trade variables was not clearly observed. Second, in the exchange rate of most countries, the yuan factor is not statistically significant, whereas in Korea, the response of the won to the yuan is statistically significant. In particular, the yuan factor explains about 10% of the volatility of the won, and we observe a co-movement between the won and the yuan.
   Our above results are of policy significance in that they provide an empirical basis when addressing the pressure to appreciate the won. Meanwhile, an analysis of the effect of exchange rate changes on the Korean economy will have another policy significance. In particular, given the recent situation where the won’s appreciation pressure is expected to persist for the time being, it is necessary to examine the impact of the exchange rate on the competitiveness of the Korean exporting firms. In Chapter 5, we empirically analyze the effect of exchange rate changes on Korean export companies, using microdata on export companies. What differentiates this study from previous studies is that we classify the exporting companies based on size such as capital amount and sales, thereby analyzing how the correlation between exchange rate and the variables related to these companies’ business activities would vary by size. We find that if the won continues to be strong, the negative impact on exports, profitability, investment, and added value of small exporting companies is more pronounced than those of large exporting companies. In addition, we also find that in response to the negative effects caused by the won appreciation, the capital income of small exporting companies is the most sensitive among the factor incomes. Based on our results, we conclude that to strengthen export support for SMEs, it is necessary to pay attention to strengthening the provision of market information and re-establishing the roles of policy finance and trade insurance. In addition, it is a high time to discuss the direction of improvement of the Trade Adjustment Assistance Program to support rapid adjustment of labor and capital.

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