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Growing Fears, High Dollar Demand Engulf FX Market

Posted October. 10, 2008 03:16,   

The Korean foreign exchange market is in turmoil, with the won’s value yesterday falling to its lowest level against the U.S. dollar since the 1997 financial crisis.

Foreign exchange experts say the won’s sudden depreciation is excessive given conditions in the domestic market and the state of other major currencies. The structural flaws of the Korean forex market and speculation are cited as the main causes of a “pot reaction,” referring to a situation in which things get easily excited but quickly cool down.

○ ‘Releasing muddy loaches in a small pond’

Several factors are pulling down the won. Korea is expected to record its first current account deficit in 11 years of 10 billion dollars. Foreigners have also net sold 33 trillion won worth of shares this year.

Korea’s economic growth forecast next year has been readjusted downward to under four percent.

The majority of foreign exchange experts, however, say the massive drop in the won’s value over the past four days cannot be explained by macroeconomic factors alone. They blame an abnormal repeating situation of a dollar buying spree and the dearth of greenbacks sold on the foreign exchange market, whose trading has plunged more than one third.

“The currency market has frozen so much, the actual demand in the foreign exchange market was under three billion dollars Tuesday,” said Choi Jong-gu, director of the international finance bureau at the Strategy and Finance Ministry.

“While foreign investment funds have reduced the volume of forward exchange and hedge funds, financial management companies sought to buy 700 million dollars, dealing a blow to the won’s value. The actual demand from importers such as oil refiners was reportedly less than 100 million dollars.”

○ Hoarding dollars amid market insecurity

The international balance of payments between January and August this year was a deficit of 18.2 billion dollars. In theory, the amount of the trade deficit is equal to a dollar shortage. The government has injected 20 billion to 30 billion dollars this year into the foreign exchange market in a vain attempt to deter the won’s fall.

“You should look at the international balance of payments to gauge dollar inflow,” a senior executive of a foreign bank said. “Though the current account was in the red in August, the trade balance returned to the black after the capital account did so.”

“The market is being driven by an irrational herd mentality responding only to the current account deficit.”

Foreign exchange authorities say certain companies are keeping their remaining dollars to protect against a weaker won or dollar shortage. Speculation is one of the suspected causes of the currency’s plunge.

“Because of the high chance that the foreign exchange rate will plummet, if companies delay their payments in dollars, they will eventually be the ones to suffer,” Choi said.

○ Tiny FX market

The Korea Institute of Finance examined changes in the values of major Asian currencies between January and July this year. The think tank found that the Thai baht and Korean won, whose trading volumes are relatively lower, depreciated considerably more than the Indian rupee and the Philippine peso.

“Unless the market has sufficient foreign currency trading volume to absorb the impact of foreign stock sell-offs, a sharp depreciation cannot be avoided,” said institute researcher Park Hae-shik.

Another cause of the unstable currency is Korea’s heavy dependence on foreign investors, foreign banks in Korea, and export companies for dollar supply.

“It’s difficult to borrow dollars from foreign-owned banks and hard currency owned by export companies are tied to forward exchange, so the market is in an abnormal state where everyone is hesitant to sell dollars despite strong demand,” said Jeon Jong-woo of SC First Bank.

○ Bottleneck phenomenon in FX infrastructure

Though foreign exchange trading is rising with the liberalization of the capital market, the foreign exchange infrastructure lags behind. One prime example is offshore non-deliverable forward (NDF), which is considered highly speculative.

The size of offshore trading has constantly increased since domestic banks were allowed to conduct NDF trading in 1999. The daily volume of such trading has jumped from 2.6 billion dollars in 2005 to 9.8 billion dollars between January and August this year.

NDF markets in Hong Kong, Singapore and London are open 24 hours a day and serve as an ideal place for foreign currency speculators, who only have to place a small bond to get a forward exchange contract and pay only the difference later. The offshore NDF market’s movement is reflected in the Korean foreign exchange market the next day, giving rise to the phenomenon of “a tail wagging the body.”

“If someone buys and sells 200 million to 300 million dollars on the NDF market at once, the market cannot avoid the shock,” said a foreign exchange dealer at a commercial bank.

Distrust in Korea’s foreign exchange authorities is another cause of market anxiety. “Market players don’t believe the government as it intervene a step later and send signals that worsen market anxiety, like having officials urge banks to sell their dollar assets,” said a former senior foreign currency dealer at a state-run bank.

○ Improve infrastructure in FX market

To dispel anxiety in the foreign exchange market in the short term, experts say the government should secure overseas capital liquidity. In the long run, the infrastructure of the domestic foreign exchange market should be strengthened and more efforts are needed to bolster the international position of the won.

“In the short term, as the current foreign exchange market is excessively abnormal, the government should consider this as market failure and take appropriate measures such as setting limits on the daily rise and fall of the currency,” said Yoon Deok-ryong, an economist with the Seoul-based Korea Institute for International Economics.

“In the mid to long term, the government should consider broadening foreign market players to small and medium-size companies and promote trading in other currencies rather than the dollar, such as the euro.”

Others say the Korean electronics and shipbuilding industries, which command leading positions in the global market, should increase transactions made in won, adding the two sectors can promote the won as an international currency.



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