Can high FX reserves protect Korea from another crisis?

In the wake of the Asian currency crisis in 1997 and the global financial crisis in 2008, Korea has experienced severe contractions in foreign currency liquidity that led to negative economic growth.

The currency crisis was triggered by massive bad debts of large companies and the depletion of foreign exchange reserves, while the global crisis stemmed from rising defaults on subprime mortgages in the U.S. The side effects of incidents have been huge, however, as they caused a sharp increase in short-term foreign debt that in turn led to the steep depreciation of the Korean won and a sluggish economy.

The Korean government says the situation is different now, citing a dramatic improvement in the country’s foreign debt structure including record-high foreign exchange reserves and a sharp reduction in short-term foreign debt. Analysts say having a sense of relief is premature, however.

Though indicators have improved, Korea’s small but open economy is vulnerable to external shocks, meaning foreign exchange reserves of 310 billion U.S. dollars might not be sufficient. Moreover, external liabilities are just 18.1 billion dollars short of the psychologically critical level of 400 billion dollars.

○ Situation different now

One reason the government is confident of foreign liquidity conditions is improved indicators. Foreign exchange reserves, foreign debt structure, current account balance and Korea`s sovereign credit rating have all improved since the financial crisis in 2008.

Total foreign liabilities stand at 381.9 billion dollars, slightly up from 365.1 billion dollars when the 2008 crisis erupted, but the government says this is no big problem.

Deputy Strategy and Finance Minister Choi Jong-ku said, “An increase in foreign debt is inevitable for economic growth. Including a sharp reduction in short-term foreign debt, economic conditions are far better now than when the global financial crisis erupted.”

Korea overcame the global financial crisis faster than other major economies and its economy has been growing at a sustainable pace, two factors behind the government’s confidence. After posting a deficit of 3.1 billion dollars in the first eight months of 2008, the current account posted surpluses of 32.8 billion dollars in 2009 and 28.2 billion dollars last year.

The ratio of government debt to GDP is 35.1 percent, considerably lower than the average of 102.4 percent in the Organization for Economic Cooperation and Development. Moody’s raised Korea’s sovereign credit rating by one notch in April last year, while Standard & Poor’s and Fitch maintain a “stable” credit outlook for the country.

Another reason for Seoul`s confidence is the long positions of foreign investors in the nation’s bond market, despite their selling spree in the stock market. From August 1-8, foreign investors net purchased 11,903 contracts in government futures while unloading 1.83 trillion won (1.7 billion dollars) worth of stocks.

“Foreign investors were net buyers until last week. Funds are flowing out of stock markets and into bond markets, which is a global trend,” said Choi.

○ Feeling of relief premature

It is premature to feel a sense of relief, however. In 1998 and 2008, the government also had said the situation was different from the past, but a liquidity crisis erupted unexpectedly.

The U.S. Treasury market, which had been considered the world’s most efficient financial market, is faltering and the status of U.S. dollar is weakening. So simply saying Korea will be unaffected because of high foreign exchange reserves is being too optimistic.

Against this background, renewed debate has appeared on if the level of foreign exchange reserves is sufficient. Though the government and the Bank of Korea have not released their official foreign reserves target, calls within these organizations are growing that the optimal figure should be 300 billion dollars or more.

A Strategy and Finance Ministry official said, “There`ve been claims that Korea holds excessive foreign exchange reserves, but this is a cost we must bear as a small open economy. We need more foreign exchange reserves considering our past experience of having been bailed out."

The ratio of short-term foreign debt has dropped to 38 percent, but financial authorities are not loosening tension. According to financial supervisory sources on Monday, the Financial Services Commission has set up a task force team for monitoring foreign liquidity in the country and ordered commercial banks to submit foreign currency funding plans against emergency situations.

The Finance Ministry summoned top executives of six domestic and three foreign-invested banks on July 29 to express concern over rising short-term foreign debt and requested them to refrain from issuing the so-called Kimchi bonds (foreign currency-denominated bonds).

Kookmin Bank last month raised funds through a long-term contract to prepare for foreign-denominated bonds worth 300 million dollars maturing at year’s end, and Shinhan Bank in April issued 500 million dollars in foreign-currency bonds.

How the government will tackle the potential rise of foreign debt to more than 400 billion won is also a concern. A Finance Ministry official said, “The level of market opening between Korea and China can be compared to a young and healthy Chinese man wearing a warm and heavy coat while a Korean child wears underwear. The former will not catch cold while the latter will for sure.”

The official implied that while Korea embarked on aggressive financial market opening at the U.S.`s request after being bailed out by the International Monetary Fund, this has repeatedly affected Korea adversely in times of crisis.

Financial Services Commission Chairman Kim Seok-dong blasted banks for their poor management of the liquidity situation, saying they deceived him three times since 1997 about their liquidity status. “Don’t trust banks that say they`re okay. Analysts say Korea should have stricter criteria than other countries," said Kim.

Park Won-am, an economics professor at Hongik University in Seoul, said, “Chairman Kim’s comments reflect that financial regulators have failed to understand the situation correctly. Regulators must raise the bar to help banks cope with a possible mismatch of short-term foreign debts against long-term foreign assets.”

Yoon Chang-hyeon, a business professor at the University of Seoul, said, “Korea has steadily accumulated foreign exchange reserves, but being optimistic on this means the government is being negligent in its role,” adding, “The government should re-examine the debt structure and strengthen safety measures against banks if necessary.”

Though not saying he was deceived, Yoon said he agreed with Financial Services Commission Chairman Kim`s opinion.

january@donga.com constant25@donga.c