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According to the Bank of Korea on August 4, South Korea’s foreign exchange reserves hit an all-time high of 458.68 billion US dollars at the end of July, up nearly 4.6 billion dollars from the previous month. The U.S. is moving to normalize its monetary policy earlier than expected to signal the exit from massive quantitative easing. In this situation, what would South Korea’s record-high foreign exchange reserves imply? Here is researcher Oh Joon-beom at the Hyundai Research Institute to explain. 

South Korea’s foreign exchange reserves broke new records for seven months in a row from June to December last year, in the face of the COVID-19 crisis. They increased and decreased between January and June this year to reach an all-time high of 458.68 billion US dollars in July. 

Foreign reserves consist of marketable securities such as government and government agency bonds, deposits, gold holdings and the International Monetary Fund reserve position. Securities came to 414.9 billion dollars, accounting for 90.5 percent of the forex reserves, while deposits amounted to 30.8 billion dollars. Gold bullion and the IMF position stood at 4.79 billion dollars and 4.67 billion dollars, respectively.

 

Foreign exchange reserves of a country serve as a safety valve for its economy in case of emergency and contribute to stabilizing the foreign exchange rate and improving its sovereign credit rating. Researcher Oh explains two main reasons why Korea’s forex reserves have reached an all-time high. 

First, gains from foreign asset investments increased. Securities make up the majority of the total foreign exchange reserves. An increase in profit gains from the assets will therefore raise the forex reserves overall. Second, a weak dollar trend helped boost the value of assets in other currencies such as the euro, the Japanese yen and the British pound. Also, Korea has posted a current account surplus for a while, thanks to its robust exports, despite the pandemic crisis. This is not the main factor behind the increase in the forex reserves, but it certainly lowered the possibility of a decline in the reserves. 

As of the end of June, South Korea was the world’s eighth-largest holder of foreign exchange reserves, retaining the same position for three months. In terms of the size of foreign exchange reserves, China ranked first in the world with 3.21 trillion dollars, followed by Japan and Switzerland. 

During the Asian financial crisis in 1997, South Korea was forced to seek a bailout package from the IMF as its foreign exchange reserves fell to as low as 3.9 billion dollars. After the crisis, however, the situation improved. Since the 2008 global financial crisis, Korea’s forex reserves have remained solid, over 100 times larger than the level during the crisis in the late 1990s. Even amid the pandemic situation now, Korea holds sufficient foreign exchange reserves. Researcher Oh explains what this means. 

It means Korea can better safeguard its economy since it has ample resources for external payment. In other words, its macroeconomic soundness has improved. But when assessing the soundness in the foreign exchange sector, we need to examine other indicators as well, apart from the amount of foreign exchange reserves. For example, Korea’s short-term foreign debt accounted for 29.3 percent of its total external debt in March this year, indicating an improvement from the 10-year average of 30.8 percent. The ratio of Korea’s short-term foreign debt to its foreign exchange reserves was 37.1 percent, a slight increase from the 10-year average of 36.4 percent. Still, it is at a safe level. In comparison, Turkey’s short-term external debt-to-foreign reserves ratio is 148 percent, Argentina, 100 percent and Malaysia, 84 percent. Compared to those emerging economies, Korea’s foreign exchange sector remains relatively sound. 

Considering that foreign exchange reserves prove useful in case of emergency, people might think the more, the better. But there is something that should be given up in the process of holding the reserves. 

Forex reserves are invested in assets that are safe and cashable, although they may not produce high returns. U.S. government bonds, for example, are safe but their return rates are relatively low. In the course of securing stable foreign exchange reserves, a country may lose an investment opportunity to earn higher profits. Given the opportunity costs, it is necessary to maintain foreign exchange reserves at an appropriate level. 

Now, the U.S. economy is preparing for a COVID-19 exit strategy, which is feared to have a negative impact on the global economy and the Korean economy. 

The Federal Reserve said that it put the issue of tapering on the discussion table during a recent Federal Open Market Committee meeting. That is, the Fed has begun to discuss when and how to reduce—or taper—quantitative easing. Analysts expect that the Fed will start reducing asset purchases within this year. If that happens, some of the excessive liquidity in the market will be absorbed. It may result in the outflow of foreign capital from Korea and instability in the local financial market. A shift to monetary tightening in the U.S. will influence the monetary policy of the Bank of Korea. With household debt soaring in Korea, an increase in the key interest rate will place a heavy burden on indebted households. 

A shift in the U.S. monetary policy is expected to bring about a major change in the global economy. It is necessary to prepare for various safety measures, including an appropriate level of foreign exchange reserves. 

Growing concerns over the global movement for monetary tightening have generated controversy over the appropriate level of foreign exchange reserves in Korea. Clearly, it is necessary for the country to maintain a considerable amount of forex reserves, since the local economy relies heavily on external trade. Aside from the level of the reserves, it is also necessary to discuss measures to strengthen the fundamentals of the nation’s financial and foreign exchange markets overall. For instance, Korea could expand currency swap deals with “key currency” countries, tighten regulations on short-term speculative capital and induce the private sector to hold foreign currency assets through incentives. Basically, I think Korea needs to maintain or improve its economic fundamentals.

Korea’s record-high foreign exchange reserves may cushion the impact of the COVID-19 pandemic, which has caused the entire world to experience a recession. Korea needs to come up with specific ways to utilize the benefits of its abundant foreign exchange reserves and also to increase profits from the ever-growing reserves so the nation’s forex coffers will be operated in a more solid and efficient way.