February 1, 2006｜Korean Peninsula
Jai Min Lee
Director General, Overseas Economic Research Institute, The Export-Import Bank of Korea
The pace of the appreciation of the South Korean won since the beginning of this year has been extraordinary. On 4th January, the won broke through the $1 = KRW1,000 barrier and appreciated by 4.9% over the course of the month. Compared with the appreciations in the euro and yen exchange rates (2.7% and 0.4% respectively) during the same period, the pace of the appreciation of the won has been quite rapid.
When the exchange rate declines sharply in this way, the ROK immediately worries about its exports. This is because the South Korean economy relies heavily on exports, with exports accounting for about 40% of GDP. In fact, exports made a decisive contribution to maintaining the economic growth rate at 4-5%, even amidst the extremely severe slump in domestic demand that occurred during 2004 and 2005. This year, although domestic demand is recovering, the pace is not all that fast, so a great deal of hope is being placed in exports.
A decline in the exchange rate can result in a hike in the price of a country’s exports and play a part in reducing their price competitiveness. However, in the case of the ROK in recent years, the decline in the exchange rate has been having a greater effect on export profitability than on export price competition. In other words, in 2004 and 2005, when the won was appreciating, the ROK recorded a high rate of increase in exports, totaling 31.0% and 12.2% respectively. This kind of situation can be understood to be due to the fact that, with the recent increase in the sophistication of the export structure, the economic potential of exports depends more on quality and technological competitiveness than on price competitiveness, as was the case in the past.
The profitability of export-oriented companies is deteriorating significantly. For example, the export profitability of South Korean companies recorded negative growth compared with the same period of the previous year for five consecutive quarters, from the fourth quarter of 2004, when the exchange rate began to decline sharply, until the fourth quarter of 2005. During the first to the third quarters of 2005, the operating profit of the ROK’s leading export-oriented companies Hyundai Motor Company and Samsung Electronics declined by 36% and 43% respectively on the same period of the previous year.
In particular, in the case of the electrical and electronics industry, which is a major export-oriented industry, the share of dollar-based payments is 80%, so the decline in the exchange rate is directly linked to a fall in earnings.
This kind of deterioration in the profitability of export-oriented companies can ultimately be a factor that slows economic growth. In other words, if the decline in corporate profitability continues, companies’ willingness to invest will diminish, leading to a fall in capital investment, while at the same time bringing about a vicious circle in which the intensification of cost-cutting measures by companies causes a deterioration in employment conditions, which in turn results in consumption becoming atrophied. Thus, the high won can be said to have a significant effect on the economy via indirect routes, such as decreasing investment and employment due to deteriorating export profitability, rather than the direct route of a fall in exports.
Consequently, in responding to the appreciation of the won, I think that this kind of mechanism ought to be considered. Policymakers must become a support line to defend the exchange rate by ensuring that they have a constant grasp of the current exchange rate, which has an impact on corporate profitability. It is neither easy nor right for governments to intervene in exchange rate fluctuations, but it is not likely that the adjustment of the pace of exchange rate fluctuations by policymakers would mimic and distort the market. Governments cannot simply stand by and watch as sound companies rack up insurmountable losses due to sudden exchange rate fluctuations, irrespective of their own management activities.
Nevertheless, it is certainly not permissible for companies merely to rely on the government and neglect to implement their own measures to deal with exchange rate fluctuations. In order to maintain profitability in the face of the appreciation of the won, companies must raise export prices and cut production costs equivalent to the degree of appreciation. It is important to maintain the quality competitiveness of export items, to ensure that there is no fall-off in orders as a result of the rise in export prices; in order to reduce production costs, it may well be necessary to achieve an understanding between workers and the company, establishing a policy of wage restraint at times when the won is appreciating.