Korean Won Falls Below 1400:1 Amid Trade Negotiation Uncertainty

This week, the trade negotiations between Korea and the Trump administration have become increasingly challenging due to political uncertainty. This has raised concerns among investors who fear that Korea may end up signing an unfavorable agreement or failing to reach an agreement altogether. On Thursday, the Korean won to US dollar exchange rate fell below the psychologically significant level of 1400:1. This breach is seen as a "red line" by Korean authorities in their efforts to combat speculative short selling of the won, and it has opened the door for further depreciation of the currency.

Earlier this week, the Korean president expressed that if Korea were to accept the US demand for a 3500 billion dollar investment, the fourth-largest economy in Asia would need to sign a currency swap agreement with the US. This statement further intensified the selling pressure on the won. The president's concerns have sparked public worries about the potential for a financial crisis in Korea, similar to the one experienced in 1997, or the possibility of the trade agreement collapsing entirely. This would be a significant competitive blow to Korea's export-driven economy.

A representative from a securities firm noted that if an agreement is reached in the form of direct capital flows as demanded by the US, it would create an additional demand of approximately 100 billion to 120 billion dollars per year. This would exert significant upward pressure on the dollar to won exchange rate, leading to a depreciation of the won. The securities firm estimates that without a currency swap agreement, investing 3500 billion dollars directly in the US over the next three years could result in an annual depreciation of 100 won against the dollar.

This is one of the reasons why the Korean president has called for the establishment of a foreign exchange swap line between the Bank of Korea and the Federal Reserve, similar to the mechanism already in place between the Bank of Japan and the Federal Reserve. However, an economist pointed out that the US is unlikely to agree to an unlimited swap line between the Bank of Korea and the Federal Reserve. Instead, the Federal Reserve may suggest using the 'Foreign and International Monetary Authorities Repo Facility' (FIMA Repo Facility), an alternative dollar liquidity mechanism that allows foreign central banks to obtain dollars by pledging their holdings of US Treasury securities.

Currently, both sides are at an impasse over the "structural design of the 3500 billion dollar investment fund." Although they have agreed in principle to establish this fund as part of a broader trade agreement, which sets a 15% tariff cap on Korean goods exported to the US, the final agreement has yet to be reached. If the agreement is not finalized, Korean goods exported to the US could face a 25% tariff, making them more expensive for American consumers compared to competing products from Japan and Europe, which would only face a 15% tariff.

The shadow of past crises looms large over Korea's efforts to internationalize the won. The memories of the late 1990s foreign exchange crisis make it difficult for Korean officials to relax strict capital controls. Unlike the yen, the won does not have an offshore market and accounts for only about 2% of global foreign exchange transactions, far less than the yen's 17%.

The political considerations surrounding the trade negotiations are also influenced by Korea's history of presidential impeachments. Although the current president faces a relatively low risk of impeachment, they have publicly stated that they are under pressure to prioritize national interests. Many Koreans are already angry about immigration raids targeting Korean companies in Georgia, and a financial crisis at this juncture could quickly spark opposition within their support base.

Korea has proposed that the 3500 billion dollar investment should be structured as a combination of "investment and policy-based financial institution loan guarantees." On the other hand, the US is demanding that Korea accept terms similar to those agreed with Japan, where Japan agreed to transfer funds within 45 days of the US selecting a project. A professor noted that the president's remarks indicated that the current terms of the agreement are unacceptable. However, given the ruling party's majority in parliament, the risk of impeachment for the president is actually quite low.

Currently, the intertwining of political and financial risks casts a shadow over the potential trade agreement. Many investors believe that regardless of the outcome of the agreement, it will be a "lose-lose" situation for the Korean economy, further exacerbating the pressure on the won. A local foreign exchange trader in Korea, who wished to remain anonymous, stated that if the market prices in the expectation of a 3500 billion dollar capital outflow, the won to dollar exchange rate could easily fall to 1450:1. Currently, due to uncertainty, the exchange rate is volatile, and once the capital begins to flow out, the won will depreciate immediately.