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Stephen Lee, chief economist of Meritz Securities / Courtesy of Meritz Securities

The Korean won's traditional relationships with export growth and capital flows have been broken these days. It seems likely that elevated uncertainties and widening cross-country rate differences dominated the FX market and caused the U.S. dollar to strengthen as a trend.

Traditional formulation explaining Korean won broken

The foreign exchange rate is regarded as one of the most vulnerable and delicate financial indicators, given its reflection of nearly every event. Therefore, it is one of the most difficult financial indicators to forecast. It has become an increasingly challenging task, as the existing formulation — with those variables explaining the Korean won vis-à-vis the U.S. dollar — has become obsolete. Here are some examples.

First, Korea's export growth traditionally led the Korean won to strengthen. Except for 2004 and 2005 when authorities implicitly intervened to weaken the won, the two variables coincided. Recently, however, Korean exports have been growing nearly 10 percent year-on-year, but the won continues to weaken against the dollar. (Chart 1)

Second, the Korean won used to strengthen when the sovereign yield spread between emerging markets and advanced markets narrowed. A narrowing spread indicates net inflows to emerging financial markets from elsewhere. Therefore, the won, serving as both an emerging currency and a risk indicator, aligned with the narrowing spread, except during periods of heightened geopolitical tension on the Korean Peninsula. The relationship between the two has also been broken for the recent two years in the absence of any significant events from North Korea.

Third, the Korean won strengthened when foreign investors were net buyers in the nation's equity market. An exception occurred in 2006 and 2007 when the won remained strong despite net selling from foreigners. Back then, short-term borrowing from overseas rose very quickly, as banks had to neutralize their foreign exchange (FX) positions amid a massive hedging demand from shipbuilders and domestic residents investing outside Korea. The relationship between the two is now also broken. (Chart 2)

Hypotheses on US dollar dominance

I might just insist that the broken relationship is temporary and argue that the won will appreciate against the dollar. But I believe, rather than simply putting forth assertions, that a macroeconomist should always be suspicious about changes in dynamics and possibilities of emerging variables that people may have missed previously.

What I assume is that the dollar's dominance within the foreign exchange market may have been at the core of its continual strength. I would like to raise three hypotheses on this.

First, the U.S. may be absorbing most of the investment needs from elsewhere. U.S. equity indexes were at all-time highs and many investors are increasingly allocating their assets based on the dollar. This makes sense somewhat, as the financial account balance in the U.S. saw $890 billion worth of net inflows in 2023, and if accounting for portfolio investment balance, net inflows were a whopping $1.16 trillion. That said, massive net inflows into the U.S. have not always translated to a stronger dollar since 2000, hence this alone cannot explain the dollar's strength.

Second, the dollar's global presence may have surged. My conclusion on this is that the dollar is maintaining its status as the global key currency. Although the portion of the dollar within global foreign exchange reserves had been falling consistently since 2000, the U.S. still accounts for 25 percent of the global GDP in 2023 (IMF), and 88.4 percent of foreign exchange transactions were made via the dollar in 2022 (BIS triennial survey).

Third, escalating uncertainties on policies may have led to increasing speculative demand of the dollar and had the dollar strengthen consistently over time vis-à-vis non-U.S. currencies. I see this one as the most credible hypothesis.

Come to think of it, the global economy been confronting repetitive crises and elevated uncertainties since 2007. There were the well-known global financial crisis (2007-09), followed by the European debt crisis (2011-12), the trade war between U.S. and China (2018-19) and COVID-19 (2020-). For example, major central banks were extremely dovish and even adopted untraditional policies during the first 10 years following the global financial crisis. Now they are at their most hawkish in decades, as they moved to address the strongest inflation since 1980.

COVID-19 brought about massive forecast errors for the economy as well as policy. We never knew that recessions in major nations were to be that deep, nor that short-lived. Whether the inflation rate would surge near 10 percent, aggressive central bank responses were unknown. While it has become more comfortable to forecast the economy than it was in 2020, policy uncertainty stays heightened, which triggers consistent demand for safe havens.

On the other side, I note that the Korean won is exceptionally sensitive to uncertainties. This is because heightened uncertainties often lead to conservative attitudes on corporate investment. Korean exports are mainly B2B-oriented, so any elevated uncertainties create woes on the nation's export growth and the whole economy. This may have had greater influence on the FX market scene recently. (Chart 3)

Apart from elevated uncertainties and increased safe haven demand, the strength of the dollar can be explained from a factor that is certain — the government yield difference across regions. Since U.S. economic growth outperformed its advanced nation peers, and the U.S. Federal Reserve being most aggressive among major central banks, U.S. treasury yields stood far higher than those of Germany and Japan in recent years. This has led the euro or the Japanese yen to weaken against the dollar.

Conditions for non-dollar currency revaluation

I see three conditions for the dollar to reverse its trend going forward. First is the Fed initiating its rate cut. This would prompt cross-country rate differences to narrow going forward. Second, other central banks' rate cuts prompting non-U.S. economic recovery. The eurozone economy will likely benefit from this, given its sensitivity to manufacturing — a rate-sensitive industry. Third, the economy and policy should be more predictable. In other words, uncertainties should alleviate. Returning to a normal business cycle we have seen before COVID-19 can be an example, which is difficult to predict when.

The first and second conditions are likely to be met in the next 12 months. That said, given elevated policy uncertainties, the dollar will weaken to a limited extent. Under this environment, the Korean won will likely stay above 1,300 vs. the dollar for an extended period of time.

The writer is the chief economist at Meritz Securities in Seoul.