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The recent won depreciation has come as a surprise to both us and the markets. Abundant dollar liquidity, Korea's strong semiconductor-driven exports, and weak dollar momentum seemed to support won resilience; instead, the currency has depreciated much faster than its Asian peers this year. While we had expected the pace of won appreciation to moderate following a 4.5 percent gain from early November to the end of 2020, the magnitude of the adjustment has exceeded expectations.
Was the move driven by economic, fiscal and monetary policy fundamentals in the United States and Korea? Does it put our bullish won view at risk? In short, no. There has been no fundamental change in the U.S. economic outlook or fiscal policy, in our view. Congress has passed the $1.9 trillion fiscal stimulus package, and vaccination rollout is supporting an economic rebound for the U.S. In the meantime, the Fed continues to provide expansionary monetary policy to support employment.
Then what has changed? We believe that expectations for U.S. growth, inflation and monetary policy are the key factors. The market is now concerned that a faster-than-expected economic rebound could fuel inflation, pushing up U.S. long-term rates. The Fed's response to rising U.S. Treasury rates has also disappointed the market, leading to global risk-off sentiment.
Higher yields are hurting tech stocks the most, with the Nasdaq down about 11 percent from the highs. This decline has led to outflows from tech-heavy Korean equities, hurting the Korean won. The short U.S. dollar―Korean won was a popular expression of the short U.S. trade at the start of the year, given its beta to the global growth and trade rebound. That positioning has come under pressure with the rebound in U.S. Treasury yields and the U.S. dollar.
For any economy, the immediate reaction to inflation is usually a negative impact on the currency. Inflation erodes the value of the currency and lowers the real interest rate, a key determinant of currency value. For the dollar, the market is currently concerned about the Fed's reaction to inflation and its impact on global dollar liquidity. This situation is pushing up long-term rates faster than inflation expectations, causing real rates to rise.
While the Fed is delivering the message that it will not tighten monetary policy in the short term, the market wants to see actions, not words. The market expects the Fed to expand quantitative easing (QE) or provide other policy tools for long-term yield control, as the economic rebound (supported by fiscal stimulus), pent-up demand, and rising commodity prices threaten to push up inflation. We do not expect the Fed to take immediate action to contain the rise in long-term rates, but we do think it will take action to depress long-term rates to support the economy, driving U.S. dollar weakness.
We also see a few positive factors driving up the Korean won. Korea's exports should continue their strong performance, supported by semiconductors. Exports rose 9.5 percent year-on-year in February, despite three fewer working days than the period one year earlier. Memory chip prices are showing early signs of recovery ― since December, DRAM prices have risen as much as 50 percent from multi-year lows, marking the biggest recovery since prices started to slump in late 2017. We expect Korea to be the biggest beneficiary of this price recovery from a cyclical slump.
While Korean investors' foreign asset purchases are seen as a drag on the Korean won, we are not particularly concerned about them. Korea has traditionally been a dollar-rich country. Supply of dollars via the current account surplus has averaged over $70 billion a year for the past 10 years.
Demand for dollars has strengthened further as Korean investors ― particularly the National Pension Service (NPS) ― move money abroad due to declining returns on investment locally. Increasing foreign asset allocation by the NPS has been a bearish driver of the Korean won view in recent years.
However, we expect the dollar supply to exceed demand this year, cushioning the impact on the Korean won. Meanwhile, retail investor outflows may not be sustained at high enough levels to have a material foreign exchange impact in the medium term. On the other hand, we believe that the upside for Korea's current account, from the ongoing recovery in memory chip prices, may be underappreciated.
Finally, we expect only limited capital outflows in case of an equity market correction. Korean equities have recently rallied sharply to new all-time highs. They are up around 37 percent since November and approximately 115 percent from the March 2020 lows. However, foreign investors have hardly participated in this rally.
The recovery in Korean equities failed to attract significant inflows until after the U.S. election. Korean equities saw net outflows of $24 billion from January to October 2020. After short-lived inflows of $5 billion in November, flows have recently dissipated again, with foreigners turning into net sellers in a domestic investor-led rally. Light foreign investor positioning reduces risks to the Korean won, from heavy outflows in the event of a stock-market correction.
So, where will the Korean won go from here? We are neutral on the currency in the short term. Rising U.S. Treasury yields and the resulting U.S. dollar strength, along with the weakness in tech equities, create short-term headwinds to the Korean won. But we expect the currency to appreciate thereafter, breaking 1,100 and reaching 1,080 by the end of September.
Park Chong-hoon (ChongHoon.Park@sc.com) currently heads the Korea Research Team at the Standard Chartered Korea. Before joining the bank, he worked as a senior research fellow and head of telecommunication policy at the Korea Information Society Development Institute (KISDI).
