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[Editorial] Brace for the worst

The nation’s foreign exchange reserves fell by a margin of $8.8 billion to $303.3 billion between the end of August and the end of September, the largest drop since November 2008. The decline, government officials say, resulted mainly from the weakening value of assets held in euros and pounds.

There is no denying, however, that a substantial amount of foreign exchange was used to defend the weakening Korean currency, which threatened to stay above the exchange rate of 1,200 won to the U.S. dollar. But the wisdom of such market intervention is questionable.

Greater discretion needs to be exercised in the use of foreign exchange reserves at a time when another global financial crisis, this time of European origin, is looming large. Moody’s has recently downgraded Italy’s sovereign credit rating by three notches and a Greek default is now regarded as a matter of when, not if.

In a global financial crisis, foreign exchange reserves must be made to serve as the Korean currency’s defender of last resort. In this regard, it is worthwhile for the financial authorities to reflect on the grave mistakes they made in the wake of the Lehman Brothers debacle of Sept. 15, 2008.

The foreign exchange reserves, which were at $239.6 billion at the end of that September, dropped to $212.2 billion one month later. Despite the massive market intervention, however, the won’s value against the dollar plummeted 14.6 percent during the 40 post-Leman Brothers business days. The financial authorities were accused of playing into the hands of speculators, who were betting that they would intervene in the foreign exchange market at the mere sign of a forthcoming fall in the won’s value.

The financial authorities are confident the won will not plummet, as it did in 2008, because the nation’s financial fundamentals are now in better shape. Kwon Hyouk-se, governor of the Financial Supervisory Service, says, “The demand for and the supply of dollars are now much more stable than in 2008.”

Indeed, the fundamentals have much improved since 2008. The first among them are the foreign exchange reserves, which increased from $243.2 billion at the end of August 2008 to $303.3 billion last month. The fear of a sudden outflow of foreign exchanges has been much allayed, given that the portion of short-term foreign debt in the total foreign debt fell from 51.9 percent to 37.6 percent. Also encouraging is the nation’s current account with an accumulated surplus of $12.3 billion so far this year, compared with the deficit of $3.1 billion incurred in the first eight months of 2008.

Yet, not many market players are convinced that the domestic economy would weather a global financial crisis with ease, should one come. In the past, the financial authorities have invariably referred to sound fundamentals ahead of an impending global crisis. But never has Korea emerged without being severely bruised. Market players do not want to be duped again.

Moreover, there is no consensus on what quantity of foreign exchange reserves would be enough to shield the domestic economy from a global financial crisis. Some say the current level of foreign exchange reserves is more than enough. But one calculation puts the proper amount at $384.8 billion ― much larger than the current reserves.

Another problem is that the domestic economy does not perform as well as in the past. Growth is slowing and inflation is refusing to be tamed. True, Korea’s external trade has been producing monthly surpluses. But their amounts are declining.

Foreign exchange earnings could drop further if the European crisis should be protracted and spill over to other regions. Already there is much talk about a double-dip recession coming to the United States. Nouriel Roubini, a U.S. economist, goes as far as to say, “At this point, the debate is not whether we’re going to have a double-dip recession or not. The double dip has started.”

The best way to protect the domestic economy is for the financial authorities to prepare for the worst situation imaginable by putting more into foreign exchange reserves, reducing short-term foreign debts and taking other necessary measures. It is of no use to talk about sound fundamentals to market players with deep suspicions.
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