TCS Daily


Seoul Searching

By Christopher Lingle - April 7, 2005 12:00 AM

Several lessons can be derived from the resignation of South Korea's Finance-Economy Minister and Deputy Prime Minister Lee Hun-jai over speculative property transactions. Just as revolutionaries devour their own children, Mr. Lee was hoisted on the petard of the government he served.

He stepped down in the face of allegations that his wife amassed 6.5 billion won ($6.48 million) through land dealings that were allegedly illegal. As chairman of the Financial Supervisory Commission, Mr. Lee was an important player in the policy response after South Korea was affected by financial turmoil in late 1997.

Despite claims of innocence, his actions reflect a tendency for public officials (or, as in this case, members of their family) to think that laws they pass or enforce do not apply to them. If his denial is true and that he broke no laws, it suggests that a confusing plethora of legislation makes it difficult for citizens to be law-abiding. Either way, it is an indictment of the political status quo.

An equally troubling prospect concerns an anti-market hysteria that has fueled an ongoing witch hunt against "speculators". For his part, President Roh has joined Korean policy makers and politicians in shrill denunciations of speculation including an open declaration of war against property speculation. And the Bank of Korea governor pledged to combat "abnormal" currency moves while the Finance Minister set a top priority to halt a sharp rise of the won against the dollar.

It is true that the won's upward move against the weak dollar has exceeded the gains by other currencies. But this upward movement has occurred despite heavy currency market interventions by the BOK and Korea's Ministry of Finance. The won rose by 15 percent against the dollar in 2004 and is already up another 3 percent so far this year.

As it is, central bank interventions have contributed to Korea's foreign reserves rising to about $207 billion, up 70 percent from the end of 2002. Of the total of 7 trillion won set aside for the currency stabilization bonds this year, bonds worth 2 trillion won were issued in January and February.

With the stock of foreign reserves so large, it is unlikely that such extensive currency market interventions will continue. Even so, there are plans to increase the manpower committed to foreign currency management operations.

And so it is that the won will probably continue to strengthen. In light of these circumstances, the hedge funds smell blood carelessly splashed around by bureaucrats and central bankers at the BOK.

Despite its record level of reserves -- the fourth-largest in the world -- Korea's economy remains vulnerable to external shocks. As it is, excessive market intervention exposes the local currency to being undervalued, but it also comes at a high cost.

Besides causing inflationary pressures due to introducing excessive liquidity, the issuance of bonds adds to growing public-sector debts. And continuing to hold weaker dollar-denominated reduces the returns on foreign reserves.

It is ironic that the government has declared war against speculative attacks by foreign hedge funds. It is the policies implemented by the government and the exchange market activities of the BOK that have made the local currency a target of hedge funds.

Korea's small currency market and high dependency on make the won more vulnerable to external shocks. Similarly, the dominance of bank lending for funding, due to the underdeveloped domestic capital market, exposes the economy to changes in US interest rate policies.

It is true that hedge funds seeking speculative short-term gains have pressured the won by selling dollars in offshore non-deliverable forward markets in Singapore and elsewhere. But the movement of these hedge funds out of dollar-denominated assets and into Asian markets has also inspired a substantial rise in the prices of emerging market assets. As such, the funds experienced short-term gains from rising stock prices and from the appreciation of the local currency.

In all events, hedge funds did not cause the 1997-1998 financial turmoil. Instead, they found profit opportunities created by misguided government policies that increased volatility in currency markets.

In all events, attempts to control the foreign exchange rate by intervening in the market are based upon the notion that low export prices can boost short-term economic growth. It is time to abandon the costly illusions of mercantilist logic and export-led growth policies that were defeated intellectually in 1776 with the practical limits made clear in 1997. As such, exchange rates should be determined by supply-and-demand conditions and economic fundamentals that do not introduce price distortions into the economy.

Following bad economic advice, the government engaged in deficit spending while the BOK lowered interest rates to reverse two years of sluggish domestic spending. And now in a classic case of political bait-and-switch, there is an attempt to blame market forces and faceless outsiders for policy-induced problems.

Seoul should refrain from whipping up anti-market hysteria by targeting fund managers. Instead, there should be some serious soul searching over the optimum level of foreign exchange reserves and their influence over the domestic money supply.

Christopher Lingle is Global Strategist for eConoLytics.

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