Won's rapid strengthening raises fears of export headwinds as currency reverses course

After holding stubbornly above 1,500 won per dollar, the exchange rate has been gradually retreating, offering South Korea's economy a tentative exit from a prolonged period of won weakness. But with factors favoring further won appreciation piling up, some analysts are cautiously warning that a sharp and rapid decline could expose exports and economic growth to serious headwinds — and may even force authorities to intervene in the opposite direction to prevent excessive won strength.

The won-dollar rate has been widening its decline in recent weeks, according to the Bank of Korea. On Thursday, the intraday low reached 1,477.1 won, the weakest level for the dollar since May 12, when it touched 1,474.8 won. The intraday low first broke below 1,500 won on July 8 — for the first time in 27 trading sessions — and has continued to fall since.

A foreign exchange authority official attributed the accelerating decline to a confluence of factors: offshore dollar selling tied to reduced equity hedging on domestic stocks, and expectations that proceeds from SK Hynix's American depositary receipt (ADR) issuance would flow into the foreign exchange market.

Still, authorities and market watchers broadly agree that the won-dollar rate remains elevated relative to South Korea's economic fundamentals. Bank of Korea Governor Shin Hyun-song said at a monetary policy press briefing on Thursday that the exchange rate "has shown some signs of stabilizing compared to a few weeks ago, but remains at a high level."

The prospect of further US interest rate hikes continues to provide a floor for the won-dollar rate. Inflation concerns in the United States have intensified in the wake of the Iran war, lending support to expectations of additional Federal Reserve tightening.

At last month's meeting, the Federal Open Market Committee held its benchmark interest rate at 3.50–3.75 percent annually, but raised the median year-end rate projection in its dot plot from 3.4 percent to 3.8 percent — signaling that at least one more hike before year-end is the committee's prevailing expectation. A US rate increase would exert upward pressure on the exchange rate.

According to the CME Group's FedWatch tool, the probability of the FOMC raising its benchmark rate at least once before year-end stood at 70.9 percent as of Wednesday (local time). That was down 7.6 percentage points from the previous day's 78.5 percent following a softer-than-expected consumer price index reading, but still 13.8 percentage points above the 57.1 percent recorded a month earlier.

Even so, markets see more factors pointing toward further won strength ahead. Chief among them is the current account balance. South Korea's current account surplus in May reached a record $38.61 billion, driven by semiconductor exports. The cumulative surplus through May this year has already surpassed last year's full-year total. June exports also crossed $100 billion for the first time in history.

Bond inflows have also continued on a net basis, supported in part by South Korea's inclusion in the World Government Bond Index. Net bond inflows in June totaled $1.65 billion, marking three consecutive months of net inflows since April. The cumulative net inflow for the first half of the year reached $9.28 billion.

Demand for dollar conversion is also expected to persist, driven by semiconductor companies' domestic investment and tax payments. Particularly notable is the $26.5 billion SK Hynix raised through its US ADR issuance — converting those proceeds into won is expected to release a large volume of dollars into the spot foreign exchange market. An expansion of the National Pension Service's currency hedging ratio is also expected to boost demand for won.

Some in the market are now warning that the won could strengthen faster than expected. Exchange rates tend to amplify momentum once a direction is established. With the Iran war and sustained foreign equity net selling having suppressed won-strengthening forces until recently, a full-scale decline in the exchange rate — if it feeds into expectations of further appreciation — could accelerate sharply.

A falling exchange rate benefits importers and eases inflationary pressure, but exporters take a direct hit: the same volume of goods sold abroad translates into less revenue when converted to won. That, in turn, affects the trajectory of economic growth. South Korea is particularly exposed given its high dependence on external trade, with exports accounting for a large share of GDP. The economy is currently sustained largely by semiconductor-led exports. A sharp won appreciation that puts the brakes on the current account surplus could reduce corporate investment and employment, weighing on overall growth.

Should such a one-sided downward move materialize, authorities may find themselves intervening to restrain excessive won strength. Whereas they have been selling dollars in the spot market to curb upward exchange rate pressure, they could soon face the opposite situation — buying dollars to prevent a too-rapid decline.

"Compared to the pace of the recent rise, the current decline cannot be called steep," a foreign exchange authority official said. "But there are, and will continue to be, many factors favoring won strength."