Weakening Won Puts Pressure on Inflation

The falling won has exerted a heavy toll on the nation’s top refiner. SK Energy, which imports the entire quantity of crude oil needed to produce its petroleum-based products, suffered a foreign exchange loss of 150 billion won in the first quarter. The loss came from its assumption that the won-dollar exchange rate would remain in the 915 range on average this year. The company signed oil import contracts based on this exchange rate. Due to this loss, it saw its operating profit shrink 16 percent year-on-year. GS Caltex, another of the nation`s leading oil refiners, also posted profit losses in the first quarter for a similar reason.

The steep rise in the won-dollar rate has led import prices to jump. Import costs, in turn, affect consumer prices in a matter of one or two months. The fall in the value of the won coupled with skyrocketing commodities prices put a strain on the public and place pressure on the government to curb inflation.

Against this backdrop, Minister of Strategy and Finance Kang Man-soo’s policy direction on foreign exchange rates is being challenged. His policy is meant to increase exports and reduce current account deficits by keeping the won’s value low. Some say his policy has hit a snag.

○ Import prices continue to rise

According to a report on export and import prices for April released Friday by the Bank of Korea, won-based import prices in April soared 31.3 percent compared to the same month last year, recording a 10-year high since May 1998 when the value of the won plummeted in the aftermath of the Asian-wide financial crisis.

Soaring import prices subsequently raise production prices, followed by increases in consumer prices.

The year-on-year rate of import prices has steadily risen. Last December posted a 15.5 percent rise, and this year also recorded increases for three consecutive months with January at 21.2 percent, February at 22.2 percent and March at 28.0 percent. On the heels of rising import costs, inflation has also risen since last December, continuously exceeding the annual target of 3.5 percent, the upper limit set by the central bank to curb inflation.

This year’s sharp fall in the value of domestic currency is further raising import prices.

According to the central bank, foreign currency-based import prices, which eliminate impacts from exchange rate fluctuations, jumped 21.9 percent in April, down 9.4 percent from the same month last year. This means rises in import costs were two thirds due to increases in commodities prices and a third due to the weakening won.

The difference between won-based import prices and foreign currency-based ones was a mere 1.5 percent last December when the won-dollar rate stood at 930.24.

To this, Bank of Korea Governor Lee Seong-tae pointed out, “In the nation’s economy, the value of the won has more influence on inflation than commodities prices.” If the won loses ground against the dollar by 1 percent, consumer prices rise 0.08 percent for the year, which has four times more impact on inflation than oil prices, according to the Bank of Korea.

○ Weakening domestic consumption is more problematic than current account deficit

The won’s weakness encourages exports, exactly what the government wishes for. And rising volumes in exports slash current account deficits, contributing to economic growth.

The Korea Customs Service announced on Friday that the trade deficit slipped by a large margin to 195 million dollars. In March, the figure was 820 million dollars. A 26.4 percent rise in export compared to the same period last year, which is largely due to the “government–induced” high won-dollar exchange rate, has resulted in the slash in trade deficits.

However, as the depreciation of the won has given rise to rising inflation, there are growing voices that the weakening won’s virtuous effect on the current account balance is being overshadowed by the negative effect of sagging domestic demand. That’s because inflation has squeezed the working class’ purchasing power.

“When the value of the won is low, the price competitiveness of Korean goods naturally rises, leading to export growth,” said Oh Mun-seok, director of the LG Economic Research Institute. “But along with this positive result, unfavorable impacts of rising inflationary pressure and contracting domestic consumption should be taken into consideration,” he added.

Weakening domestic demand could take a toll on the service industry which has an ability to create jobs in large numbers. This means the government’s ultimate goal of high economic growth and job creation could be hampered by its intervention in exchange rates.

In fact, domestic demand is rapidly going down. According to the Bank of Korea, the rate of increase in consumer goods slumped 3.5 percent in the first quarter, down from 5.7 percent in the same period last year.

“It’s time for the government to adopt a low currency rate policy to control inflation and to help boost domestic consumption with low interest rates and budget expansion,” said Kywan Soon-woo, manager of the macro-economy analysis team at Samsung Economic Research Institute. “Recently, growth in export hasn’t translated into increases in employment and consumption,” he added.

According to experts, even if the economy continues to grow domestic consumption including growth in the service sector contributes to economic growth less than exports do, so businesses feel the overall economy is not in good condition.

Some argue that the weakening won exerts less sway on export these days, citing the situation in 2003 to 2006 when the nation saw a double-digit export growth despite domestic currency’s appreciation against the dollar.

“The falling won gives little help to domestic companies in lowering prices due to rising commodities prices. Export now depends on quality of goods and demand in importing countries rather than price competitiveness,” said an official of the central bank.