What Makes the Recent KRW Depreciation Episode Different from the Past?

Abstract

This paper studies why the Korean Won has recently remained depreciated against the US dollar relatively longer compared to earlier  depreciation episodes. We identify three depreciation episodes for the Korean Won against the US Dollar since 1999, following the Asian Financial Crisis: (i) the Dot-Com Bubble in 2000, (ii) the Global Financial Crisis in 2008, and (iii) the Global Monetary Policy Tightening after COVID-19. We show that the first two episodes of depreciation were primarily driven by risk factors, such as the global risk premium, and their durations were relatively short. In contrast, the recent episode has been largely driven by macroeconomic fundamentals, including monetary policies and Korea’s external imbalances, resulting in a relatively prolonged depreciation. One key factor contributing to the depreciation of the Korean Won in the recent episode is the upward shift in the fundamental real exchange rate, driven by negative external imbalances arising from increased foreign asset demand and weak trade balance performance. Notably, the increased foreign asset demand, which caused a shift in net financial asset trends, accounts for 40% of the depreciation rate during the recent global tightening episodes.

Keywords: Exchange rate, External Imbalance, Monetary Policy, Foreign Asset Demand, TradeBalance, Fundamental Exchange Rate