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The Effect of Global Financial Volatility on Won/Dollar Exchange Rate

The Effect of Global Financial Volatility on Won/Dollar Exchange Rate

JUNG Dae-Sun

Jan. 18, 2012

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Originally released on November 22, 2011

At a recent conference held by The Economist in Seoul, one banker labeled the won the “VIX currency” in honor of the market gauge that measures volatility. In fact, the won/dollar exchange rate has seesawed in tandem with the global financial market’s ups and downs. The CVIX, the average of volatility indices for the four developed nations (the US, Japan, the UK and Germany), was used to measure the won/dollar exchange rate’s sensitivity towards global financial anxiety. The result showed that a 10-point increase in the CVIX led to a 2.4% gain in the won/dollar exchange rate. Among a total of 33 major currencies, the won ranked 7th in terms of sensitivity towards global financial instability. It was found that the closer the currency was to the floating exchange rate system, the more sensitive it was to global financial anxiety. The won was also highly sensitive among currencies under the floating exchange rate system.

The determinants of the won/dollar exchange rate’s sensitivity towards global financial uncertainty were divided into macroeconomic variables and overseas ones. First of all, on the macroeconomic front, currencies of nations who have high interest rates or high inflation and current account deficits reacted sensitively to global financial instability. As for external variables, in emerging economies, the higher the financial market openness, the higher the ratio of short-term external debts to foreign exchange reserves, the more sensitive the currency was towards global financial anxiety. In addition, the currencies of nations, whether developed or emerging, which have a small-scale foreign exchange market turned out to be sensitive to global financial instability.

The won’s high sensitivity towards global financial instability seems to stem from external variables rather than macroeconomic variables. Korea’s interest rates and inflation were below the average of comparable nations’ and Korea’s current account surplus was relatively higher. Yet Korea ranked 5th in the degree of financial market openness among emerging economies and Korea’s ratio of short-term overseas debt to foreign exchange reserves exceeded the average of emerging economies. Lastly, the size of Korea’s foreign exchange market was only a third of the average of the entire nations. Excessive fluctuations in the won/dollar exchange rate fuel economic uncertainties, negatively affecting the economy. As aforementioned, external variables need to be improved to stabilize the exchange rate. To that end, while maintaining policies designed to open up the financial market, the government needs to take measures to relax sudden in- and outflows of foreign ca pital. In addition, short-term overseas debt should be put under strict control to quell worries over a possible foreign exchange liquidity crisis when the global financial market unsettles. Lastly, the size of the foreign exchange market should be increased through efforts for nurturing market makers to curb herd behavior and expanding the base of foreign exchange trading.

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