CAPITAL CONTROLS

The won that got away

SEOUL

WHENEVER South Korea’s currency, the won, has fluctuated against the dollar in recent months, the authorities in Seoul have trembled. They remember the dark days of 2008 when they sent senior officials around the world to try to convince anyone who would listen that their export-dependent country was not about to become the next Iceland. It was a tough sell.

Back then local and foreign banks in Seoul had amassed huge short-term dollar debts. This was partly to fund foreign-exchange hedging in South Korea’s huge shipbuilding industry, and partly the result of investors pursuing a “carry trade”—swapping cheaply borrowed dollars for won on the expectation that the local currency would rise. But when debt markets dried up after the collapse of Lehman Brothers, there was rapid deleveraging. As South Korea’s capital account plunged into the red at the end of 2008, the won tumbled. In 2009, it was the second worst performing currency in the OECD—only slightly better than the Icelandic krona.

Fast forward to 2010 and South Korea has experienced the same pattern in miniature. An economy that the OECD this week said may grow by 5.8% this year has once again attracted lots of speculative foreign capital, funded by negligible interest rates in America and elsewhere. But investors have again proved fickle. Some of the biggest foreign banks in South Korea are European ones. As Europe’s debt crisis has unfolded, they have reverted to deleveraging, pushing down the won.

The government of President Lee Myung-bak has not been idle since it stared over the abyss in 2008, however. Advised by Hyun Song Shin, a well-known economist at Princeton University in America, it has pondered ways to control destabilising capital flows, which it hopes will influence “macroprudential” thinking in the G20, which it chairs this year.

On June 13th it set limits on the build-up of foreign-exchange derivatives that it believes makes the won one of the most volatile currencies in the rich world. Local banks will be allowed to have foreign-exchange derivatives no higher than half their capital base. Foreign branches, which have greater access to hard currency, have a higher ceiling of 2.5 times their capital. The limits are close to current levels; they will be introduced with a three-month grace period; and some existing positions can be held for up to two years. That helped minimise disruption in currency markets—the won actually rose against the dollar.

Taking control

Lots of countries are now experimenting with capital controls: three days after South Korea’s announcement, Indonesia introduced some mild curbs on flows of hot money. But Mr Shin insists the Korean measures are a “surgical response” to the country’s unique circumstances. These include a shipbuilding industry that is paid in dollars over three years and needs to hedge its costs in won by means of heavy buying of forward dollar contracts from banks. The country also lacks a deep local-bond market attractive to long-term foreign investors. There is, says Mr Shin, a maturity mismatch in South Korea between long-term assets and short-term liabilities that makes it vulnerable to sudden bursts of deleveraging. “Whenever Europe trembles, we are the first place to jump from,” he says.

The carry-trade activity also hampers monetary policy. For fear of encouraging speculative inflows, official interest rates have so far had to be kept at a meagre 2%, which raises inflation fears. With foreign-exchange limits in place it may be easier for the Bank of Korea to raise interest rates to a more appropriate level given the economy’s rapid growth.