Monday, September 20, 2010

Korea's Reason for Feasting This Year: The Yen's Strength

Chuseok is here and Korea is Feasting...because of the Japanese Yen
Well, it is Chuseok (추석) season, which begins tomorrow, September 21st, and lasts for 3 days.  This year, Korea's economy has to be especially thankful for one thing:  the Japanese Yen's incredible strength.  There is little doubt that Korea has feasted on the decline of Japan's influence on the world. 

Two years ago, the JPY/KRW exchange rate:  10
Now:  13.40

To those of you that don't know, it means the following: a Japanese product is now 34% more expensive, or less profitable than the same product made in Korea.  Well, what types of products might those be?  Try automobiles, ships, steel, and electronics.  Guess what Hyundai Motor, Hyundai Heavy, POSCO, and Samsung Electronics sell?  Who are their main competitors on a global basis?  Japanese in every case.  So, there is no doubt about why Japanese companies are bitterly complaining to the Bank of Japan.  For the moment, it has been effective:  the JPY/KRW exchange rate was over 14.25 just a week ago.

What does this mean for Korea going forward?
It is rare for the world to compliment both the corporate sector and the government, but this may in fact be true in Korea's case.  The government has been slow to reduce fiscal stimulus measures, and the Bank of Korea has responded to inflationary pressures by slowing increasing interest rates.  So while the demand for imports into the U.S. and China has waned, the JPY/KRW rate has kept Korean-made products very competitive, and now, as we all know, Korean-made products are, as a whole, on par if not superior to their Japanese-made counterparts. 

Derivatives the ugly word are most likely a partial solution.
Derivatives in Korea have left particularly ugly scars.  During the Asian currency crisis, Korean securities firms were heavily invested in speculative, leveraged investments linked to the Thai Baht.  During the Financial Crisis of 2007, Korean companies were found to have owned KIKO (Knock-In, Knock-Out) derivatives on the Japanese Yen. 
In today's case, it is the writer's view that Korean corporations need to get hedged, at least in part.  There is no way to tell, given the relatively weak global economic recovery, whether or not demand for Korean-made products will continue, and more importantly, how much of this demand is due simply due to the appreciation of the Yen.  Korean companies need some protection in case the Yen declines, and Korean-made products become relatively expensive and do not sell.
Notably, the carry trade would suggest that the Yen may in fact decline at the time that there is more optimism in financial markets as a whole.  That is what has confounded many experts in the market.  Equity markets globally are not far from their highs, and yet the Japanese Yen is near its greatest levels in 15 years. 
What does this means?  Either Korean-made products will continue to grow, and the Yen may or may not appreciate.  Or Korean-made products' sales will decline, as a result of either a global economic slowdown, or a depreciating Yen.  The worst case would be if the Yen depreciates, and Korean-made products' sales decline by more than would be anticipated due to a global economic slowdown.  It is this case that needs to be hedged in part.  

The days of Korean products needing to be cheaper in the global marketplace no longer exists.  In every major industry, Korea's products are competitive with other nations', at nearly every level.  As a result, Korea's companies shouldn't take extra risk by hoping that the JPY/KRW continues to be at such high levels.  Korean companies need to buy some puts on the JPY/KRW (that appreciate when the JPY/KRW level declines).  They should buy a partial hedge, which will cost money, but will provide protection against unfavorable moves.

No one knows exactly what will happen, but one thing is for certain:  the global economy is, and will contiune to have strange relationships due to the aftermath of the Financial Crisis.  Korean companies should take advantage of the sharp increase in JPY/KRW, with the knowledge that it, over the multiple-year horizon, will most likely not last.


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