Elsevier

Japan and the World Economy

Volume 24, Issue 4, December 2012, Pages 227-234
Japan and the World Economy

Measuring misalignments in the Korean exchange rate

https://doi.org/10.1016/j.japwor.2012.09.001Get rights and content

Abstract

This paper measures to what extent the real effective exchange rate of the Korean won is misaligned from its equilibrium value by estimating the equilibrium value using the behavioral equilibrium exchange rate (BEER) approach. The economic fundamentals such as the terms of trade, the relative price of non-traded to traded goods, net foreign assets and real interest rate differentials are employed to assess the equilibrium exchange rate. Considering the drastic changes in Korea's trade pattern, the trade partner weights, which are used to compute the real effective exchange rate, are not fixed, but variable. The estimation results using the quarterly data from 1982Q1 to 2009Q4 indicate that the actual exchange rate of the Korean won was substantially overvalued for the period from 2005Q1 to 2007Q4, and substantially undervalued for the period from 2008Q2 to 2009Q3. The actual exchange rate deviates from the BEER and from the long-run equilibrium (or sustainable value) of the BEER by 32% and by 24% respectively in 2008Q4.

Highlights

► We measure to what extent the exchange rate of the Korean won is misaligned. ► We estimate the equilibrium value using the BEER approach. ► The Korean exchange rate was substantially overvalued from 2005Q1 to 2007Q4. ► It was substantially undervalued from 2008Q2 to 2009Q3.

Introduction

Over the last decade, the Korean won has been one of the most volatile East Asian currencies. When the standard deviations of the log-valued monthly exchange rates of East Asian currencies against the US dollar from 2000M1 to 2009M12 are computed, Korea's standard deviation, 0.123, is the highest, followed by 0.100 of Thailand, 0.093 of the Philippines, and 0.088 of Indonesia. With respect to the difference between the highest log value and the lowest log value during the same time period, Korea's difference, 0.463, is the second highest in East Asia following 0.489 of Indonesia.

In the literature that discusses the dynamics of exchange rates, it is often pointed out that it is highly probable that volatile exchange rates are misaligned from economic fundamentals because they are not as volatile. Although some economic fundamentals have been somewhat unstable in Korea over the last decade, especially when Korea was hit by external shocks, it remains questionable whether the highly volatile dynamics of the value of the Korean won can be explained by the movement of Korea's economic fundamentals.

Korea's macroeconomic indicators soon stabilized after a short period of instability caused by the Lehman shock in 2008. For example, the quarterly real GDP growth rate, which was as low as −4.3% in 2009Q1, has been higher than 6% for three consecutive quarters since 2009Q4. In addition, the current account balance, which was negative in 2008 for the first time in the 2000s on an annual basis, became positive in 2009. However, the exchange rate did not recover its pre-2008 crisis value, implying a possibility of exchange rate misalignments.

Although the value of the Korean won has fluctuated considerably in the last decade, the misalignment of the Korean won during this time period has rarely been explored. Papers that do address this issue such as Chinn (1998), Goldfain and Baig (1998), and Kinkyo (2008) mostly focus on the 1997 financial crisis period. Bénassy-Quéré et al. (2011) include Korea in their research on the world-consistent equilibrium exchange rates, but their data covers up to 2004Q3. Therefore, we cannot conclude whether and to what extent the won is under- or over-valued from the equilibrium rate assumed by economic fundamentals for the last decade. This is especially germane to the last few years in which the won has fluctuated severely due to the turmoil of the global financial crisis.

The issue of the misalignment of the Korean won is important not only for understanding the Korean economy, but also in the global context because an increasing number of papers point to under-valued Asian currencies as one of the major causes of the so-called “global imbalance.” However, the current literature does not give enough information concerning whether and to what extent, if at all so, the Asian currencies have been undervalued.

Considering this background, this paper aims to measure the extent to which the real effective exchange rate of the Korean won is misaligned from its equilibrium value as determined by Korea's economic fundamentals. To this end, this paper estimates the equilibrium value of the Korean won using the behavioral equilibrium exchange rate (henceforth BEER) approach of Clark and MacDonald, 1998, Clark and MacDonald, 1999. Examples of recent articles which have examined East Asian currency values adopting the BEER approach are Funke and Rahn (2005), Kinkyo (2008), Koske (2008) and Wang et al. (2007) among others.1

The following section briefly outlines the BEER approach. The reduced form of the equilibrium exchange rate equation is presented in this section. In addition, the definitions of ‘current misalignment’ and ‘total misalignment’ are explained. Section 3 presents the specific form of the exchange rate equation used in the present paper and its estimation results along with a description of how the data was obtained and computed. The last part of Section 3 reports the measured misalignments and discusses related issues. Finally, the conclusion appears in Section 4.

Section snippets

Behavioral equilibrium exchange rate (BEER)

This paper adopts the behavioral equilibrium exchange rate (BEER) approach, which computes the equilibrium exchange rate using econometric tools, and compares it to the actual exchange rate to determine whether the actual exchange rate is undervalued or overvalued. To compute the equilibrium exchange rate, the BEER estimates a reduced-form equation that explains the behavior of the real effective exchange rate over the sample period.

In particular, the BEER derives a reduced form equation based

Estimating the BEER equation and measuring misalignments

The BEER equation, or Eq. (2), is estimated using conventional time series econometric tools and the equilibrium exchange rate and the long-run equilibrium exchange rate are computed using the estimation results. This paper uses the quarterly data covering the period from 1982Q1 to 2009Q4 to estimate the BEER equation, to compute the equilibrium exchange rates and to measure exchange rate misalignments. The following subsection (Section 3.1) presents the specific form of the estimation equation

Conclusion

This paper measured the misalignments of the Korean real effective exchange rates. In particular, the actual real effective exchange rate was compared with the equilibrium exchange rate and with the long-run equilibrium exchange rate. The equilibrium exchange rate was calculated using the BEER approach and the long-run equilibrium exchange rate was calculated by plugging the long-run values of economic fundamentals into the BEER equation.

Of interest from the findings is that the Korean won

Acknowledgements

I would like to thank the anonymous referee for valuable comments. I am also grateful to participants at the 2011 Conference of Korea and the World Economy and at the seminars at ERINA and Keio University for their invaluable comments and suggestions. Research reported in this paper was supported by JSPS under Grant No. 21530237. The usual disclaimer applies.

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