While it is generally believed that an appreciating exchange rate improves the current account balance, it does not always guarantee such an outcome due to the J-curve phenomenon and the complexity of the demand structure, which can actually worsen in the short term. In the long run, it is also possible for the current account to deteriorate if exporters simply rely on an appreciating exchange rate without making efforts to improve quality.
In general, an appreciating exchange rate is known to improve the current account. The current account balance is the value of exports of goods (including goods and services) minus the value of imports, and is categorized as a surplus when exports are greater than imports and a deficit when they are less. An improvement in the current account balance has a positive impact on a country’s economy and, along with the trade balance, is one of the most important indicators of a country’s economic health. For example, Korean companies bring foreign currency earned from exports into Korea and convert them into Korean won, so if the exchange rate appreciates, the amount of exports increases even if foreign countries slightly lower the foreign currency-denominated price of our goods. This can increase the profitability of companies, which in turn can stimulate the economy as a whole. At the same time, the local currency-denominated price of imported goods rises, which means that we consume less of them, so our imports decrease. However, this is just economic theory, and in practice, many variables can affect the current account.
For example, if a country imports a large amount of raw materials or energy during a given period, a rising exchange rate can be a burden. If a country is highly import-dependent, the increased cost of imports as a result of a rising exchange rate can increase the cost of production for businesses, which can lead to higher final product prices, which can adversely affect the domestic economy. In addition, the increasing complexity of global supply chains makes the impact on imports and exports from a simple change in exchange rates more complex than before.
While it may seem that an appreciating exchange rate will always improve the current account, this is not always the case. There is a phenomenon where the current account balance can worsen in the short term as the exchange rate increases and then gradually improve, which is known as the “J-curve” phenomenon because it looks like a J-shape on a graph. One of the reasons for the deterioration of the current account in the J-curve is that the price of imported goods does not increase at the same rate as the exchange rate increases. This is because for a considerable period of time after an exchange rate appreciation, foreign companies do not immediately increase the local currency-denominated price of their goods for fear of losing sales. It also takes a considerable period of time for consumers to reduce their consumption of imported goods in response to price changes. Furthermore, even if Korea reduces the foreign currency-denominated price of exported goods, it takes some time for foreign consumers to recognize it and increase their consumption. This complex time lag is one of the main factors that contribute to the J-curve phenomenon.
However, as the shape of the J-curve shows, if the initially appreciating exchange rate is sustained and the price and volume of goods adjust properly over time, the current account balance improves. In this situation, firms adjust to the exchange rate appreciation by making their prices more competitive, and consumers adjust to the new prices. If this adjustment process stabilizes over time, the current account balance improves as exports increase and imports decrease.
On the other hand, apart from the J-curve phenomenon, there are cases where the current account does not improve after some time following an exchange rate appreciation. First, even if the price of goods adjusts, the current account balance may not improve depending on the demand structure, which is how the demand for goods in Korea and abroad responds to prices. For example, if the goods you export are commodities with fixed demand, a change in price may not improve the current account because demand doesn’t change much. This means that even if the volume of exports increases and the volume of imports decreases, the current account balance may not improve much, or even worsen.
Second, in the long run, if exporters do not continue their efforts to improve quality or reduce costs by relying solely on exchange rate appreciation, they may lose competitiveness and worsen the current account. In particular, without technological innovation or productivity improvement, companies will lose their competitiveness in the global market, which in turn will lead to a decline in exports and a deterioration in the current account. Therefore, while exchange rate appreciation may be beneficial in the short term, it is important to improve the overall health of the economy and secure sustainable competitiveness for companies in the long term.
In South Korea, the exchange rate is determined by the foreign exchange market, but the policy authorities use exchange rate policy to indirectly intervene in the foreign exchange market as needed. If the current account is in deficit, a high exchange rate policy is generally favored. However, due to the complex relationship between the exchange rate and the current account mentioned above, exchange rate policy should be carefully considered. Given that a high exchange rate does not necessarily lead to an improvement in the current account, policymakers need to design a comprehensive policy with a multifaceted approach across the economy. In this complex interplay, exchange rate policy plays an important role in the overall stability and growth of the economy.
