Korea's Optimal Basket Exchange Rate: Thoughts on the Proper Operation of the Market Average Rage Regime (Written in Korean)

Abstract

For the last several years, considerable criticism has been leveled against Korea's ex­change rate management. While Korea was designated a currency manipulator by the U.S., domestically it is often complained that the won/dollar rate did not adequately reflect changes in Korea's export competitiveness and fluctuations in the exchange rates of major currencies. In view of this situation, Korea changed its exchange regime at the beginning of March this year from the dual currency basket system to a more flexible one, called a "market average rate regime". Under this new regime, the won rate is deter­mined in the exchange market based upon the supply of and demand for foreign ex­change and is allowed to freely fluctuate each day within a + 0.4 % range. This paper, first, seeks to evaluate Korea's exchange rate management under the dual basket regime of the 1980s, and then to construct an optimal currency basket for the won which could provide a proper indicator for exchange market intervention under the new market average rate regime. The analysis of fluctuations in the real effective exchange rate (REER) of the won in­dicates that the won rates in the 1980s failed not only to offset changes in relative prices between home and trading partner countries, but also to properly respond to variations in major exchange rates as further evidenced by sizable fluctuations in the nominal effective rates of the won. In other words, the currency basket regime which was adopted in 1980 for the stabilization of the REER of the won has not been operated properly, mainly because authorities often resorted to policy considerations in determining the won's rate. In the second part of the paper, an optimal currency basket for Korea is constructed, designed to minimize the fluctuations in the REER of the won without including policy considerations as a factor. It is recognized、however、that both domestic and foreign price data are not available immediately for the calculation of the REER. For this problem、the approach suggested by Lipschitz (1980) is followed、in which optimal weights for currencies in the basket are determined based upon the past correlation between price and exchange rates. When the optimal basket is applied to Korea since the mid-80s, it is found that the REER of the won could have been much more stable than it actually was. We also argue for the use of variable weights rather than fixed ones which would be determined by the changing relationship between exchange rates and relative prices. The optimal basket, and the optimal basket exchange rate based on that basket, could provide an important medium-or long term reference for proper exchange market intervention under the market average rate regime, together with other factors, such as developments in the current account balance and changes in productivity.