FINANCE AUTHORITIES SEEK WON STABILITY

C O N F I D E N T I A L SECTION 01 OF 03 SEOUL 001727

SIPDIS

SIPDIS

STATE FOR E, EEB, AND EAP/K, PASS TO FEDERAL RESERVE BANK
OF NEW YORK - CHOI & BOEGE,
TREASURY FOR OASIA/POGGI AND HAARSAAGER
NSC FOR TONG

E.O. 12958: DECL: 06/07/2017
TAGS: ECON EFIN EINV ETRD KS
SUBJECT: FINANCE AUTHORITIES SEEK WON STABILITY

REF: SEOUL 1490

Classified By: A/ECON CHIEF MIKE SPANGLER FOR REASONS 1.4 B&D.

SUMMARY
--------------

1. (C) The Korean won hit a nine-year high versus the
Japanese yen on June 1, prompting the Ministry of Commerce,
Industry, and Energy publicly to ask the Ministry of Finance
and Economy (MOFE) "to pursue currency stability and
strengthen export supports." Earlier in May, the won's
appreciation took center stage for the ROKG at its Trilateral
Finance Ministerial with Japanese and Chinese counterparts in
Kyoto. The won has climbed 18.5 percent against the yen over
the past two years compared to an 8.3-percent appreciation
relative to the dollar. Some MOFE officials attribute the
won/yen trend partly to increased currency and interest rate
speculation by foreign banks here and are concerned about a
concomitant spike in short-term foreign exchange (FX)
borrowing. As a result of these pressures, MOFE is likely to
step up FX market monitoring but avoid imposing non-market
controls. END SUMMARY.

Foreign Exchange Intervention
--------------

2. (SBU) Following several queries to banks about their FX
acquisitions, MOFE intervened in the FX market on May 17.
MOFE and the Bank of Korea (BoK) publicly announced their
intention to halt the recent won appreciation and bought
dollars and yen worth about USD 500 million. After the
rapidly executed intervention, the won weakened by 4.10 won
per dollar to 928.1 won from the previous day, while
softening to 7.7 won per yen. This was MOFE's first
intervention since December 6, 2006. Since May 17, the
won-dollar and won-yen rates have hovered around 927 won and
7.7 won, respectively, not far from previous highs. Market
analysts acknowledge the BoK's May 17th intervention seems to
have helped curb further appreciation for now, keeping the
won/yen in a tight range. However, they argue the won's
strengthening trend could reassert itself since market
participants appear to be discounting the possibility of
Japanese interest rate hikes.

Trilateral
--------------

3. (C) In discussions with us, Korean finance authorities
maintain the won's recent gains against the yen are
unjustifiable in terms of fundamental economic factors. They
point to Korea's chronically large trade deficit with Japan
as the main factor that flies in the face of the won's
continued appreciation. Perhaps more importantly, the
depreciating yen hurts Korean exports to Japan, while
bolstering Korean dependence on Japanese machinery and part
imports, up 10.8 percent in the first four months of 2007.


4. (C) Against this backdrop, the won's appreciation took
center stage for the ROKG at its Trilateral Finance
Ministerial with Japanese and Chinese counterparts on the
fringe of the Kyoto Asian Development Bank meeting in early
May. MOFE International Finance Bureau Director Kim
Yoon-Kyung recently told us the ROKG is "extremely
frustrated" by Japanese Finance Minister Omi's insistence
that the Yen's value is market-determined and his refusal to
"help untie the choking knot of the Japanese yen carry
trade."


5. (U) Nonetheless, the May 4th Trilateral Ministerial did
see the Chinese, Japanese, and Korean finance ministers agree
to enhance cooperation in regional currency markets, and to
promote a new Asian bond market initiative. The three
ministers undertook to strengthen information exchanges on
regional financial volatility. They also boosted their
bilateral FX swap arrangements to USD 80 billion under the

SEOUL 00001727 002 OF 003


Chiang Mai Initiative (CMI) system. (Note: The CMI is a
regional accord to fend off currency crises, adopted during
the ASEAN-plus-three meeting held in Chiang Mai, Thailand in

2000. It aims at lifting member nations out of financial
crisis by establishing a network of currency swap contracts
among member countries. End note.)

Foreign Banks
--------------

6. (SBU) Korea's complex FX situation has also put a
glaring spotlight on the role of foreign banks here. On
April 19, the BoK urged thirty-six foreign banks operating in
Korea to reduce their FX borrowing, particularly in Japanese
yen. The BoK noted short-term FX bank debt stood at a record
USD 113.6 billion in late 2006, up 72 percent from 2005 and
exceeding USD 100 billion for the first time. Short-term
debt (maturing in one year or less) accounted for 43.1
percent of all FX borrowing, up from 34.7 percent in late

2005. This trend persists into 2007, as banks ramped up
$12.7 billion in new loans in the first quarter of the year,
including USD 11.3 billion assumed by foreign banks. Our MOFE
contacts attribute the FX loan rise partly to the yen carry
trade, i.e., borrowing yen, converting it into won, and
parking it in interest-bearing securities to speculate on
continued won appreciation.


7. (C) From a systemic perspective, finance authorities
seem to be focusing on foreign bank branches in their
investigation of short FX debt flows because:

--only about 28 percent can be explained in terms of hedging
activity surrounding Korean ship-builder receipts. Korean
shipbuilders are believed to hedge around 70-80 percent of
their dollar exposure, amounting to about USD 40 billion in
both 2006 and 2007.

--domestic commercial banks are subject to FX liquid asset
ratios, which basically limit their net open positions in FX
and ensure they do not assume excessive risk.


8. (C) However, foreign bank branches are not subject to
the same regulations. Their capital is incorporated abroad
and their FX risks regulated by the country in which they are
incorporated. Since foreign bank branches are mainly driving
the increase in short-term debt, MOFE and the BoK are now
more frequently requesting information from the branches on
their FX positions. MOFE apparently believes foreign banks
are borrowing FX at lower interest-rate costs and exploiting
the spread on Korean treasuries. In addition, MOFE officials
suspect some of the yen swapped into won may be channeled
into on-lending to small- and medium-sized enterprises,
thereby raising BoK concerns about excessive risk-taking in
the market as a whole. The IMF's Article IV team is
currently in Seoul investigating these and other issues till
June 15.

COMMENT
--------------

9. (C) We believe MOFE's concern about the sharp increase
in short-term FX borrowing by foreign banks does not portend
any policy change. MOFE and BoK are unlikely to curtail FX
borrowing directly because they are reluctant to go against
their strong public commitments to the market mechanism.
However, the BoK will probably continue to intervene
indirectly in the FX market, as needed. Recent short-term FX
borrowing is a natural reaction to global trends in the Yen
carry trade coupled with rational expectations of the Korean
economy backed by ample liquidity and strong exports. In
light of the upcoming December 2007 Presidential election,
the BoK can be expected to keep walking a fine line on its
soft monetary policy, providing sufficient liquidity to
stimulate the economy, while watching for any signs of
overheating. END COMMENT.

SEOUL 00001727 003 OF 003


STANTON