This blog post examines the impact of exchange rate appreciation on the current account balance based on the J-curve phenomenon and demand structure. It provides an analysis considering various economic factors.
Generally, exchange rate appreciation is known to improve the current account balance. The current account balance refers to the result of subtracting import value from export value (including goods and services). It is classified as a surplus when export value exceeds import value, and a deficit when import value exceeds export value. An improved current account positively impacts the national economy and, alongside the trade balance, is a key indicator of a country’s economic health. For instance, domestic companies bring foreign currency earned from exports back into the country and convert it into won. Therefore, when the exchange rate rises, even if the foreign currency price of our goods is somewhat lowered abroad, an increase in export volume leads to higher export revenue. This can boost corporate profitability and inject vitality into the overall economy. Simultaneously, the won-denominated price of imported goods rises, leading to reduced consumption of imports and consequently lower import value. However, this is merely a simplified economic theory; in reality, various variables can influence the current account balance.
For instance, in countries heavily reliant on importing raw materials or energy during a specific period, a rising exchange rate can become a burden. High import dependency means increased import costs due to the stronger currency raise corporate production costs, potentially leading to higher final product prices and negatively impacting the domestic economy. Furthermore, the growing complexity of global supply chains means the impact of exchange rate changes on imports and exports is now more intricate than before.
While a rising exchange rate might seem to always improve the current account balance, this is not necessarily the case. Even when the exchange rate rises, the current account balance can initially worsen before gradually improving. This phenomenon, when graphed, forms a J-shape, hence the term ‘J-curve phenomenon’. One reason for the initial worsening of the current account balance in the J-curve phenomenon is that the prices of imported goods do not rise by the same percentage as the exchange rate increase. This occurs because, for a considerable period after the exchange rate rises, foreign companies hesitate to immediately raise the won-denominated prices of their goods, fearing a decline in sales. Furthermore, it takes a significant amount of time for consumers to reduce their consumption of imported goods in response to price changes. Additionally, even if domestic companies lower the foreign currency-denominated prices of their export goods, it takes some time for foreign consumers to recognize this and increase their consumption. These complex time lags are one of the main factors causing the J-curve phenomenon.
However, as the shape of the J-curve illustrates, if the initially risen exchange rate persists and sufficient time passes for proper adjustments in product prices and quantities, the current account balance improves. In such situations, companies adapt to the higher exchange rate, enhancing their price competitiveness, and consumers also adjust to the new prices. As this adjustment process stabilizes over time, exports increase and imports decrease, leading to an improvement in the current account balance.
On the other hand, separate from the J-curve phenomenon, there are cases where the current account fails to improve even after a certain period following an exchange rate rise. First, even if price adjustments occur, the current account may not improve depending on the demand structure—how domestic and international demand for goods reacts to price changes. For example, if the exported goods are essential items with inelastic demand, demand may not change significantly despite price changes, preventing current account improvement. Even if exports increase and imports decrease, the current account balance may not improve significantly or may even deteriorate.
Second, in the long term, if exporting companies rely solely on exchange rate appreciation and fail to continue efforts like quality improvement or cost reduction, they may lose competitiveness, worsening the current account balance. Particularly, without technological innovation or productivity gains, companies lose competitiveness in the global market, inevitably leading to reduced exports and a worsening current account balance. Therefore, while a stronger exchange rate may be advantageous in the short term, improving the overall economic structure and securing sustainable corporate competitiveness are crucial from a long-term perspective.
In Korea’s case, the exchange rate is determined in the foreign exchange market, but policy authorities implement exchange rate policies that involve indirect intervention in the market as needed. A high exchange rate policy is generally preferred when the current account is in deficit. However, due to the complex relationship between exchange rates and the current account mentioned above, exchange rate policy must be carefully considered. Since a high exchange rate does not necessarily lead to an improvement in the current account, policymakers need to design comprehensive policies through a multifaceted approach encompassing the entire economy. Within these complex interactions, exchange rate policy plays a crucial role in the overall stability and growth of the economy.
