The Mysterious Overvaluation of KRW in the 1990s

Existing theories on real exchange rates predict a significant undervaluation of the Korean won (KRW) in the early and mid-1990s. For instance, given the historical importance of exporting sectors in the Korean economy, the optimum currency area (OCA) literature would postulate that massive current account deficits in the mid-1990s should have led to drastic weakening of KRW. The paper demonstrates why this expectation did not materialize and instead an unprecedentedly large degree of overvaluation occurred. It first shows that the KRW overvaluation during the 1990s was indeed unique in a quantitative, cross-national passion. Second, focusing on three variables, namely, financial repression, devaluation pass-through, and policy exhibitionism, the paper examines how the unraveling of the developmental state eventually gave rise to the 1990s’ overvaluation. It argues that the policy exhibitionism of the new civilian government amplified the influence of Chaebols on monetary policies, which in turn created a strong appreciative force to KRW. It also contends that the increasing pass-through cost of devaluation explains why Chaebol did not want to tame the excessive appreciative trend despite its detrimental effect on their exports.