Why did the South Korean won depreciate against the US dollar in the recent economic crisis and the Asian financial crisis 1997/1998? Won-dollar exchange rate movements and the role of capital flows

Stable exchange rates can contribute to a country's economic development and growth, whereas large exchange rate fluctuations could impair growth, price stability, and could lead to debt problems. Modeling exchange rates has generated a large literature but is nontrivial. One strand of the literature focuses on the role of cross-border capital flows which have increased dramatically in the last 15 years. This paper argues that net capital outflows have contributed to two significant won-depreciation events in the last 15 years. In addition, it examines the role of macroeconomic fundamentals or structural variables to capture differences between the US and Korea, and their influence on the won/dollar exchange rate. The data set covers 1995 to 2010 and uses time series primarily obtained from the Bank of Korea, but also from the Treasury International Capital System, Yahoo Finance, the Chicago Board Options Exchange and the Bank for International Settlements.;Results from testing several model specifications using OLS and various ARMA regressions support the hypothesis of this paper that capital outflows indeed contributed to the depreciation of the won/dollar exchange rate. Net debt securities, net loan and net trade credit flows were significant contributors to the won-depreciation. Regarding the control variables, a growth in the Korean money supply has contributed consistently and significantly to a won-depreciation, whereas a foreign exchange reserve accumulation has tended to significantly induce a won-appreciation. This is in line with expectations from economic theory.;Policy implications include that in order to reduce adverse effects of capital flow reversals, Korea could strive on the domestic front to reduce its reliance on (foreign) loans and enhance its financial markets to make them more resilient. Regarding its global linkages, Korea may influence the composition and maturity of cross-border capital flows by regulating capital flows, by strengthening the won's international role, by diversifying the role of and links with foreign financial institutions and investors and by strengthening bilateral and regional cooperation with other central banks.