With South Korea’s currency swap with Türkiye set to expire in August, concerns over whether the funds will be recovered have been raised. The Turkish lira has plummeted to the lowest level against the U.S. dollar in the past year, indicating financial instability amid rocketing inflation and a sluggish economy that teeters on the brink of default.
Bilateral currency swaps are agreements between two central banks to exchange currencies to secure foreign exchange liquidity for various purposes, including supporting bilateral trade and investment activities and preserving financial stability. On the specified date that the swap unwinds and the funds are returned, the central bank that requested the funds must return the principal plus interest to the other central bank.
The Bank of Korea (BOK) asserts that it will not incur losses even if the lira depreciates further, as the funds are to be returned at the exchange rate when the currencies were first exchanged. Since the currency swap with Türkiye is only used to settle trade, the BOK claims that it is unlikely that a large amount of Korean won will be withdrawn all at once.
The BOK and the Central Bank of the Republic of Türkiye signed a bilateral currency swap agreement worth $2 billion in August 2021, according to the BOK on June 7. The swap agreement is valid for three years and can be extended by mutual consent.
The BOK explained that it signed the agreement to stabilize trade between South Korea and Türkiye. The trade volume between the two countries increased by 32.7%, from $5.2 billion in 2012 to $6.9 billion in 2020. The BOK emphasized that the swap facilitates trade by allowing payments in both currencies without using reserve currencies.
But Türkiye’s overly accommodative monetary policy has stoked inflationary pressures. The country’s inflation rate hovered between 30% and 80% from late 2021 to March this year. As inflation rose, the lira’s value fell against the dollar. The lira’s exchange rate against the dollar surged to a record high of 32 lira earlier this year from 8 lira in August 2021.
Türkiye’s economy suffered another blow in February last year following a 7.8-magnitude earthquake. Türkiye’s 5-year credit default swaps (CDS), indicating the risk of national default, topped 900 basis points (bps) in 2022, reaching the highest level since 2008. While the CDS is now down to around 250 bps, it remains significantly higher than a decade ago when it was below 200 bps.
This instability has also affected the Korean won-Turkish lira exchange rate, which dropped from 130 won per lira in August 2021 to 40 won earlier this year. The value of the 175 billion lira, 2.3 trillion won at the time of the bilateral currency swap agreement, fell to around 746.9 billion won based on the May 31 exchange rate of 42.68 lira per won.
The BOK maintains that it will not incur any losses even if the lira depreciates because the agreement ensures that the won Türkiye receives through the currency swap must be returned based on the exchange rate at the time of the swap. This means that if the Central Bank of Türkiye buys 10 billion won in exchange for a certain amount of lira, it would have to return 10 billion won at maturity under the same condition.
Unlike typical bilateral currency swaps, the Korea-Türkiye currency swap funds can only be used for trade settlements. Companies from both countries can only withdraw funds in won or lira for trade-related transactions, which means the Central Bank of Türkiye cannot use the Korean won to provide market liquidity.
“Many misunderstand currency swaps as emergency liquidity measures, but the Korea-Türkiye currency swap serves a different purpose,” a BOK official explained. “The central banks of both countries deposit each other’s currencies and can only use them when a trade settlement request is made.”
Even if the currency swap expires without any problems, it is uncertain whether it will be extended for another term. When the BOK initially signed the agreement, the goals were to expand trade with Türkiye and leverage Turkey’s strategic position as a gateway to the Middle East and its accessibility to Europe. While trade with Türkiye surpassed $10 billion last year, the country’s high inflation and financial instability remain significant challenges.
