KiKos and the South Korean Won Analysis


The international system of banks, loans, and transactions is based on the sanctity of agreements between different parties participating in the process. In theory, unless the agreement was made on an unlawful basis, its power is absolute, and the sides that signed it are expected to follow the agreement to the end, even if it is not in their best interest. Supreme and international courts, in general, ensure that agreements are upheld, as any decision to go against the practice is sure to undermine the foundations of trust and certainty of deals, which are paramount in a global economy. However, there are instances when following the agreement in a large-scale event, such as an economic crisis, could potentially lead entire economies to ruin, forcing supreme courts and governments to choose between the bad and the worst. Such a development was amply demonstrated by the South-Korean Won crisis of 2008, which demonstrated the inefficiency of the Knock-in Knock-out option (KiKo) (Ko & Moon, n.d.). The faulty structure of the agreement between banks and the manufacturers, as well as an obvious lack of prescriptions for Force Majeure circumstances, lead to the development of the crisis, where South-Korean manufacturers and banks operating in the country lost billions of dollars and affected the economy of the entire region.

Background of the South-Korean Won Crisis

The economic crisis in South Korea that happened in early 2008 was preceded by the mass adoption of the KiKo options by the majority of South-Korean manufacturers. As South Korea is a major exporter of numerous high-tech products, ranging from electronics to automobiles, all branches of its industrial sector were tied to the KiKo options provided by local and foreign banks. KiKo stands for Knock-in and Knock-out. It is essentially a double-barrier exchange option, where a condition is activated upon reaching the Knock-in, or the upper barrier, and is deactivated should the exchange rate drop below a certain rate, which is a Knock-out barrier (Ko & Moon, n.d.).

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The reasons why so many companies signed up with this option is simple – for the past years, between 2006 and 2007, Korean Won was steadily growing stronger. Manufacturers receive payments for their products in USD, which they later exchange into Won in order to conduct operations in the Korean market. If the Won is strong, they receive less of them per dollar, which means an economic loss, as prices in the Korean market remain the same. In order to protect themselves from these losses, many companies signed KiKo contracts, which was supposed to offer them a fair exchange rate, so long the balance did not drop or go above the Knock-in and Knock-out barriers.

However, at the beginning of 2008, the South-Korean Won started to rapidly lose its strength. It surpassed the Knock-in rate of 980 Won per USD and continued to grow exponentially (Ko & Moon, n.d.). As per the KiKo option, the companies were not allowed to trade their currency for more than 980 Won per USD, when the actual currency rates were much higher. The prices on the local market responded to the weakness of the Won, as many products imported from abroad also grew in price, thus leaving the manufacturers in a deficit. By the end of August 2008, South-Korean exporters lost more than 1.67 trillion dollars in US currency (Ko & Moon, n.d.). The situation had only gotten worse since the beginning of 2009, when the exchange rates rose to over 1600 Won per USD, almost 2 times above the Knock-in rate (Ko & Moon, n.d.). The losses suffered by the manufacturers, big and small, including South-Korean strategic and economy-forming industries faced potential bankruptcy, should they have had committed to following the KiKo contracts they signed with the major banks. If they were to break the contracts, however, the banks would lose profit. Series of lawsuits from many companies followed, with over 160 lawsuits involving 13 major banks operating in the country. Among those banks were Standard Charted, Citibank, and the HSBC (Jung-a, 2009). The decisions made by the South-Korean Supreme Court became a subject of controversy, as the judges made an en banc decision in some cases while forcing other companies to adhere to the KiKo contract. It set a precedent both in South-Korean and international jurisprudence and was critiqued by the Korean media and the International Swaps and Derivatives Association alike. The former criticized the Supreme Court for not protecting the national interests by letting some of the manufacturers suffer penalties and pay to the foreign entities, whereas the ISDA accused South Korea of undermining the tenets of international law and potentially threatening the integrity of the entire region (Jung-a, 2009).

Ethical Issues

The ethical issues surrounding the KiKo contracts formed the base behind the lawsuits towards the major banks. The manufacturers called the banks out on not fulfilling their duties to the customers by offering them products they did not need, not explaining the contract in detail, and purposefully withholding information from the customer in order to lure them into a flawed deal. The banks responded in turn, calling out the companies on filing lawsuits as soon as the conditions of the contract stopped being beneficial to them, and stated that the effects of economic crisis on the KiKo contract were not their fault or responsibility (Ko & Moon, n.d.).

Each side of the argument has a degree of truth to their position, which resulted in much controversy over the matter. The banks have a moral obligation to avoid offering their clients a deal that would potentially bring them to ruin. Under the US Law, this is called the Fiduciary Responsibility. The major flaw in the KiKo system was the lack of safeguards against major currency drops, which originated the crisis. However, it could be speculated that neither the Banks nor the Customers expected the crisis to happen, which was why the safeguard was never included in the final draft of the agreement (Ko & Moon, n.d.).

The manufacturers, on the other hand, are obliged to follow the contract, even if it does not benefit them. This is the basis for any agreements, for if those were detracted every time they stop being profitable, the entire economic system would collapse. The true reasoning behind the lawsuits on the part of the manufacturers en-masse was to avoid ruination and bankruptcy. Just like the banks, they were not responsible for the economic crisis that hit South Korea. Both the banks and the companies became the victims of an imperfect contract (Ko & Moon, n.d.).

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The government and the Supreme Court of South Korea were caught between a rock and a hard place. If the decision were to be made in favor of the banks, the entire national economy would collapse. If the decision were to be made in favor of the companies, it would create a major precedent and possibly exclude the country from the international banking system as “untrustworthy.” The government has a moral obligation to honor international agreements and ensure justice. However, its greater moral obligations are to its people. Thus, the Supreme Court of South Korea was unable to remain impartial in these matters (Ko & Moon, n.d.).

Economic Effects

Both the South-Korean Banking system and the industry were forced to take a hit, as having either bear the entire weight of the crisis would result in a collapse. In 2014, Seoul Central District Court made decisions on 11 major lawsuits, four of which were solved in favor of the manufacturers rather than banks (Lee, 2014). As a result, the banking sector is currently struggling with a foreign currency liquidity crunch. Standard Chartered, Citibank, Korea Exchange Bank, and Shinhan Bank are all taking a big hit, as they are forced to pay for the damages, and collectively are responsible for 70% of the KiKo agreements (Lee, 2014). Certain major Korean companies, like the GM Daewoo, have also suffered a hit, and a loss of 1.11 billion in USD (Ko & Moon, n.d.). The damage dealt with the Korean banking sector, one of the most prominent in the region, helped transmit the economic crisis to other countries in the Asian-Pacific region.

In addition, the decision of the Seoul Central District Court caused a lot of discontent in the ISDA and the international banking system as a while. According to Keith Noyes, the ISDA director for the Asia-Pacific region, “The Seoul Central District Court rulings could severely inhibit derivatives activity in Korea and in turn risk upsetting financial stability if these decisions are upheld and banks made wary of entering into financial contracts” (Ko & Moon, n.d., par. 7). Thus, the long-term effects on South Korea would involve decreased financial flows, investments, and more cautious banking activities, as the banks in South Korea no longer feel that the law is protecting them.

Recommendations

The obvious and glaring flaw in the KiKo system is the fact that it did not have a safeguard against financial Force Majeure events such as the economic crisis of 2008-2009. The two-barrier system was inefficient, as while the Kick-out barrier served to protect the interests of the bank, had the USD to Won exchange rates fallen too low, the upper barrier served only to maximize the profits of the banks in case the exchanged rates went up, with no limitation as to how high the exchange rates could go before the contract would expire. As a consultant, I would recommend a specific strategy to counteract this, which involves adding a third barrier, above the Kick-in rate. The purpose of this barrier is to prevent the companies from suffering extensive economic damage in the event of a Force Majeure similar to that of the economic crisis of 2008-2009. Should the exchange rates ever rise above said barrier, the obligations of the manufacturers under the KiKo contract would become null.

Each contract, thus, would require elaboration and negotiation between both the Bank and the Manufacturer, as the third Kick-out barrier would need to be determined individually, according to the company’s capabilities to endure the unfavorable conditions under the conditions of the contract. Still, the responsibility to accurately draft and construct the agreement lies with the Bank, as it is more qualified to do so, and has the moral obligation to protect the interests of the customers by offering them fair and secure deals, and preventing them from signing potentially detrimental agreements, as per Fiduciary responsibility section of the Korean law.

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References

Jung-a, S. (2009). Outcry over Korean ‘Kiko’ suspensions. Web. 

Ko, H., & Moon, W. (n.d.). How Koreans deal with foreign exchange rate risk: A behavioral law and economics perspective on the KIKO forward contract. Web.

Lee, S. (2014). South Korea: Supreme Court decides on KIKO cases. Web.

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