Rising Won has South Korea Worried

South Korea's currency, the won, has been rising against the currencies of its major trading partners, China, the United States, the European Union and Japan. South Korea's economy is heavily dependent upon exports, which made up 44.6 percent of GDP in 2010.

Since the beginning of the year, the South Korean won has risen by 6.4 percent against the U.S. dollar, 5.5 percent against the euro, six percent against the Chinese yuan and 13 percent against the Japanese yen.

South Korean government officials are worried. So much so that they intervened in the currency market on Thursday, buying up to $1 billion in an effort to weaken the won, according to the Financial Times.

The FT reported that South Korean officials are considering tightening restrictions on trading currency derivatives to curb the won's volatility in the currency market. South Korean deputy finance minister Choi Jong-gu, told the FT, Recent movement of the market shows that the volatility continues to increase, mainly driven by some expectation that the won will continue to appreciate further.

The rapid appreciation of the won against the U.S. dollar affects Korea's trade with two of its major trading partners, the United States, which accounts for 11.1 percent of South Korea's exports, and China, which is South Korea's biggest export market, taking 25.8 percent of South Korea's total exports.

China's currency, the yuan, is not freely convertible and trades in a designated band around the U.S. dollar set by Chinese monetary authorities. Unless China widens the trading band, which they do on occasion, the yuan will generally rise or fall against other currencies in line with the U.S. dollar.

That means that, all else being equal, South Korean companies are earning about six percent less on nearly 37 percent of their exports than they were at the beginning of the year. To put it another way, if prices remain stable, South Korea has to increase export volume by six percent just to stay where they were in January.

That is why the sharp appreciation of the South Korean won against the Japanese yen is so important.

Japan is South Korea's second largest trading partner after China, accounting for 10.7 percent of South Korea's total trade. But, of South Korea's four main trading partners, Japan is the only one that runs a trade surplus with South Korea.

South Korea imports large quantities of industrial goods, particularly chemicals and machinery, from Japan. Much of this is incorporated into South Korean products that are exported to the rest of the world, including Japan.

Much of South Korea's competitive advantage in automobiles, construction equipment, electronics and steel comes from the fact that the won has been persistently weak against the Japanese yen for the past five years. If the exact same LCD TV were built in South Korea and Japan, the Korean model would be much cheaper because of the weak won.

With the yen now 13 percent cheaper against the won than it was at the beginning of the year, South Korea is losing some of its competitive edge in its export markets. If currency Is less of a factor, other competitive advantages and disadvantages between Korean and Japanese companies come into play.

If traders want to take a view on the trend in the South Korean won, one way to do this is through a pair trade between the iShares MSCI South Korea Index (NYSE:EWY) and the iShares MSCI Japan Index (NYSE:EWJ).

If you think the appreciation of the won against the yen will continue, they you would short EWY and go long EWJ. If you think the trend will reverse, then short EWJ and go long EWY.

Regardless of your view, the seldom-watched Japanese yen/South Korean won exchange rate will be the key to which country will have a relative competitive advantage in 2013. Keep your eye on the chart below:

Chart from Yahoo Finance

Stock chart: