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Korea Becomes the Red Flag for Asia's Currency War

Jeffrey Coolidge | Photodisc | Getty Images

South Korea's threat to impose a broad tax on financial transactions is the first sign of deepening concern in Asia that speculation of competitive currency devaluations is prompting investors to head for the exit.

Until then, and because investors had not shown any big signs of concern, Asia's reaction to the tensions centering on the yen had been passive, comprising an asymmetric mix of jawboning and light currency intervention.

(Read More: Currency Wars Can't Be Won: Bank of Korea Chief)

The selloff in Seoul markets this week turned into a warning sign. Foreign investors posted their biggest daily stock selloff in 16 months in South Korea and pushing the won, a currency that best serves as a proxy for Asia, to a three-month low.

The risk is that the threat of policy action will prompt more market selling, pushing currencies down yet further and raising investor fears of the competitive devaluations that policymakers are trying to avoid.

"Korea is going to be the first domino, and it's that domino effect that the yen's depreciation clearly risks," said Rob Ryan, currency and rates strategist at RBS, referring to the increasing likelihood that Korea announces some form of currency control measure soon.

"The real trigger has been the equity market reaction and the outflows from Korea. I think the concerns over intervention are a little overdone just yet, but clearly it is a big risk if the yen continues to weaken."

Concerns about competitive currency devaluations are the result of easy monetary policies in advanced economies, including the United States.

The latest focus of attention is the yen, which has weakened nearly 12 percent against the dollar since mid-November as the government and the Bank of Japan ramped up efforts to lift the country out of a recession and years of deflation. The Bank of Japan last week doubled its inflation target to 2 percent and agreed to an "open ended" commitment to buy assets.

South Korea has understandably been the most vocal of Asian policymakers on the subject of the yen.

Heavyweight Korean exporters such as Samsung Electronics and Hyundai Motors, which compete directly with Japanese electronics and auto companies, have seen their competitiveness eroded as the won increased in value from as low as 15 per yen to near 11.8 over the past six months.

Foreigners have sold a net 1.8 trillion won ($1.65 billion) Korean stocks this month. The stock market is down 3 percent so far this year.

Foreigners have been buying Taiwanese stocks, but those volumes are far lower than they were in 2012.

"The recent wave of quantitative easing policies has created an unprecedented situation and makes it necessary (for affected countries) to adopt a paradigm shift in response," South Korea's Deputy Finance Minister Choi Jong-ku said in Seoul this week.

The Korean government will tell state-controlled firms to refrain from borrowing abroad and will further tighten rules on banks' currency derivatives trading to ease volatility in foreign exchange markets, Choi said.

Seoul was opposed to imposing an outright levy on financial transactions, such as the Tobin tax being debated in Europe. But it would consider similar measures should speculation in the won intensify over time, he said.

Yuan or Yen?

Chinese authorities have chimed in as well to denounce the weakening of the yen, while the Philippines and Thailand have protested for a different reason -- too much of capital entering their countries to earn higher yields.

Two countries that may not protest are India and Indonesia. Capital inflows could help them fill huge current account deficits and support their pressured currencies.

While Korea may be a pointer to growing concern among Asian policymakers, it's China that analysts are keeping a keen eye on. Most Asia countries have aligned themselves to the yuan since 2005, when it was revalued, rather than the yen.

China has so far said little and done nothing perceptible about the yen's decline.

"We find limited impact on Asia FX from yen weakness and the sensitivity to yuan matters more," Bank of America Merrill Lynch's strategist Claudio Piron said in a research note.

"This suggests the recent sell-off in Asia FX is related more to position unwinding and squeeze, rather than a round of competitive depreciation."

Still, many believe policy risks are rising. Nearly half of Japan's trade is with the Asia-Pacific region and China may not stand pat if Korea imposes currency controls given it is Korea's largest export market.

In addition, capital controls have gained some acceptability as a policy response in emerging markets to deal with easy money in the developed world.

Even the International Monetary Fund, traditionally a champion of liberalized markets, has conceded that capital controls are sometimes necessary.

And there's plenty of precedent in Asia.

China cut foreign debt quotas in 2010 and Indonesia has set a minimum holding period for foreigners buying its high-yielding debt.

Korea has taxed securities' income and repeatedly cut quotas on derivative contracts, Singapore and Hong Kong have property restrictions, and the Philippines has clamped down on offshore currency positions for its banks.

(Read More: First Shots Are Fired in Global 'Currency War')

This time however the challenges over the choice of a policy tool for controlling the currency are different, particularly for high-yielders in the region.

Intervening to weaken the currency by buying up dollars can be inflationary because it entails printing equivalent amounts of local currency.

To prevent inflationary pressures, authorities have to take the local currency out of circulation, such as by issuing bonds, a process known as sterilization. But that would be expensive since most of Asia has relatively high interest rates.

A more palatable option would be to keep interest rates on hold or maybe even cut them, to reduce the costs of sterilization as well as to reduce the appeal of their currencies.