Reference no: EM133282631

Exchange Rates and the Profitability of Korean Airlines

In May 2019, South Korea's two major airlines-Korean Airlines and Asiana Airlines Inc.-were hit by foreign exchange losses arising from the weakness of the Korean won against the U.S. dollar. Korean Air announced that it posted 148.20 billion won ($124.49 million) in operating profit from January to March, down 16.2 percent from the same period a year ago. Asiana Airlines announced on the same day that its operating profit in the first quarter had declined 89 percent to 7.20 billion won ($6.05 million) from a year earlier. In February 2020, it happened again. Asiana Airlines announced that for the three months that ended on December 31, 2019, net losses widened to 234.8 billion won ($199 million) from 163.9 billion won a year earlier due to foreign exchange losses.

These foreign exchange losses arose from two sources. First, like the oil from which it is derived, in the global marketplace jet fuel is priced in U.S. dollars. Hence, any fall in the price of the won against the U.S. dollar drives up fuel purchasing costs when translated back into won. Second, Korean Airlines and Asiana Airlines have both taken on dollar-denominated debt in order to finance their purchase of jet aircraft from Boeing and Airbus, both of which are also priced in U.S. dollars. They have done this because interest rates on dollar-denominated debt have been significantly lower than interest rates on won-denominated debt. However, borrowing in a foreign currency brings with it an exposure to foreign exchange risk. A fall in the price of the won against the U.S. dollar will drive up the costs of servicing that dollar-denominated debt when translated back into Korean won-and that is exactly what has happened.

So how much has the won fallen against the U.S. dollar recently? In mid-February 2018, one U.S. dollar was trading at around 1,065 won. By mid-February 2020, one U.S. dollar bought about 1,200 won. Put differently, the won had depreciated in value against the U.S. dollar by around 12.5 percent. When the dollar cost of jet fuel and debt service, both paid for in dollars, was translated back into won, this implied a 12.5 percent increase in costs for these Korean airlines over this time period and, consequently, a fall in their profitability.

The decline in the value of the won against the dollar has primarily been driven by economic uncertainty created by America's tariff-raising binge after Donald Trump became president, and a desire on the part of investors to put their money in safer assets that are less vulnerable to disruption from American-imposed tariffs and trade conflict. Those safe assets have included U.S. Treasury bills. So, investors have taken their money out of other currencies, including Korean won, and put them in U.S. dollar assets. This increases demand for dollars and reduces demand for won-hence, the depreciation in the value of the won against the dollar over the last two years.

Looking forward, economic uncertainties seem to be increasing due to the spread of coronavirus in 2020 and 2021 and the global pandemic of COVID-19 infections. Economic experts say that the spread of COVID-19 has seriously disrupted global supply chains and dealt a blow to business earnings, hurting countries such as South Korea that depend significantly upon international trade to drive their economies. Thus, it seems possible that the won will decline further against the U.S. dollar, which will cause all sorts of financial pain for both Asiana and Korean Airlines.

Case Discussion Questions

Why did both Korean Airlines and Asiana Airlines report foreign exchange losses in 2019 and 2020?

What could Korean Airlines and Asiana Airlines have done to limit their foreign exchange losses? Why do you think they did not take these steps?

Why did the Korean won decline in value against the American dollar in 2020? Could this decline have been anticipated?

During 2020, the U.S. dollar fell in value from $1 = 1,200 won in February 2020 to $1 = 1,088 won in December 2020. How do you think this impacted the financial performance of Korean Airlines and Asiana Airlines?]