The exchange of jabs between Japan and South Korea over the territorial dispute in the Sea of Japan will reach a key turning point in October when a temporary bilateral currency swap arrangement comes to an end.

But while the latest quarrel has some calling for the government not to extend elements of the $70 billion agreement, others say an annulment of the emergency dollar swap line would be imprudent, and possibly backfire on Japan.

If Japan were to pull out of the scheme out of retaliation against President Lee Myung Bak’s Aug. 10 visit to Takeshima, known as Dokdo in South Korea, which controls the islets, market players could see it as one less safety net for the South Korean won. Foreign investors could quickly pull their funds out of South Korea in the event of global economic volatility.

Experts warn that a monetary crisis in South Korea would effect Japan’s economy as well. The Wall Street Journal last week went as far as to say that the squabbling between Tokyo and Seoul is one of five sources that could cause stress to the global economy, along with instability in Syria.

“This swap agreement provides merit for both countries,” Hidehiko Mukoyama, senior economist at Japan Research Institute, told The Japan Times on Tuesday. “It is understandable that both governments are unable to take back their position, but it is important to judge the matter on a broader basis,” he warned.

The currency swap agreement was originally reached between Tokyo and Seoul in 2005 with the aim of bringing stability to Asia’s financial markets. The agreement would have Japan exchange its yen and dollars for won when necessary, with the won considered vulnerable to financial crises since the South Korean economy relies heavily on foreign money.

The original swap agreement was for $13 billion but was expanded to $20 billion when the Lehman shock triggered the 2008 global financial crisis. The agreement was most recently increased to $70 billion under a one-year agreement last October as Europe’s sovereign debt woes continued to cause uncertainties across the global market.

Although no swaps have occurred since the original agreement in 2005, some pundits say Japan’s guarantee to supply short-term liquidity to South Korea helped the won from falling more than it did against foreign currencies during the Lehman shock or the euro crisis.

The expansion is due to end in October if the government opts to hit South Korea over the Takeshima issue. It will bring down the size of the swap agreement to $13 billion, leaving questions of whether Seoul can secure sufficient dollar funds in the case of sudden market instability.

“What we will do after (the arrangement expires) is still undecided,” Prime Minister Yoshihiko Noda said Aug. 24 while criticizing Lee’s visit to the islets.

Finance Minister Jun Azumi said earlier that Japan is considering reviewing the swap agreement.

There are also those who demand quick action from the Noda administration.

“The currency swap agreement should be scrapped immediately, and Japan should sell all the South Korean government bonds it owns. That is how far we need to go in order to send a clear message to the global community,” Isshu Sugawara, a Liberal Democratic Party member of the Lower House, told a meeting earlier in August of lawmakers opposing the extension of the swap agreement.

Some South Korean media outlets meanwhile claim that even if Noda were to shut down the expanded swap exchange, it would have little economic impact in the South.

According to a report released in July in Tokyo by the Foreign Ministry, South Korea has secured more than $300 billion in foreign currency reserves in recent years, the sixth-biggest stockpile in the world. South Korea also has a swap agreement with China as well as under the Chiang Mai Initiative Multilateralization scheme, in which Tokyo and Seoul will continue to maintain a $10 billion swap accord.

The won hasn’t moved much in recent days despite rumors that Japan will trim the dollar swap line, signaling that regardless of what Noda chooses, the impact could may be limited.

But the implications of not extending the swap accord are huge for both economies.

According to government statistics, South Korea is Japan’s third-largest trading partner, with trade growing 6 percent in 2011 to ¥8.44 trillion. Japan’s trade surplus with South Korea hit a record ¥2.96 trillion in 2010.

Japan meanwhile is the second-largest trade partner for South Korea. In 2011, 1.66 million South Koreans visited Japan, accounting for approximately 27 percent of all foreign tourists in the country. At the same time, 3.29 million Japanese visited South Korea, about a third of that country’s incoming tourists.

Some market observers say Japan is also reluctant to tarnish a scheme that it helped create in the first place.

The swap agreement “was created because it was deemed necessary,” financial services minister Tadahiro Matsushita said during a news conference last week. “We must be cool-headed when making a decision,” he added.

JRI’s Mukoyama supports this view. “This is not the first time that Japan and South Korea have experienced a quarrel, but the two countries have continued to build close economic ties regardless of that,” he said.

“To escalate the current scuffle would invalidate much of the bilateral efforts the two sides have continued to build up to today,” Mukoyama added.

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