Strengthened Regulation on Financial Institutions’ FX Soundness
2010/07/12 8 Comments
Korea is well-known for experiencing steep growth since devastating Korean War by strongly implementing open economic policy. Korea however, is also famous for experiencing a deep fall from historic Asian financial crisis in 1997-98. It is shown through many evidences that the cause of recent financial crisis and 1997-98 crisis was from excessive volatility of capital flows.
Open economic policy brought high growth for Korea however, it was also one of the main causes for instability of finance market resulting in recession in real economy; the volatility of finance market flux and capital was unstable and Korea’s heavy dependency on trades worsened the wound. The volatility caused by banking sector, especially foreign counterparts, lead to this increase. Thus variance of capital flux should be manageable to deter the occurrence of financial crisis. Now, as the worldwide crisis calm down, capital inflows to Korean financial market significantly rose and experts anticipated that this trend will continue. To impede transferring rapid efflux of capital flown into Korea into system risk, the government should improve stability by effective measures and learn from the past.
(data from Reuters Blog)
An Appeasement Policy to lessen the volatility of capital flux
The goal of appeasement policy is to sustain free capital inflows and to make the method to manage capital flows to diminish system risk. However being able to control is too almost impossible. Korea’s dependence on trade terms is very high and therefore, without free capital inflows, the real economic growth can hardly be achieved. The government as a foreign currency supplier should provide appropriate amount of foreign currency to demanders to stabilize foreign currency market. Moreover the government should design ways to diminish the system risk owing to excessive foreign currency demand. For a long-run, the government should provide and implement fundamentally sound policies and countermeasure such as enhance monitoring and create a strong financial safety net to stand rapid financial flows. There are three major plans to do these objectives.
The institution for a forward exchange position
What is the motivation of this institution?
According to the experts, one of the most critical reasons behind Korea’s financial crisis was short-term foreign debt. The business like ship builders and asset managers usually has significant roles in increasing the amount of debt. They usually sell their trade payments to the bank in advance to hedge the exchange rate risk. In fact, this was the main reason of the increased short-term debt amount from 2006 to 2007 and, increased chance of system risk in 2008. Even though the government has a clear understanding of this process, the institutional strategy for managing the situation is very much needed. As of now only the total position including spots and futures is regulated.
Then what are the Future steps?
The government has a plan to limit the future positions for most derivatives such as foreign exchange swap, currency swap and NDF. The position limit of domestic branch is still, 50% of its previous month’s equity capital. Foreign Banks’ local branch is at 250% of its previous month’s equity capital. The government will adjust the limit quarterly, depending on economic situation, market condition, and the effects. Considering the burden of the banks and for them to adjust to the new limitation smoothly, the government will allow a three-month grace period for those who would be effected by the proposal bill. If the liquidity of foreign currency is aggravated by market unrest, foreign currency authority will take every supplementary measures including supplying foreign currency and instituting relevant government branches to collaborate as an examination team.
Management of foreign currency loan
The authority has plans to regulate the purpose of foreign currency loan: permitting primarily for foreign use, such as foreign settlement, foreign direct investment, and redemption of foreign loan, and exceptionally purchasing domestic installment provided by the banks. Still now, the effect of global financial crisis exists and the foreign loan is diminishing deeply. Signs of a long waited recovery started to appear and the demand for foreign loan would probably increase. In fact, in 2005 and 2006, there was huge inflation of foreign currency loan, pursuing low interest rate and foreign exchange profit. The government knows about this and has a plan to revise this old fashioned law by limiting the purpose of foreign loan as just for foreign use. This rule will be applied only to new foreign currency loan and prolong the duration of exist loan will be determined by the banks. However, a small and medium-sized business can get money from the banks as a form of foreign loans to install or expand domestic facilities. The more increasing rate of foreign loan, the more rigorous rule will be applied.
Control management of foreign currency health
The vulnerable factor of foreign sector was revealed and the government made it very clear the way to enhance the supervision of foreign currency January 2010. After implementing this policy, overall health of the banks’ foreign currency level improved. However, the overseas branches were not applied for foreign liquidity by the head office. The foreign banks’ local branches were exposed to incongruence risk by managing long-term and won-dominated asset with short-term and foreign-currency dominated capital and created the discrepancy between asset and liability.
The government has two plans to remedy these weak points: regulation of the foreign currency liquidity ratio and to raise the ratio of mid and long term debt. These two regulations are definitely expected to become significant roles in enhancing the foreign currency stability.
The volatility of capital inflows will be diminished and the foreign shock will be palliated more adroitly from new regulations. It will decrease the recurrence of economic crisis caused by finance market factor secluded with real economic situation. To be more specific, it will result in; the stability of foreign liability, the improvement of the banks’ balances, and the restraint of sudden capital outflows. The government would be able to manage sudden growth of short term foreign currency liability by controlling excessive transactions of foreign currency and foreign debts. In the aspect of capital outflows, the government can minimize the outflow in recessive times.