Mitigating systemic spillovers from currency hedging.

Chung, Kyuil ; Park, Hail ; Shin, Hyun Song 等

Korea has been a forerunner in incorporating macroprudential policies to mitigate the vulnerabilities from currency crises that can turn into a more generalised liquidity crisis. This paper examines longer-term design issues for a more resilient and stable financial system that could be expected to complement the existing macroprudential measures in achieving a more stable financial system. In particular, the paper examines the rationale and mechanics of a new public financial institution, provisionally called the Exchange Stabilisation and Guarantee Corporation (ESGC) whose main role is to buy dollar forward positions from Korean exporting companies who wish to hedge the currency exposure from long-term export orders. The ESGC is intended to mitigate the risks arising from the reliance on the role of the banking sector in providing currency hedging services to exporters. Rapid growth of short-term foreign currency denominated debt has been the result of banks receiving forward dollar sales by exporters, and then hedging the long dollar position by borrowing short in dollars. A public institution that can buy dollars forward, but which is designed so that there is no need to hedge by taking short dollar debt, can mitigate the rapid increase in short-term dollar debt in booms.

Keywords: Currency hedging; banking stability; exchange rate overshooting

JEL Classifications: F31; F33

I. Introduction

External financial conditions provide the backdrop to domestic financial conditions, especially when the domestic banking system is open to funding from crossborder banks. An IMF report on capital flows (IMF, 2011) identifies three epochs of capital flows, the first being the period 1995Q4-1998Q2 associated with the Asian crisis, the period 2006Q4-2008Q2 associated with the credit boom that led to the recent global financial crisis, and the most recent period in the aftermath of the crisis (2009QB-2010Q2).

The distinguishing feature of the credit boom that preceded the global financial crisis of 2007-9 is the role played by banking sector inflows. In contrast to the other two episodes where banking sector inflows account for less than 20 per cent, banking sector inflows surged during the period leading up to the Lehman bankruptcy and the subsequent global crisis.

Figure 2, from the IMF's Global Financial Stability Report in 2010, shows the capital inflows into 41 countries including many emerging economies, where the flows are disaggregated into the four main categories of capital flows. Aggregate FDI flows are steady and portfolio equity flows are small in net terms. However, banking sector flows display the signature procyclical pattern of surging during the boom, only to change sign abruptly and surge out with the deleveraging of the banking sector.

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Korea has been vulnerable to 'twin crises' in which a banking crisis and currency crisis reinforce each other. Although twin crises show many different forms across countries and across time, the common thread that links them is the balance sheet mismatch at the aggregate economy level arising from excessive short-term debt denominated in foreign currency.

In this paper, we explore the extent to which the buildup of short-term foreign currency of the banking sector can be attributed to the currency hedging activity of firms who seek to reduce the risks arising from currency movements. For the case of Korea, we present estimates for the period up to the 2008 crisis that suggest that the build-up of foreign currency liabilities of the banking sector can be attributed in large part to such currency hedging activity.

In Korea's case, the vulnerability to reversals of capital flows is owed in large part to the currency hedging need of exporting companies, since exporting companies acquire long-term dollar receivables through their export orders, and then wish to hedge the currency exposure until receiving final payment in dollars. Hedging takes the form of selling dollars forward to banks in Korea.

However, the counterparty to the forward transaction (the bank) must then hedge its own long dollar exposure, which it does by borrowing in dollars, and then investing the proceeds in Korean won.

Hedging is a desirable activity from the point of view of each individual firm undertaking the hedging operation, but may entail a collective outcome where the financial system is left vulnerable to a sudden shift in external financial conditions, especially from a sudden reversal of capital inflows as was experienced in 2008.

In this paper, we review the rationale for an institution--dubbed the Exchange Stabilisation and Guarantee Corporation (ESGC)--which can provide the public good of providing hedging services to individual firms, but which does not have the harmful side-effect of generating short-term foreign currency liabilities that lie at the heart of the vulnerability of an economy to financial shocks.

2. Background

Before sketching the details of the institutional design, we first review evidence on the spillovers of hedging activity and how such spillovers undermine systemic stability.

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Figure 3 gives an overview of total customer lending by the banking sector in Korea and how it was financed. Up to the end of 2005, core liabilities consisting of customer deposits were adequate to fund total lending, so that the loan to deposit ratio was below 1. However, lending outstripped deposits in the period leading up to the Lehman crisis, and banks resorted increasingly to noncore funding, especially the non-core funding in foreign currency as seen in figure 3.

The reliance on foreign currency funding of the banking sector makes the financial system more vulnerable to 'twin crises', as amply demonstrated by the Asian financial crisis of 1997 and the turmoil in global financial markets in the autumn of 2008. Such crises are particularly dangerous due to their mutually reinforcing nature, and the rapid deterioration of economic fundamentals caused by the amplification of the crisis.

From 2005-7, Korean banks and the foreign bank branches in Korea saw rapid increases in short-term foreign currency liabilities (see figure 4). The severity of the financial crisis in Korea in 2008 can be attributed largely to the rapid deleveraging that took place in the banking sector (both domestic and foreign) with the onset of the 2008 financial crisis.

Figure 5 shows the contrast in the pattern of capital inflows and outflows for two sectors--the equity sector and the banking sector.

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The banking sector saw very substantial capital outflows from Korea. Although Korean banks also held dollar claims, such as the long dollar forward positions on Korean corporations, such assets could not be used to meet maturing dollar liabilities without exacerbating the economy-wide liquidity crisis. Non-financial firms in Korea had dollar receivables, such as the receivables of the shipbuilders, but they were long-term dollar receivables that could not be realised immediately.

Korea's vulnerability to currency crises arises from the large hedging needs of exporting companies. Since these companies acquire long-term dollar receivables through their export orders, they prefer to hedge the currency risk by selling dollars forward.

The banking sector in Korea (including foreign bank branches) has been the counterparty, buying the forward dollars sold by the exporters. However, the counterparty to the forward transaction (the bank) must then hedge its long dollar exposure. The bank can hedge its long dollar position by borrowing in dollars, and then investing the proceeds in Korean won, thereby hedging the long dollar forward position with a carry trade position in the Korean won.

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By hedging the exchange rate risk in these long-term dollar receivables, the exporting companies could transfer to the banking sector the long-term dollar claims, but the banks then would engage in maturity transformation by borrowing short in dollars.

In this way, the overall currency mismatch on the consolidated balance sheet, consisting of the corporate and banking sectors, could be eliminated through the hedging activity, a maturity mismatch between long-term dollar claims and short-term dollar liabilities taking its place. In effect, the currency mismatch was replaced by a maturity mismatch which left the Korean financial system vulnerable to the global financial crisis in 2008 that followed in the wake of the bankruptcy of Lehman Brothers.

Figure 6 depicts the stylised aggregate balance sheet of the banking sector as a result of the hedging transaction by Korean exporting firms. The figure illustrates a shipbuilder in Korea who has received an order and wishes to hedge the foreign currency risk by selling a long-term dollar forward contract to a bank. The forward contract shows up as an off-balance sheet claim on the bank's balance sheet, and entails a long dollar position for the bank.

The bank can hedge the currency risk by borrowing in dollars and holding the proceeds in Korean won by purchasing local assets, or by entering into a hedging transaction of its own with another bank in Korea. However, in aggregate, the banking sector in Korea will have the form depicted in figure 6, where the long dollar forward position is offset by a 'carry trade' position that funds the purchase of local Korean assets with short-term dollar liabilities. Figure 4 refers to the 'banking sector inside Korea' in order to highlight the role of foreign bank branches that operate in Korea. As shown in figure 4, the foreign bank branches had larger outstanding amounts of short-term foreign currency denominated liabilities in the run-up to the 2008 crisis.

3. Banking sector foreign currency liabilities due to hedging activity

The main findings from a survey conducted jointly by the Bank of Korea and the Financial Supervisory Commission (FSC) in November 2007 were announced in January 2008 as a press release (Bank of Korea, 2008). This survey found that in the nine months from January to September 2007, 67 per cent of the receivables of exporting companies in Korea were hedged for currency risk, while only 15 per cent of the future orders of importing companies were hedged. The asymmetry between the large hedging activity of the exporters and the relatively much smaller hedging activity of the importers created the preconditions for a mismatch in the demand and supply of long-dated dollars, with supply outstripping demand. Of the importing firms in Korea, the hedging by the petroleum refining sector and the steel sector were found to be particularly low, at only 2-6 per cent of total orders.

The imbalance in the hedging activity of the exporting and importing sectors reflects both the nature of the goods involved and also the market structure in Korea. The receivables of exporting companies tend to be medium- to longer-term, involving large indivisible items typified by shipping orders. In contrast, importing companies' liabilities are short-term and relatively easier to predict. Moreover, the market power of companies in the importing sectors in the domestic Korean market enables them to pass on any cost increases resulting from exchange rate changes onto the final consumer. The same is not true of exporting companies who face relatively stiffer competition in global markets.

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In addition to the hedging activity of Korean exporting companies, another important source of hedging activity in the run-up to the 2008 crisis came from the asset management sector in Korea. The asset management sector includes both stock mutual funds serving retail investors, as well as institutional investors in the insurance and pension sector.

Figure 7 plots the monthly capital flows in the equity sector, distinguishing the flows generated by foreign and domestic investors. The sum of the two series in figure 7 gives the net equity sector flows depicted in figure 5. The downward pointing bars indicate capital outflows while upward pointing bars indicate capital inflows.

We see from figure 7 that domestic investors in Korea sharply increased their holding of foreign stocks in the period before the 2008 crisis, especially in late 2006 and in 2007. However, the boom in the sale of managed equity funds to retail investors during 2007 took place during a period of sustained appreciation of the Korean won, and asset managers offered retail products that hedged the currency risk in the equity fund. A survey by the Financial Supervisory Commission (FSC, 2007) found that 84 per cent of the retail funds investing in foreign securities were hedged for currency fluctuations. For such currency-hedged products, Korean investors were promised a return in Korean won terms equal to the change in the foreign stock index itself rather than the stock index change combined with exchange rate changes.

In practice, the currency hedging by asset managers took the form of selling forward contracts in dollars to banks, in a similar way to the hedging transaction of the exporting firms shown in figure 6. In one respect, however, the hedging demand from the asset management sector was more sensitive to market conditions than for the export sector in Korea. The reason is that hedging of currency risk for foreign equity holdings entails marking to market the outstanding stock at any moment in time, so that changes in market prices and the exchange rate entails shifts in the hedging need. A buoyant stock market when prices are rising entails hedging demand that applies to the whole outstanding amount, rather than just the new flows that are generated in each time period.

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Figure 8 plots the net increase in foreign stock holdings of domestic investors from 2003 to 2007. The sharp increase in 2007 reflects both the large new outflows and the marked-to-market increases in the value of existing foreign equity holdings of domestic Korean investors. Figure 8 also plots the new orders received by Korean shipbuilders in the same period. The two series combined represent the underlying demand for currency hedging that had to be met by the banking sector in Korea. By utilising information on the percentage of exposures that were hedged by the shipbuilders and asset managers, we can calculate the approximate amount of the banking sector's foreign currency liabilities attributable to the hedging activity of the exporters and asset managers, and this is shown in table 1. The two series shown above in figure 8 are presented in table 1. The first row of table 1 shows the new orders of shipbuilding firms in Korea, while the seventh row shows the net increase in the value of foreign stock holdings of domestic investors.

Starting with these series, we can then estimate the increase in banking sector foreign currency debt that is attributable to the respective hedging activities. Consider first the hedging activity by shipbuilders. For shipbuilders, we have both the series for new orders and the purchase of dollar forwards by the sector (first and third rows of table 1). We then net out the settlement of maturing forward dollar contracts (fourth row) to calculate the net new sales of dollar forward contracts by the shipbuilding sector. Figure 9 plots the series associated with the hedging activity of the shipbuilders.

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The banking sector is on the other side of these sales, and hence accumulates long positions in dollar forwards. The banks then hedge their own exposure by taking on dollar liabilities which in turn are used to purchase local assets. However, the hedging activity by the banks does not translate into a one-for-one increase in foreign exchange liabilities, as the banking sector will have pre- existing foreign currency liabilities which are unrelated to hedging activities by non-banks. In any case, the banks' ability or willingness to bear some currency risk will mean that the increase in foreign currency debt due to its purchase of dollar forwards will not be one- for-one. The Bank of Korea/FSC joint survey (Bank of Korea, 2008) estimated that approximately 73 per cent of the shipbuilders' new orders were hedged for currency risk by the banking sector.

Figure 10 applies the 73 per cent estimate of banks' hedging activity to estimate the increase in banking sector foreign currency liabilities directly attributable to the hedging activity of the shipbuilders. It is calculated as 0.73 times the net new purchase of dollar forwards by the shipbuilding sector.

We can use an analogous procedure to estimate the increase in banking sector foreign currency liabilities directly attributable to the hedging activities of asset managers. First, we use the estimate from the survey by the Financial Supervisory Service (FSC, 2007) that approximately 84 per cent of the holdings in foreign equity retail funds are hedged by asset managers. We then combine this with the Bank of Korea/FSC survey estimate that 73 per cent of forward dollar contract purchases by banks are hedged by their taking on foreign currency liabilities.

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Thus, the estimated increase in the banking sector foreign currency liabilities directly attributable to asset managers' hedging activities is given by

0.73 x 0.84 x outstanding foreign equity holding

Figure 11 plots the increase in banking sector foreign currency liabilities attributable to asset managers' hedging activity and adds the analogous series for the foreign currency liabilities arising from shipbuilders' hedging activities. In figure 12, we plot our constructed series given by the sum of the two series in figure 11 (dashed line), and then compare it with the actual increase in banking sector foreign currency liabilities (red line).

With the exception of 2006, we see that the two series are very close to each other, adding weight to the hypothesis that the increase in foreign currency liabilities of the Korean banking sector can be largely attributed to the hedging activity of domestic non-bank market participants.

The interaction between hedging activity by non- banks and the banks' own profit incentives is an important potential explanatory factor in the exchange rate dynamics leading up to the 2008 crisis. There is the potential for a feedback loop that links exchange rate movements, hedging demand and exchange rate changes.

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The feedback loop generated by hedging activity can be depicted as in figure 13. Hedging activity by exporters and asset managers implies sale of forward dollars to banks. In order to hedge the forward dollars, the banks take on short-term dollar liabilities and either sell the dollars in the spot market for Korean won, or enter into a currency swap agreement for delivery of dollars in the future in exchange for delivery of Korean won at the contracting date. Either way, the banks' own hedging activity generates sales of dollars and purchase of Korean won in the spot market, leading to the appreciation of the Korean won value in the spot market. The spot market appreciation of the won sets off marked-to- market valuation changes on banks' balance sheets and possibly also expectations of further appreciation of the Korean won, which in turn further exacerbates the hedging demands of the non-banks. Dynamic hedging by the bank that adjusts the amount of foreign currency liabilities in line with changes in the valuation changes on its balance sheet entails borrowing more dollars and selling them on the spot market as the Korean won comes under further appreciation pressure.

The feedback loop is potentially potent for those exporting firms (such as shipbuilders) where the gains or losses from foreign exchange movements constitute a large component of total profit.

As well as the demand for hedging, the incentives of the banks in generating business should also be taken into consideration. The Bank of Korea/FSC survey (Bank of Korea, 2008) reports that the banks entered into a period of intense competition to increase market share in the foreign currency hedging services. Banks engaged in intensive marketing to customer firms, through site visits, customer seminars, training and educational programmes for customers, and so on. The BoK/ FSC survey visited six banks in Korea over the survey period. (1)

During the nine-month survey period from January to September 2007, the six banks visited 2,453 customer firms, 80 per cent of which were export firms. The banks made a total of 10,802 visits--an average of 4.4 visits for each customer firm. During this period, the banks issued research reports that consistently and unanimously forecast continued strong appreciation of the Korean won. The research was then used in the marketing effort by the banks to induce customer firms to engage in further hedging activity. Part of the marketing drive by the banks was to point to the potential advantages of pre-emptive hedging in which firms hedge in anticipation of further hedging need, rather than hedging based on realised need.

Pre-emptive hedging may have led to a systematic over- hedging by exporting firms, which left them exposed to the sharp fall in the Korean won with the onset of the crisis in 2008. It is difficult to gauge the precise amount of over-hedging by exporting companies, even ex post. When the customer of a shipbuilder cancels an order, then the shipbuilder will be left with a hedge against the cancelled contract, leaving it exposed to the depreciation of the Korean won. However, the shipbuilder may have entered into the hedging of the order in good faith. Nevertheless, the 2008 crisis and the sharp depreciation of the Korean won left many Korean exporters exposed to exchange rate movements that exacerbated the financial distress of 2008.

Figure 14 plots the capital flows reflected in the banking sector foreign currency liabilities (left-hand scale), plotted against the USD/KRW exchange rate (right-hand scale). We see that throughout 2006 and 2007 the Korean won appreciated steadily, touching 900 won to the dollar in late 2007. During this period of won appreciation, research emanating from the banks predicted in unison further appreciation of the Korean won. The market consensus at the time was that the exchange rate would eventually break through the 900 level. Intense marketing by the banks based on such research could have further fuelled the feedback loop in Korean won appreciation by encouraging firms to engage in more aggressive hedging against it.

Figure 13 also explains why the Korean won exchange rate moves in line with the increase in bank foreign currency liabilities in figure 14, rather than with the equity sector capital flows. The period when bank foreign currency liabilities are increasing coincides with the period of increased hedging activity which is then amplified through appreciation of the Korean won. The feedback loop then goes into reverse once the bank liability flows reverse, as happened with the onset of the crisis in 2008. We see in figure 14 that the Korean won falls very sharply in the summer of 2008 coinciding with the deleveraging of the banking sector in Korea. Notice that during the crisis period, there was actually a net inflow in the equity sector, as foreign investors' sales of Korean equity were outweighed by the repatriation flows by Korean investors.

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The close link between the hedging activities of non- banks with the increase in the foreign currency liabilities of Korea's banking sector has important lessons for the financial stability implications of real activity. Given the very high economic costs associated with financial crises, we need to take account of the negative spillover effects of the banks' hedging activity using foreign currency liabilities. An institution that can alleviate the negative spillovers of currency hedging activity may enhance system stability. We outline the possible workings of such an institution here. We give it the hypothetical name of the Exchange Stabilisation and Guarantee Corporation (ESGC). The purpose of the ESGC is to cut the link between the need for non- banks to hedge their exposures to currency risk and the creation of vulnerabilities to financial stability.

4. Exchange Stabilisation and Guarantee Corporation (ESGC)

The discussion so far has highlighted the double-edged nature of hedging activity. Hedging is an activity that is privately optimal, but it generates significant negative spillover effects on the broader economy through increased fragility of the financial system and the greater amplification of exchange rate movements. The main channel of the negative spillover is the banking sector's role in being the counterparty to hedgers and the fact that the bank needs to neutralise its own currency mismatch by increasing its foreign currency liabilities. In practice, banks' foreign currency liabilities tend to be short term, which exacerbates the fragility of the financial system. The Exchange Stabilisation and Guarantee Corporation (ESGC) is intended as an alternative to the banking sector whose core role is to be the counterparty to exporters or asset managers who wish to hedge the currency risk. The ESGC would have the following three balance sheet attributes.

* The ESGC is a public entity which is 100 per cent equity financed.

* The ESGC is valued in US dollars for computing gains and losses.

However, the ESGC is permitted to hold Korean won denominated assets as well as foreign currency denominated assets.

The exact corporate form of the ESGC would depend on governance and accountability imperatives, but its charter and mission would be to promote the public good through enhancing financial stability.

The primary purpose of the ESGC is to play the role of the counterparty to exporting firms or other private sector economic entities who wish to hedge currency risk. The ESGC could also serve a subsidiary role of providing trade finance as part of the currency hedging service to those small and medium sized enterprises (SMEs) that do not have access to export trade financing, or face high costs of obtaining such funding.

The ESGC would buy dollars forward when an exporter wished to sell dollars forward. The difference between the ESGC and the banking sector is that the ESGC is fully equity financed. Hence its ability to provide hedging services does not result in the creation of volatile short- term banking sector foreign currency liabilities. In this sense, for every dollar that the ESGC buys from a Korean export company, there will be one fewer dollar's worth of short-term bank liability created.

Crucially, the ESGC can hedge its own currency exposure by holding Korean won assets (such as Korean government bonds or Bank of Korea bonds) but be valued in US dollars. The fact that the ESGC holds Korean won assets but is valued in US dollars creates a natural short dollar position, which creates the capacity to take on long dollar exposures--for instance, by buying forward dollar positions from Korean exporting companies.

The basic idea can be illustrated in terms of the schematic in figure 15, which illustrates the balance sheet of the ESGC at its inception and then after a series of transactions. At its inception, the ESGC holds US dollar assets, such as short-term US Treasury bills. The ESGC is fully equity financed, and valued in dollars.

However, the ESGC would then begin a series of transactions and modify its portfolio of assets. An exporting firm wishing to hedge its long-term currency exposure can sell forward contracts for US dollars to the ESGC. For its part, the ESGC can hedge its own currency risk by adjusting its portfolio of assets. The ESGC sells an amount of US dollar assets equivalent to the discounted face value of the forward contract, and purchases safe Korean won assets, such as short-term Korean government bonds.

Through this adjustment of its asset portfolio, the ESGC creates a short position in the US dollar which exactly offsets the long dollar exposure created by the forward position. However, unlike a bank, the ESGC is fully equity financed, and the vulnerabilities created by the banking sector's short-term foreign currency debt can be avoided. When the forward contract matures, the ESGC reverses the initial set of transactions. When the exporting firm delivers dollars at the maturity date, the ESGC sells Korean won assets and purchases US dollar assets to rebalance its portfolio so that the ESGC remains perfectly hedged against currency fluctuations. In general, the day-to-day operation of the ESGC will entail fine-tuning of the mix of Korean won and US dollar assets held in its portfolio, in order to offset exactly the long forward dollar position bought from the Korean exporting companies.

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Although the currency risk is perfectly hedged through these transactions, the ESGC bears some counterparty risk from the possibility that the exporting company is unable to deliver dollars at the maturity date of the forward contract. In order to deal with such counterparty risk, additional safeguards can be put in place. For instance, the counterparty risk could be mitigated by imposing a haircut on the notional value of the forward contract relative to the notarised value of the invoice for the export order, or the collateralisation of the forward contract through letters of credit or other securities.

For small and medium sized enterprises (SMEs) unable to provide such collateral, the credit guarantees that are currently provided by the Korea Credit Guarantee Fund (KODIT) could be used to secure the forward transaction. By combining credit guarantees with its own operations, the ESGC will be able to provide trade financing as well as hedging services, as we will detail below.

We now provide a more detailed description of the workings of the ESGC through a series of examples. For simplicity of illustration, we assume that the risk-free interest rate for both the Korean won and the US dollar is zero.

Example 1: ESGC as counterparty to US dollar forward contract sold by exporter

* Date 0 (initial date): The ESGC has equity of $100 million, and holds $100 million of US treasury bills.

* Date 1 (transactions date): The exchange rate at the transactions date is 1,000 Korean won for one US dollar. The ESGC conducts two transactions.

** First, the ESGC buys a forward contract from an exporter for the delivery of $1 million at date 2 (the maturity date) in exchange for KRW 1 billion.

** Second, the ESGC sells $1 million worth of dollar-denominated assets and buys KRW 1 billion worth of short-term Korean government bonds.

Through this paired transaction, the ESGC ensures that its value remains at $100 million irrespective of subsequent exchange rate fluctuations. Any gains or losses (in US dollar terms) on its on-balance sheet portfolio of assets are exactly offset by the reverse marked-to-market gains and losses on its off-balance sheet forward position. Notice the crucial importance of valuing gains and losses for the ESGC in US dollars for this immunisation property to hold.

* Date 2 (settlement date): The forward contract matures and settlement takes place. The exchange rate will have changed from the contract date, but the ESGC can ensure its value remains unchanged after settlement.

** The ESGC sells the KRW 1 billion worth of Korean government bonds on its portfolio, and delivers the won to the exporter, as specified in the forward contract.

** In return, the exporter delivers $1 million dollars to the ESGC, as stipulated in the forward contract. The ESGC then purchases $1 million worth of US dollar safe assets, to bring its on-balance sheet portfolio to $100 million worth of US dollar-denominated safe assets.

After the settlement date, the ESGC's balance sheet is back to its initial portfolio. Provided that counterparty risk can be eliminated, the ESGC's trades enable it to remain perfectly hedged against currency fluctuations between the contract date and the settlement date.

Example 2: ESGC as counterparty to US dollar currency swap

Suppose that a Korean bank wishes to sell a US dollar currency swap contract with face value of $1 million. Suppose that the exchange rate at the transactions date is 1,000 Korean won for one US dollar. Under the swap contract, the Korean bank delivers KRW 1 billion in exchange for $1 million at the contracting date, and receives KRW 1 billion for $1 million at the settlement date (recall that interest rates are zero for illustration). The ESGC can play the counterparty to such a swap as follows.

* Date 1 (transactions date):

** The ESGC delivers $1 million to the bank in exchange for KRW 1 billion as specified in the swap.

** The ESGC conducts no further transactions. The

KRW 1 billion proceeds stay on the ESGC's balance sheet until maturity.

In the swap transaction, the ESGC does not adjust its on-balance sheet portfolio of assets. By keeping the KRW 1 billion proceeds on its balance sheet, the ESGC can fully hedge its obligation to deliver Korean won at the settlement date. Notice that any gains or losses on its on-balance sheet portfolio of assets are exactly offset by the reverse marked-to-market gains and losses on its off-balance sheet position.

* Date 2 (settlement date): The swap contract matures and settlement takes place. The exchange rate will have changed from the contract date, but the ESGC can ensure its value remains unchanged after settlement.

** The ESGC delivers KRW 1 billion to the Korean bank.

** In return, the Korean bank delivers $1 million dollars to the ESGC.

After the settlement date, the ESGC's balance sheet is back to its initial portfolio, provided that counterparty risk can be eliminated in some other way.

Example 3: ESGC as provider of combined hedging and trade credit services

Suppose that a Korean manufacturing firm from the SME sector wishes to accept an export order for a long-dated project. The project entails significant currency risk but also entails financing needs. The small firm does not have the financing in hand, and lacks collateral for obtaining trade finance from the banking sector.

Under these circumstances, the ESGC can provide a combination of trade financing and currency hedging by working in unison with existing agencies such as the Korea Credit Guarantee Fund (KODIT) which provides credit guarantees for small and medium sized companies that lack collateral demanded by banks. The ESGC can provide the combination of a loan and a forward contract as depicted in figure 16.

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In this example, the small exporting firm has obtained an export order for $1 million, but also needs to borrow in Korean won for working capital to fulfill the order. Say that the firm needs working capital of 1 billion Korean won, which is exactly equal to the $1 million export order at today's exchange rate of $1 = KRW 1,000.

In this example, the ESGC acts as a discounter of the export invoice. The discounting of receivables is known as 'factoring', and the ESGC provides factoring as well as hedging services. The specific transactions are as follows.

* Date 1 (transactions date):

** The ESGC sells $1 million and obtains KRW 1 billion. The ESGC lends this sum to the export firm, with promised repayment of 1 billion won at the settlement date. This loan is secured on the export invoice and the credit guarantee from KODIT.

** Simultaneously, the exporting firm enters into a forward contract with the ESGC and sells $1 million forward to the ESGC at today's exchange rate of $1 = KRW 1,000. The forward contract is also guaranteed by KODIT.

Provided that there is no credit risk--either on the loan to the exporting firm, or on the export invoice, the ESGC's claim of 1 billion won exactly offsets the obligation to deliver 1 billion won at the settlement date. Meanwhile, any currency risk is eliminated by the fact that the ESGC expects to receive $1 million at the settlement date. In this way, any gains or losses on its on-balance sheet portfolio of assets are exactly offset by the reverse marked-to-market gains and losses on its off-balance sheet position.

* Date 2 (settlement date): The forward contract matures and settlement takes place. Meanwhile, the export firm receives $1 million from its customer. The final settlement then takes place.

** The export firm receives $1 million from its customer and delivers it to the ESGC. In return, the ESGC delivers KRW 1 billion to the exporter, as stipulated in the forward contract.

** The export firm uses the 1 billion won to repay the loan of the same amount to the ESGC.

After the settlement date, the ESGC's balance sheet is back to its initial portfolio, provided that counterparty risk can be eliminated through KODIT.

In all the examples sketched above, the main benefit of the ESGC is that every dollar's worth of exposure that is hedged by the ESGC entails one less dollar of short-term foreign currency dollar liabilities of the banking sector. The direct benefit of the ESGC is to reduce the vulnerability of the financial system to crises by reducing the short-term foreign currency liabilities of the banking sector. We may also expect additional stabilisation effects of the ESGC by mitigating the feedback loop generated by the hedging via the banking sector.

Example 4: ESGC as intermediary

Although the ability of the ESGC to provide hedging services is limited by its capital, one way to increase its overall capacity would be to play the role of a central counterparty in forward transactions between sellers and buyers. Figure 17 illustrates such an example.

In figure 17, the ESGC acts as a central counterparty between an export firm wishing to sell dollars forward and an importing firm (such as an oil refiner or steel producer) wishing to buy dollars forward. Any matching transactions can free up the equity of the ESGC to provide hedging to other parties.

Due to the potential maturity mismatch between the selling and buying leg of the two forward transactions (exporters have longer-dated needs), the role that the ESGC plays in figure 17 could not be taken over by a currency futures exchange. Moreover, by playing the role of the central counterparty, the ESGC can reassure both sides of the transaction that the counterparty risk can be minimised.

The central counterparty role of the ESGC might be expected also to contribute to the development of a more active market between sellers and buyers of forwards and thus lower the costs of hedging both for exporters and importers.

[FIGURE 17 OMITTED]

The fact that the ESGC has a narrow mandate for providing hedging services provides a much stronger political economy rationale in the international context, and is much less susceptible to accusations of exchange rate manipulation through intervention. This advantage distinguishes the ESGC from the current Exchange Equalization Fund (EEF) of the Korean government, which is designed specifically for intervention purposes to smooth out exchange rate movements.

The ESGC has another advantage over the current Exchange Equalization Fund (EEF) from a political economy perspective, this time viewed from the domestic political context. The current EEF has both dollar-denominated and won-denominated accounts, and is used for intervention purposes. Since the objective is to smooth out exchange rate movements, the EEF can accumulate substantial gains or losses. From a domestic political economy perspective, the won-denominated gains and losses can be a sensitive political issue. During a time of sustained Korean won appreciation, the market intervention to slow the appreciation of the won will result in substantial marked-to-market losses in Korean won terms. Such Josses can sometimes be portrayed in the media as reckless gambling by the government and the central bank at the expense of the national budget. Such criticisms are not confined to Korea, as we have seen recently in the case of Switzerland and the Swiss policy of pegging the Swiss Franc to the euro.

The advantage of the ESGC is that it is designed to be perfectly hedged, so that there are no value gains or losses. The fact that it is valued in US dollars is crucial for this political economy advantage.

Not only is the ESGC relatively free from political economy pressures, it would be possible to construct a highly effective political economy case to highlight the many benefits that the ESGC can provide to the small and medium sized enterprise (SME) sector in Korea. The combination of lending for working capital financing as well as hedging services that are accessible to the SME firm sector would be highly beneficial to small exporters, and thereby level the playing field vis-a-vis the large firms in Korea. In this respect, the ESGC would chime in well with current consensus in policy circles on the desirability of levelling the playing field between small and large firms by reducing the competitive disadvantage of small firms.

6. Concluding remarks

In this paper, we have examined the rationale for an institution that can provide the public good of permitting economic entities to hedge their currency exposure while minimising the harmful spillover effects of their hedging activities for systemic stability as a whole. The key feature of the institution that allows us to perform its task is its capital structure financed with equity. As well as systemic stability, we have discussed the potential political economy advantages of such an institution, both domestically and internationally.

REFERENCES

Bank of Korea (2008), 'Preliminary findings of study on demand and supply imbalance in the currency forward market' (in Korean), Bank of Korea Press Release 2008-1-41, 19 January.

Financial Supervisory Commission (2007), 'Trends in mutual funds in domestic and foreign assets' (in Korean), Financial Supervisory Commission Press Release, 16 November.

Hahm, J.-H., Mishkin, F.S., Shin, H.S. and Shin, K. (2010), 'Macroprudential policies in open emerging economies', NBER working paper 17780, http://www.nber.org/papers/w17780. pdf.

Hahm, J.-H., Shin, H.S. and Shin, K. (2011), 'Non-core bank liabilities and financial vulnerability', working paper http://www.princeton. edu/=hsshin/www/noncore.pdf.

International Monetary Fund (2010), Global Financial Stability Report, April.

--(2011), 'Recent experiences in managing capital inflows--crosscutting themes and possible policy frameworks', Strategy, Policy and Review Department, February.

Shin, H.S. and Shin, K. (2010), 'Procyclicality and monetary aggregates', NBER discussion paper w16836, http://www.nber. org/papers/w16836.

NOTE

(1) Shinhan, Korea Development Bank (KDB), Citibank Korea, Standard Chartered, Credit Agricole (Calyon) and Deutsche Bank.

Kyuil Chung, * Hail Park * and Hyun Song Shin **

* Economic Research Institute, Bank of Korea. ** Princeton University. E-mail:hsshin@princeton.edu. The views expressed here are those of the authors and not necessarily the official views of the Bank of Korea. The authors are grateful to Philip Davis for comments on an earlier version of this paper.

Table 1. Underlying calculation for the increase in foreign currency
debt of the banking sector attributable to hedging activity
($ billion)

 2003 2004 2005

Shipbuilders' new orders 23.90 31.80 31.27
Estimated increase in foreign debt due
 to shipbuilders' hedging activities 1.15 4.64 5.70
Sale of dollar forwards by shipbuilders 4.47 12.50 16.82
Settlement of maturing forwards
 by shipbuilders -2.89 -6.14 -9.01
Net sale of dollar forwards by shipbuilders 1.58 6.36 7.81
Net increase in foreign stock holding
 of domestic investors 1.63 5.59 4.90
Estimated increase in foreign debt due to
 hedging activity of asset managers 1.00 3.43 3.00
Estimated increase in foreign debt due to
 hedging activity of shipbuilders and
 asset managers 2.15 8.07 8.70
Increase in total foreign debt 8.89 8.98 10.79
Increase in banking sector foreign debt 9.26 6.76 8.94

 2006 2007 2008

Shipbuilders' new orders 61.70 97.50 71.79
Estimated increase in foreign debt due
 to shipbuilders' hedging activities 14.00 19.97 5.24
Sale of dollar forwards by shipbuilders 35.25 53.26 41.49
Settlement of maturing forwards
 by shipbuilders -16.07 -25.90 -34.31
Net sale of dollar forwards by shipbuilders 19.18 27.36 7.18
Net increase in foreign stock holding
 of domestic investors 22.91 68.04 -56.98
Estimated increase in foreign debt due to
 hedging activity of asset managers 14.05 41.72 -34.94
Estimated increase in foreign debt due to
 hedging activity of shipbuilders and
 asset managers 28.05 61.69 -29.70
Increase in total foreign debt 63.79 108.23 -16.06
Increase in banking sector foreign debt 53.11 56.34 -23.46

 2009 2010

Shipbuilders' new orders 18.33 46.30
Estimated increase in foreign debt due
 to shipbuilders' hedging activities -12.99 -7.11
Sale of dollar forwards by shipbuilders 16.04 22.60
Settlement of maturing forwards
 by shipbuilders -33.84 -32.34
Net sale of dollar forwards by shipbuilders -17.80 -9.74
Net increase in foreign stock holding
 of domestic investors 24.44 9.60
Estimated increase in foreign debt due to
 hedging activity of asset managers 14.99 5.89
Estimated increase in foreign debt due to
 hedging activity of shipbuilders and
 asset managers 2.00 -1.22
Increase in total foreign debt 28.31 13.76
Increase in banking sector foreign debt 10.84 -7.18

Figure 1. Components of capital flows to emerging economies

 1995Q4-1998Q2 2006Q4-2008Q2 2009Q3-2010Q2

Portfolio Inflows 40% 17% 48%
Other Inflows
 (incl. Banking) 20% 41% 18%
Direct Inflows 40% 42% 34%

Source: IMF (2011, p. 14).

Note: Table made from bar graph.