A small, open South Korean economy saw its financial system disrupted following the 2008 global financial crisis even with a huge current account surplus. The South Korean won plunged versus the U.S. dollar and the stock market fell into the bottomless pit despite the solid economic fundamentals.

After 2008, Seoul unveiled a couple of measures to delink Asia' s No. 4 economy from the financial meltdown caused by the foreign capital exodus. Those include caps on banks' foreign exchange (FX) forward contracts and macro-prudential stability levy.

Those quantitative and price-oriented regulatory instruments have been assessed to mitigate negative externality, but given the increasingly stronger interconnectedness between advanced and emerging economies, it would be high time to mull a new mechanism that can handle the potential external shocks from a long-term perspective.

"Five years have passed since the global financial crisis happened. Now is the time to advise a new crisis-proof mechanism from a long-term perspective," Princeton University professor Shin Hyun Song said on Sunday in a paper submitted to the Bank of Korea (BOK).

Professor Shin advised Seoul should set up the so-called FX stability mechanism to disconnect its financial system from its chronic weaknesses, or currency and maturity mismatch risks. The pre-crisis surge in short-term foreign debts by local banks exposed the country to those risks, making the lenders defenseless to massive deleveraging by foreign financial institutions following the global financial crisis.

CHRONIC WEAKNESS

Short-term external liabilities owed by local banks surged to around 160 billion U.S. dollars in September 2008 when Lehman Brothers collapsed, up from about 44 billion dollars as of the end of 2004. The volume plunged to 105 billion dollars in June 2009 due to deleveraging by foreign financial institutions.

Massive net capital outflow from South Korea following the 2008 crisis came mainly from banks' balance sheet. Generally speaking, banks can cover foreign deleveraging by selling foreign assets, but the South Korean banks held non-liquid assets, making it difficult for the lenders to retrieve foreign assets.

According to the paper, this vulnerability was mainly associated with massive FX hedging transactions by local exporters, especially shipbuilders. Exporters, which came to hold foreign currency accounts receivable due to export contracts, actively hedged future FX cash flows by selling dollar/won forward contracts to banks. In case of shipbuilders, most orders are long- term as it takes years to build a ship.

Local banks, which bought long-term FX forward contracts from exporters, borrowed short-term dollar funds from overseas to hedge currency risk. Long-term FX forward contracts and short-term foreign debts brought on a maturity mismatch, disrupting the South Korean financial system with foreign fund exodus after the crisis.

LACK OF BUYERS

Domestic asset managers were active in FX hedging. According to the Financial Services Commission (FSC), South Korean asset managers sold FX forward contracts to local banks, equal to around 84 percent of net asset value (NAV) in overseas equity investment funds in 2007. If the NAVs change on global stock market fluctuation, local banks need to buy or sell dollars to cover the change in hedge assuming a constant hedge ratio.

Importers, including crude oil refiners and steelmakers, were not active in hedging FX risks. The hedge ratio for importers stood merely at around 15 percent on average for the first nine months of 2007, much lower than around 67 percent for exporters, according to the joint survey conducted by the BOK and the Financial Supervisory Service (FSS).

Local importers were inactive in FX hedging as they could pass on much of the FX risk to customers thanks to their dominance in the domestic market. Lack of natural buyers of FX forward contracts caused a supply-and-demand imbalance in the FX market.

Growth in banks' foreign debts is mainly attributable to FX hedging demand from exporters and asset managers, the paper said, noting that foreign debts linked to banks' FX forward contracts expanded in line with banks' total external liabilities during the 2003-10 period except for 2006.

FEEDBACK LOOP

The massive hedging demand caused the so-called "feedback loop" effect. The demand for FX hedging increased banks' short-term dollar funding that was sold in the local FX market. The dollar selling led to the local currency's appreciation against the greenback, driving exporters to expect the continued ascent of the won versus the dollar. Expectations for the won's persistent appreciation brought about additional hedging demand from exporters.

Based on expectations for the won's appreciation, local exporters took oversold positions in FX forward contracts. When the global financial crisis erupted, the local currency plunged against the dollar, which did huge losses to exporters.

FX hedging transactions have a nature of a double-edged sword. From a perspective of individual economic subject, FX hedging transaction is an optimal act of avoiding currency risks, but from a perspective of the overall economy, the hedging amplifies the volatile movement in the FX market.

The main channel, which the negative side effect passes through, is banks' short-term foreign debts that cover their currency mismatch arising from the purchase of FX forward transactions from exporters, according to the paper.

The FX stability mechanism designed by Professor Shin was expected to cut the channel by replacing the existing role of banks as counterparty to exporters in the FX forward transactions.

FX STABILITY MECHANISM

According to Professor Shin, the FX stability mechanism should be established to serve as public goods that can strengthen financial stability, not private goods that pursue a goal of profit maximization. It will act as counterparty to economic subjects who want to hedge currency mismatch risks.

Second, all the operating funds should be raised in the form of equity capital without any single debt. The feature will lead the mechanism not to raise short-term foreign debts even though it buys FX forward transactions from exporters.

For example, the mechanism holds all the assets in U.S. Treasury bonds at the very first time. If an exporter sells the FX forward transaction to the mechanism, the contract will be booked as an off-balance asset. After cashing in on the U.S. Treasury bonds, the FX stability entity will convert the dollar into the South Korean won, with which the Korea Treasury Bond (KTB) will be bought. The process can replace the U.S. Treasury bonds with the KTBs on the asset side and no change on the equity side.

On the balance sheet, the asset side will face the oversold position in the dollar terms due to the Treasury Bond selling, but it will be balanced with the inclusion of the off-balance FX forward buying. The mechanism can offset the rise on the asset side stemming from the FX forward buying with another asset reduction that is the Treasury Bond selling. Unlike banks, the mechanism needs not to borrow dollars from overseas.

Third, bookkeeping of profit and loss should be denominated in the U.S. dollar, not in the South Korean won. The feature will make it possible for the mechanism to have room for buying the FX forward contracts as the KTB selling brings the oversold position on the asset side in dollar terms.

MATTERS TO BE TACKLED

To materialize the FX stability mechanism, the funding issue should be dealt with first. Foreign reserves managed by the BOK and dollar funds secured by the finance ministry through the issuance of the FX stabilization bonds can finance the mechanism as it will serve as public goods, but discussions will be needed between parties concerned.

The cost of hedging interest rate risks should be considered. The mechanism's assets would be composed mostly of the U.S. Treasury Bonds and the KTBs, exposed to potential policy rate hikes that will come after the global economy gets back on the normal track.

"The interest rate risks will not be big. It's different from the currency risk. The interest rate risks can be tackled by hedging. The cost of hedging will not be big," Chung Kyu-il, head of the BOK's international economic studies team and co-author of the paper, said by phone.