Annex 1. Country Experiences and Case Studies
This annex surveys the experiences of four countries—Korea, Colombia, Brazil, and Israel—in an effort to ascertain the potential effectiveness of macroprudential restrictions on banks’ spot and derivatives FX positions. Korea and Israel are included because they have experienced capital inflows surges similar to those faced by many Latin American countries While there is an attempt to appraise country experiences analytically, the approach is necessarily somewhat descriptive. The country experiences described are illustrative—this is not meant to be a complete listing of macroprudential FX measures.
Annex 8.2. Carry Trade Using Futures Market
Prepared by Carlos Fernández Valdovinos and Chris Walker.
See for example Allen et al. (2002) for how balance sheet weaknesses could contribute to the origin and propagation of modern-day financial crises.
Having a short position is equivalent to having a net liability position (i.e., the value of liabilities is larger than the value of assets). Having a long position is equivalent to having a net asset position (i.e., the value of assets is larger than the value of liabilities).
In this case, an appreciation will reduce the value of FX assets (when expressed in terms of the domestic currency) without changing the value of domestic liabilities. In other words, the appreciation would generate a decline in bank’s capital.
For a discussion on risks arising from bank client FX mismatches and instruments which could be employed to reduce them, see companion note on Macroprudential instrument to manage foreign-exchange credit risk.
Recently, some countries have imposed capital controls to various degrees. These restrictions may be useful in addressing both macroeconomic and financial-stability concerns in the face of inflow surges, but before imposing them, countries should first exhaust their macroeconomic-cum-exchange-rate policy options. See Ostry et al. (2011) for a discussion.
See the Annex I for more details on how countries have used the instrument to limit arbitrage and carry trade for a financial stability purpose.
In addition to limiting banks’ foreign currency exposure, some countries impose capital requirements on open foreign exchange positions. Cayazzo et al (2006) indicate that Poland, Singapore and Sweden have capital charges on foreign exchange exposures. Argentina, Bolivia, Chile, Costa Rica and Honduras have only limits on these exposures. The remaining of the 17 countries surveyed, including some LAC countries, have both capital charges and limits on foreign currency exposures.
In contrast, short position limits will protect banks from an abrupt depreciation and reduce their ability to take speculative short net open FX positions that could lead to sharp currency appreciations.
An alternative approach, which would also shift marginal incentives without imposing hard limits, would be to increase the risk-based capital charges on banks’ currency derivative positions.
According to official sources, almost half of the increase in the country’s total external debt of US$195 billion during 2006–07 was due to the increase in FX forward purchases by banks.
Complementary, the limit on currency forward transactions by local companies were also cut to 100 percent of future revenues (from 125 percent).
However, they were not able to substantially stem total inflows as (i) corporates were still able to engage in contracts off-shore using nondeliverable forwards, and (ii) no new restrictions were imposed on portfolio debt and equity inflows, which were major sources of inflows.
In December 2010, Korea announced that a levy will be imposed on nondeposit foreign currency liabilities held by domestic and foreign banks, with a higher rate levied for short term debt than longer debt. The measure is expected to be implemented starting the second half of 2011.
The tax on equity investment stayed at 2 percent, while FDI (including external borrowing by Brazilian banks and firms) continued to be exempted.
The net open position of the banking system has remained usually below 6 percent of capital since 2008.
Thus, instead of having an overall net open position limit (including spot and derivative operations), banks would be subject to separated quantitative limits for these two types of transactions.
That is an increase in the interest-rate-adjusted forward premium.
Alternatively, authorities could impose a levy on foreign borrowing or subject these external funds to some kind of unremunerated reserve requirements. The disadvantage of a reserve requirements policy is that it would affect the total amount of external borrowing and, therefore, would make hedging more costly for all agents (including those not having a speculative purpose, like exporters). The Brazilian central bank recently implemented a measure requiring banks to deposit the equivalent of 60 percent of their short spot dollar positions in cash at the central bank, at no interest. This requirement applies to the amount that exceeds US$3 billion or Tier I capital, whichever is lower.