Korean authorities clamp down on banks' FX forward positions

Ceiling for local banks is now 30%.

According to DBS, the authorities announced to tighten controls on banks’ FX forward positions. The FX forward positions held by foreign banks will be cut to 150% of equity capital, down from 200% previously.

Here's more from DBS:

The corresponding ceiling for domestic banks will be lowered to 30% from 40%. These measures came as no surprise and the market reaction was mild.

The authorities have been progressively tightening the regulations on banks’ FX forward positions and short term FX borrowings in the past few years. Meanwhile, last week government officials already warned the possibility of taking further actions.

This is against the backdrop of further quantitative easing implemented in the G3 since September, an appreciating Korean won that outperforms other Asian currencies, and growing concerns about yen carry trade as a result of the recent weakening of the Japanese yen.

The past experiences suggest that lowering the caps on banks’ forward positions could effectively reduce the accumulation of banks’ short term foreign currency borrowings.

This in turn, helped to slow the pace of won appreciation in a capital inflow episode and mitigate the won’s volatility. As of end-2011, the country’s short term external debt has fallen sharply by USD 52bn from the peak levels in 2008.

Short term external debt has continued to fall by USD 4.8bn in the first three quarters this year, equivalent to a monthly decrease of USD 0.5bn, a faster pace of decline compared to USD 0.2bn in 2011.

That said, it should be noted that there have been fundamental, more permanent factors supporting the appreciation (recovery) of the won after the 2008 crisis.

Foremost, the current account has returned to surplus. Thanks to strong trade inflows, the current account surplus has widened further to USD 3.3bn per month in Jan-Sep this year, up from USD 2.2bn on average in 2011.

Meanwhile, foreign investment in KRW bonds has risen strongly in recent years. Foreign investors’ holding of KRW bonds more than doubled between end-2008 and end-2011.

In the first ten months of this year, foreign holding of KRW bonds rose further by KRW 5.6trn (USD 0.5bn per month). Trade flows are less volatile than portfolio capital flows.

The rise in foreign investment in KRW bonds also reflects some structural factors, due to the upgrade of Korea’s sovereign ratings and the strengthening of the risk-return profile of KRW assets.