FX Regulation Can Have Impact on Real Economy: Study

A study published by Liberty Street Economics, which features insights and analysis from economists working at the Federal Reserve Bank of New York, finds that regulation on FX derivatives can have a direct and negative impact on the real economy of the nation concerned.

The study, authored by Hyeyoon Jung from the New York Fed’s Research and Statistics Group, observes that FX derivatives are a “key tool for firms to hedge” due to what can be extremely high volatility, especially in emerging markets, and looks at the impact on the real economy when such hedging instruments are in short supply thanks to local regulation.

Jung uses South Korea as the basis for the study, following the country’s imposition of regulation that limits a bank’s ratio of FX derivative positions to equity capital.

The paper notes the regulation was designed to discourage risk-taking by financial intermediaries., and once implemented, was binding for some banks but not others. This allows the author to compare the effects on these two groups of banks. By exploiting this quasi-natural experiment, the study finds the regulation caused a shortage of FX hedging instruments, thus making it harder for exporters to hedge, which in turn resulted in a substantial reduction in exports, especially for small firms that relied heavily on FX derivatives for hedging.

Initially, the study defines constrained (treatment) banks as those that needed to lower their FX derivative–capital ratio and unconstrained (control) banks as those that did not need to make such an adjustment when the regulation took effect. It shows that, prior to the regulation, the FX derivative positions of the treatment and control banks moved in parallel, however, after it was introduced, the treatment banks reduced their FX derivative positions “substantially” compared to the control banks, thus supporting the suggestion that the regulation caused a reduction in the FX derivative position of those banks.

There is a question over whether this finding is due to an increase in the hedging demand of firms that traded with unconstrained banks, as opposed to a decrease in the supply from constrained banks, which Jung then seeks to answer by isolating the two effects using FX derivative contract-level data.

By comparing the contracts of firms that are within the same industry and have similar characteristics, the study finds that exporters’ hedging with constrained banks declined more than hedging with unconstrained banks by 47%, suggesting that the regulation caused a reduction in the supply of FXD by constrained banks.

A third set of analyses aims at estimating the effect on the real economy. By using the reduction in the supply of FX derivatives as the exogenous shock, the study examines whether it affected firm exports, which are the primary source of exposure to FX risk. “I find that the firms that were more exposed to the shock reduced their exports by a greater amount after the shock,” Jung writes. “Moreover, the effect was concentrated on small exporters that were heavily reliant on FXD hedging. For a one-standard-deviation increase in a firm’s exposure to the regulatory shock transmitted by banks, export sales fell by 18.9% more for high-hedging firms than low-hedging firms.”