Download Choice of Exchange Rate Regime and Innovation of Risk

EASTERN ACADEMIC FORUM
Choice of Exchange Rate Regime and Innovation of Risk
Management for Commercial Bank’s Exchange Rate
LIU Huijun1, HONG Yong2
1. Postdoctoral Programme of China Industrial Economic Security Research Center of Beijing Jiaotong
University/ Research Center for Beijing Industrial Security and Development, China, 100044
2. Strategy & Planning Dept. China Life Insurance Company Limited, China, 100033
[email protected]
Abstract: Exchange rate is an important part of international monetary system. Various domestic and
international factors of political, economic and social can affect the choice of exchange rate regime in
one country. It is needed to choose the exchange rate regime by considering domestic economic-social
development and financial stability, especially the effect on sound operation of commercial banks.
Commercial banks should strengthen financial products innovation management and constantly improve
the exchange rate risk management.
Keywords: Exchange rate regime, Commercial bank, Exchange rate risk management, Financial
innovation
1 Introduction
Exchange rate is the most important adjustment lever in international trade. It means the ratio of a
country’s currency to another country. The level of the exchange rate will directly affect the price of
goods in international market. With the deepening reform of the exchange rate regime and capital
account liberalization, the RMB exchange rate will change more frequently and make more challenges
of risk management to commercial banks. It seemed very important to strengthen exchange rate
management risk control and to promote the financial innovation in commercial banks.
2 Types and Comparison of Different Exchange Rate System
There are several exchange rate regimes in the world, including fixed peg, currency board, crawling
band, managed float and free float. Main exchange rate regimes are as follows:
2.1 Fixed exchange rate system
Fixed exchange rate system refers to each country can peg the value of its currency to gold to establish
its par value. It is a relatively stable exchange rate system. There are different fixed exchange rate
systems in different currency systems.
The advantages of stable exchange rate can help to provide the basis for trade and investors, to establish
a stable expectation, to reduce exchange rate risk and transaction costs, thus promote investment growth
and international trade. Of course, there are some disadvantages. First, a country can’t achieve the fixed
exchange rate system, free capital flows and monetary policy independence happens at the same time
according to Mundell’s theory. Second, fixed exchange rate system does not automatically correct
currency misalignment. Third, fixed exchange rate system will increase the financial fragility, many
financial crises occur in recent years, mostly associated with the fixed exchange rate system. After
World War II, Bretton Woods’s system established base on fixed exchange rate system and capital
controls①. However, with the system breakdown, the major international currencies and gold decoupled,
along with the disintegration of the fixed pegged exchange rate system.
In history, after the Bretton Woods conference, $35 equal to an ounce of gold, the dollar and gold, and other
major currencies pegged to the dollar again, this is essentially a system of fixed exchange rates.
①
572
EASTERN ACADEMIC FORUM
2.2 Floating exchange rate system
Floating exchange rate system indicates that a country not set limits the local currency and foreign
currency gold parity and exchange rate fluctuation, the exchange rate jumps up and down according to
market supply and demand.
There are three advantages of floating exchange rate system. First, it can help to digestive or absorb
internal and external impact. When the impact is useful, exchange rate will increase automatically,
otherwise, it will automatically fall. Second, it can help to maintain the independence of monetary policy,
to make independent rapid response for internal and external shocks. Third, when market participants
are aware of exchange rate risk to manage and avoid the risk through various financial tools. There are
also several disadvantages. First, in floating exchange rate system, exchange rate fluctuated easily. It
appears the imbalance of exchange rate, especially in the short and medium term fluctuation [2]. Second,
it might lead to speculative flow of international capital. When expectation of a country’s currency
appreciation is high, investors will increase their investments, otherwise, they will reduce investments.
Third, it will cause the abuse of exchange rate policy against international economic cooperation. At last,
it may lead to price increased worldwide because of the ratchet effect.
2.3 Managed floating exchange rate system
Managed floating exchange rate will be decided by market supply and demand. Long-term trend of the
exchange rate was not affected by the government management. But short term trend of exchange rate
will be intervened or influenced by authority.
There are two advantages. First, it fluctuates in a reasonable range and allows enough flexibility and to
modify the exchange parity according to the basic economic factors. Second, it can provide greater
flexibility in space for the implementation of monetary policy, reducing the risk of currency crises.
However, because of the government or the central bank authorities can set the exchange rate, floating
exchange rate system may be abused as a policy management against neighbor countries.
In a word, whether an exchange rate regime suits a country, it all depends on specific economic and
financial environment in this country. No exchange rate regime is perfect, isolated from troubles and
risks and no any kind of exchange rate system is suitable for all countries all the time.
3 Choice of RMB Exchange Rate Regime
3.1 Factors affect the choice of exchange rate regime
To a certain extent, a country’s exchange rate is decided by various political and economic factors.
Different sectors of society will have different exchange rate system and exchange rate pricing
preference because of its own interests [1]. In a country, the exchange rate is the result between interest
groups and the government which has a certain political and economic policy objectives.
There are some factors affect the choice of exchange rate regime. First, economic and financial policies
influenced the choice of exchange rate regime. Research showed that, in given condition, financial
policy is effective under a fixed exchange rate system, but monetary policy is ineffective. Second,
economic scale influences the choice of exchange rate regime. The larger economies are more likely to
choose floating exchange rate system to obtain the autonomy of monetary policy, smaller economies
tend to choose fixed exchange rate. Third, trade dependence degree② influenced the choice of exchange
rate regime. The higher degree of trade dependence is, the more impact of exchange rate changes on the
overall national economic is. Trade dependence countries are more likely to choose the fixed exchange
rate system.
The international exchange rate system reflects the power structure of international politics [3].
Internationally, changes of exchange rate in main countries directly affect other international currencies
in the foreign exchange market. Great powers seek certain interests through exchange rate arrangements.
②
The degree of trade dependence refers to the international trade accounted for the proportion of GDP.
573
EASTERN ACADEMIC FORUM
First it is necessary to reverse the country’s balance of trade, to maintain and enhance the confidence of
local currency as an international currency. Second we need to bring about the internationalization and
consolidate of home currency, thus get constant Seignior age. The third is to keep its independence of
monetary policy, and influence and even manipulate foreign policy.
3.2 The choice of RMB exchange rate system
From 1994, China adopted a managed floating exchange rate system. After the 1997 Asian financial
crisis, in order to prevent financial risks, government further narrowed down exchange rate volatility. As
a result, RMB became Pegging to the US dollar in fact.
A Managed floating exchange rate system based on market supply and demand and reference currency
basket has been operated since 2005. With China’s rapid economic growth, RMB exchange rate issue
has been focused.
In our country, economic development is facing big pressure. The growth speed has changed from rapid
to slow and the vulnerability of the economic growth increased. Second, export growth fell sharply; the
trade deficit turn narrow, foreign exchange reserve growth is slowing down. Third, although current
inflation still can be controlled, total trend is rising quickly.
In the last 10 years, China’s international balance of payments showed the current account and capital
account surplus situation, which resulted in the rapid unreasonable growth of foreign exchange reserves.
Under the rapid increase in foreign exchange reserves, the central bank put in a large amount of money
which leads to rapid growth of foreign exchange, increased domestic inflationary pressure. Increasing in
foreign exchange reserves formed an expectation of RMB appreciation. More and more international
speculative “hot money” flow into our country and increase the impact on our economy which easy to
induce the economic and financial instability.
Internationally, regional trade new framework is influencing the RMB exchange rate system. From the
end of 2011, mainly in developed countries, they have introduced a few pacts in a series of new area and
agreement between their economic and trade, investment, financial relations. The first is “trans-Pacific
Partnership Agreement (TPP)”, second is “Transatlantic Trade and Investment Partnership (TTIP)”, then
“multilateral Services Agreement (PSA)”, and “the European Economic Partnership agreement”. All
these changed international monetary system and affected international economic and trade patterns.
In short, inside and outside boundary conditions of the choice of RMB exchange rate system has
changed, China’s foreign exchange management is faced with a dilemma condition. Therefore, the
independence of monetary policy is limited.
4 Risk of Commercial Bank’s Exchange Rate
With the deepening reform of the RMB exchange rate regime and capital account liberalization,
exchange rate volatility increased and the frequency changed faster. Main problems in the exchange-rate
risk management of commercial bank in our country are as follows:
4.1 Risk of mismatching of foreign assets and liabilities in commercial bank
At present, much less attention has been focused on foreign exchange risk than credit risk and interest
rate risk. Because exchange rate fluctuation is modest and foreign business is a very small part of
China’s commercial banks. But, commercial bank foreign exchange assets and liabilities currency
positions do not match, the sources of foreign exchange and the use of duration mismatch will all lead to
exchange rate risks. From the RMB exchange rate mechanism reform, commercial banks faced with big
risk of foreign currency exposure, high dollar allocation proportion and high risk of currency
mismatch.[4] Exchange rate fluctuation may reduce current earnings or economic value of the
commercial bank when facing foreign currency exposure and maybe touch off exchange rate risk. [5]
574
EASTERN ACADEMIC FORUM
4.2 The risk of exchange rate fluctuations in capital
The system of our commercial bank capital consists of domestic and foreign currencies; the foreign
currencies ratio reached fairly high level. Under the influence of RMB exchange rate fluctuation, if there
is a significant appreciation of RMB, capital of the commercial bank may lead to shrinkage. This will
undoubtedly have an adverse impact on the adequacy level of commercial bank capital. At present, in
addition to the capital adequacy ratio of state owned commercial banks remain at a high level, small and
medium-sized banks are near or below the supervision red line. [6]
4.3 Intermediate business risk of settlement and sales of foreign exchange in commercial banks
Increased frequency and amplitude of fluctuations in the exchange rate lead to worsen foreign exchange
risk of foreign trade business accounts which increased risk of commercial bank loans. Moreover,
foreign exchange derivatives provided forms to avoid risk and keep assets value. Meanwhile derivatives
become speculative tools through their virtual and leverage properties. All This will amplify risk, bring
about tremendous challenges for exchange rate risk management of commercial banks in China. Losses
of enterprises might be converted into banks’ credit risks and losses.
4.4 The lack of perfect exchange rate risk identification and control system
For a long time, our commercial banks are mainly based on qualitative analysis, lack of quantitative
analysis and insufficient scientific on exchange rate risk identification, measurement and monitoring.
Our banks are far behind advanced international banks in the fields such as using statistical models in
their daily risk management. Our Banks haven’t integrated risk value to daily risk management, such as
product pricing and sales quota. Many commercial banks don’t have independent risk assessment
system. Especially they don’t have a system to effectively evaluate, track and monitor foreign exchange
transactions, credit and other important business risks.
5 The Innovation of Exchange Rate Risk Management of Commercial Banks
5.1 To further improve the risk management system of commercial banks
Sophisticated corporate governance structure is the basis of effective risk management. Commercial
banks should formulate long-term business strategy and clear risk management policies, business plan
and management target. Commercial banks should carry out multi-level risk management and risk
management department should be managed closely and directly from top management. In order to
further improve the risk management systems of commercial banks, they should formulate effective
monitoring and clear risk management policies and procedures. Moreover, commercial banks should
improve risk management information system and establish capital allocation mechanism of appropriate
market risk.
5.2 Improve innovation of foreign exchange risk identification, measurement and monitoring
Commercial banks ought to improve exchange rate risk identification, measurement and monitoring.
During daily risk management, overall and dynamic identification of exchange rate risk sources and
manifestations should be tested by VAR, RAROC, pressure testing and other advanced risk
measurement tools and methods. And the foreign exchange risk exposure should be accurately
calculated. During learning of foreign banks’ advanced econometric models and methods, our banks
should adjust and develop more effective tools or models suiting for our banks’ requirements.
Management and various departments could understand exchange rate risk level and effectively control
the risk of exchange rate by using specific quantified the exchange rate risk.
5.3 Constantly improve the exchange rate risk management innovation
Financial innovation is the main way to avoid or reduce the financial risks and protect the financial
security. Commercial banks can learn advanced management technology from foreign banks and
575
EASTERN ACADEMIC FORUM
establish a scientific regulatory system to control and manage the exchange rate risk. Commercial banks
should control and determine risk tolerance and risk limit through quota management and hedging.
Moreover, to keep exchange rate risks of financial innovation in a positive price range and constantly
improve the quick response ability to guard against and defuse financial risks.
5.4 To strengthen the risk management of financial innovation products
Commercial banks should make full use of financial derivatives to avoid the risk of the products and
services for themselves and other economic agents. When setting price for foreign exchange products
such as foreign exchange loans, deposit, long-term settlement and other foreign exchange derivatives,
commercial banks should consider risks caused by different customers, different tread team and different
currencies. In addition, suitable diversified risk aversion tools should be developed such as foreign
exchange swaps, options and futures trading etc. In order to avoid exchange rate risk, active
management mode should be use to meet customer needs. At the same time, the risk classification and
evaluation target should be strengthened. Mandatory information disclosure system of financial
innovation products should be enforced to maintain the dynamic coordination of financial business and
product innovation, in which can provide effective protection and promote financial security.
6 Conclusion
With the deepening reform of the RMB exchange rate regime, commercial banks faced with more
difficulties in China. It is very important to promote the financial innovation meanwhile strengthen risk
control. It is needed to choose the exchange rate regime by considering domestic economic-social
development and financial stability. At present, there are several problems in exchange-rate risk
management in commercial banks, such as the risk of exchange rate fluctuations in capital, mismatching
of foreign assets and liabilities, lack of perfect exchange rate risk identification, control system and
intermediate business risks. The authors try to give some advices to improve the risk management and
maintain financial stability, e.g. develop the risk management system, promote innovation of foreign
exchange risk identification and monitoring and strengthen the risk management of financial innovation
products.
References
[1]. Jeffry A Frieden. Exchange Rate Politics [A]. Jeffry Frieden, David Lake. International Political
Economy: Perspectives on Global Powers and Wealth [C]. Beijing: Peking University Press. 2003:
261
[2]. Rosati, Dariusz K. Foreign Exchange Rate Policies in Transition: Lesson, Challenges and Policy
Options. Http: // wisswsv.wsr.ac.at/wiiwpubl/ Rosati.pdf. 2000
[3]. Kuang Mei, Wang Hang. Influence of the Choice of Exchange Rate System and Political Factors
Empirical Anal of Analysis East Asian and Latin American Emerging Market Countries [J]. Studies
of International Finance. 2007 (10): 26-33 (in Chinese)
[4]. Zhou Shixin, Mao Yun. Research of China Commercial Bank Foreign Exchange Risk [J]. Jiangxi
Social Sciences. 2009 (3): 212-215 (in Chinese)
[5]. Lu Yan. Problems and Strategies of Commercial Bank Exchange Rate Risk Management [J].
Co-operative Economy & Science. 2009 (24): 72-74 (in Chinese)
[6]. Xie Fei, Chen Lijun, Qin Jiancheng. Exchange Rate Risk Management of Commercial Banks of
China From the Perspective of RMB Exchange Rate Changes [J]. Journal of Chongqing University
of Technology (Social Science). 2010 (3): 50-53, 58 (in Chinese)
576