New Limits Set for FX Forward Exchanges in Oct.

Forward exchange transactions will face new restrictions from October, and the Korean branches of a foreign bank will be subject to the same risk management standards as those for domestic counterparts.

Forward exchange is a derivative that allows dollar purchases at a fixed exchange rate.

A measure to force foreign currency borrowings to be used overseas only will also be implemented from next month. Accordingly, the direction of liberalizing foreign currency transactions in Korea will be partly revised after staying on the same course since 1999.

The government seeks to better handle increasing volatility in the foreign exchange market due to unfavorable conditions abroad.

The measures were included in a plan announced Sunday to ease fluctuations in capital flows in and out of the country presented by the Strategy and Finance Ministry, the Bank of Korea, the Financial Services Commission and the Financial Supervisory Commission.

Under the plan, transactions of forward exchanges that banks purchase from shipbuilding and automotive companies will be limited to 50 percent of equity for domestic banks and 250 percent for foreign bank branches.

The share of forward exchanges at domestic banks was 15.6 percent in April, so no problems are expected because of the new regulation. Foreign bank branches will be affected, however, since their share of forward exchanges is 301.2 percent.

Among countries to liberalize foreign currency exchanges, Korea is the first to impose a separate regulation on forward exchange limits.

Banks had been allowed to buy forward exchanges from exporters without limits. Domestic banks and foreign bank branches that bought forward exchanges have borrowed dollars overseas for a short period and then sold them in the domestic foreign currency market to reduce risks stemming from foreign exchange volatility.

If the won’s value is high when a company, which has sold forward exchanges to a bank, requests to the bank to convert dollar-denominated export earnings to the won, the bank will suffer huge losses. So banks buy the won by selling dollars by the time they purchase forward exchanges. In such a process, short-term loans soar and fluctuations in foreign exchange increase.

The government says the ceiling on forward exchange transactions will cause short-term loans to gradually decline, preventing a massive amount of foreign capital from flowing out of the country in a financial crisis.

To maintain a sound foreign exchange market, foreign bank branches will be encouraged to voluntarily manage foreign liquidity risks. Only domestic banks have been required to have a diversity of funding sources and devise fundraising plans in emergencies. A similar regulation will be imposed on branches of foreign banks, however, after a three-month grace period.

Companies or individuals that take out foreign currency loans from banks should use the funds overseas to pay for imports, repay foreign currency loans, and directly invest in foreign companies.

Dollars has flowed in the domestic foreign currency market due to a regulation allowing companies and individuals to use foreign currency loans in Korea for facility investment.

legman@donga.com lovesong@donga.com