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Executive summary

In response to a call for interest circulated in March 2021, 12 Asian Consultative Council (ACC) member central banks formed the Study Group on Foreign Exchange (FX) Markets in Asia-Pacific in April 2021. The group discussed (i) how to strengthen FX market monitoring; (ii) how to develop deep and efficient FX markets and encourage widespread use of FX hedging; and (iii) how to dampen the impact of FX volatility on domestic financial markets. The report provides key observations and policy takeaways in four areas. Some takeaways are relevant particularly for emerging market economy (EME) central banks but less so for advanced economy (AE) central banks in the Asia-Pacific region.

Overview of regional FX markets. Asian EME currencies increased their share in global FX turnover from 2013 to 2022, but the share remains below that of Asia-Pacific AE currencies. Rapidly growing non-deliverable forward (NDF) markets for some EME currencies indicate segmentation between onshore and offshore markets. Finally, FX markets play a bigger role in central bank operations in EMEs than in AEs, with EMEs conducting FX interventions mainly aimed at supporting market functioning and financial stability.

FX market monitoring and surveillance. Most central banks use FX market monitoring and surveillance to help inform the use of policy instruments, particularly FX intervention and liquidity provision. Improved data availability and digitalisation have increased the frequency, coverage and quality of FX market monitoring. Some central banks are also adopting big data and machine learning techniques in their FX market monitoring activities.

Challenges in FX market monitoring include data availability (especially on transactions by nonresidents or in offshore markets), the analysis of big data, the translation of data into useful information, and sharing the monitoring output among different stakeholders. Hence, within central banks, there may be room to improve cross-departmental cooperation in FX market monitoring and risk analysis. Greater scope for cooperation among central banks may also exist. As offshore markets lie outside the operational remit of the respective central bank, they are more difficult to monitor but can be the locus of price discovery or currency volatility. Given the rapid electronification of FX spot and derivatives markets, central banks may opt to invest more in big data analysis and monitoring of electronic trading of NDFs.

FX hedging markets and their development. The use of FX derivatives has grown in Asian EMEs, but still lags that of AEs and regional financial centres. Furthermore, central banks generally have limited information on FX hedging policies of market participants, especially those of non-residents, and the exact purpose for which FX derivatives are used. Regional currencies proved considerably more resilient during the 2020 Covid-19 financial market turbulence than in the 2013 taper tantrum, due partly to the swift and coordinated response by central banks, and partly to the structural FX market reforms in recent years.

In order to help balance future demand for and supply of FX hedging instruments, a more flexible approach to FX hedging requirements for non-bank financial institutions (NBFIs) may be useful, such as allowing “over-“ and “under-hedging” vis-à-vis the underlying exposure. EME financial authorities may also consider broadening the range of FX risk management tools available to market participants beyond FX derivatives. At the same time, the authorities could mitigate the build-up of systemic risks by preemptively introducing or tightening FX-related macroprudential measures during normal times.

Broader considerations for FX market structure and capital flows. The intermediation capacity of local FX markets needs to keep pace with local asset market development. If the pace at which local FX markets deepen does not keep up with the growth rate of gross capital flows over time, then FX markets can amplify market stress at times when capital inflows/outflows are volatile. In this context, the soundness of intermediaries involved in FX transactions is a particularly important factor in mitigating financial vulnerability and transmission of stress.

When FX markets cannot smoothly absorb shocks to capital flows, EME central banks may need to deploy policy tools to limit FX volatility and safeguard macroeconomic and financial stability. At the same time, there are limits to how far central banks can deploy policy tools to provide FX liquidity and mitigate capital flow shocks. Therefore, while pursuing capital account liberalisation, EME central banks may need to introduce temporary capital flow management measures when other tools do not work well. Finally, they should assure access to global or regional financial safety nets to deal with severe market stress.