[2016-8] The Relation Between Foreign Exchange Market Development and Financial Stability & Growth

Perspective Economic Development Financial Interrelations
Research Department

   The 2008 global financial crisis has shaken the consensus that there is a positive relation between financial development and economic growth. In addition, financial market development and capital liberalization since the 2000s have deepened global interrelations from a financial perspective, and thus interest in the role of the FX market as a transmission channel of both domestic and global shocks has also grown. Against this backdrop, this paper measures the degree of FX market development to examine how it affects financial stability & growth from an FX market perspective.


  First, by calculating the degree of FX market development by nation, using the financial development measurement methodology by Svirydzenka (2016), this paper finds a marked difference in the degree of FX market development between advanced economies (AEs) and emerging market economies (EMEs). This difference seems mainly attributable to the depth of the FX market, as measured by the size of daily average FX transactions, rather than FX market access. This implies that, although FX markets in EMEs have made great progress in terms of economic openness, they have still failed to make great qualitative improvements in terms of market size, the degree of interlinkages with other markets, and other such aspects. The analysis shows that in Korea's case as well, although its FX market has developed rapidly and has recently reached the level of AEs, the depth of its FX market still has much room for improvement.             


  In addition, an empirical analysis of 48 major countries, using FX development indices calculated with annual data from 1995 to 2014, finds that the development of the FX market is confirmed to have a non-linear relationship with financial stability and economic growth. In other words, this analysis finds that the development of the FX market positively influences financial stability and economic growth up to a certain point, but negatively impacts these factors with further developmental increases. Therefore, if FX market development goes beyond this threshold, to prevent further development from increasing negative impacts on financial stability and economic growth, it seems necessary to come up with several supplementary policy measures for the FX market, including macroprudential regulations. 

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