Foreign Exchange Derivatives and Bank Lending in China

With the reform of the RMB exchange rate regime, China’s banks expose to more exchange rate risks and use foreign exchange derivatives to manage these risks. This paper develops a theoretical model to examine the relationship between foreign exchange derivatives and the foreign currency lending in China’s banking sector. In our model, banks choose lending activities in a way analogous to Cournot competition commonly described in industrial organization. We find there is the positive effect of the derivatives position on the total loan volumes under the condition that the von Neumann-Morgenstern utility function of bank using derivatives displays either constant or decreasing absolute risk aversion. In the empirical section, we use Vector Autoregression (VAR) model with China’s monthly data over the period from Jan 2007 to Jun 2014. Based on techniques commonly used in the VAR literature, the main results suggest that the foreign exchange derivatives transaction has bi-directional Granger causality with bank’s foreign currency loan volume, and derivatives transaction has a significantly and persistently positive effect on bank lending. Furthermore, we find that derivatives transaction accounts for over 40 percent of variations in loan volume in the long run.