The Foreign Exchange Market
The Foreign Exchange Market
The foreign exchange market is divided into two levels, based on the nature of the market participants: the foreign exchange retail market and the foreign exchange wholesale market. The retail market refers to the market formed by foreign exchange transactions executed between the banks, enterprises, and individuals. Driven by the different needs for trade, investment, foreign currency deposit, loans, or speculation, enterprises and individuals engage in the buying and selling of foreign currencies with commercial banks. This trade forms a decentralized invisible market.
At present, China’s foreign exchange retail market mainly refers to the market of foreign exchange settlement and sales. A foreign exchange settlement occurs when enterprises and individuals with foreign exchange proceeds sell foreign currency to the authorized foreign exchange bank. A foreign exchange sale occurs when enterprises and individuals are in need of foreign currency and they purchase it from authorized banks with Renminbi. The authorized bank of foreign exchange sets the rate within a certain range of fluctuation every day, and engages in counter dealings with clients according to the middle price of the market exchange rate of the Chinese currency against the rate of major foreign currencies, as published by the PBOC. At present, the Chinese currency can only be converted under current accounts, and so the foreign exchange settlement and sales between banks and clients require a valid commercial circumstance.
Besides foreign exchange settlements and sales, China’s foreign exchange retail market also includes another business item: the conversion between different foreign currencies for enterprises and individuals through the bank. There is basically no restriction imposed on this. For instance, enterprises can avert exchange risks by handling forward foreign exchange transactions and individuals can earn differentials in either the rate of exchange or the rate spreads by operating with the current exchange rates.
The foreign exchange wholesale market is formed by the buying and selling of foreign currencies among financial institutions, such as commercial banks. As the foreign exchange transactions between commercial banks involve great amounts and small differentials in the buying and selling rates, they are often referred to as the foreign exchange wholesale market. Since it is a place where banks engage in the settlement and sales of foreign exchange and cover position, it is usually called the interbank foreign exchange market. According to state regulations, no financial institutions are allowed to make deals between Chinese and foreign currencies in the off-the-board market, and all the transactions for foreign exchange settlement and sales are conducted through the China Foreign Exchange Trade System (CFETS), a computer network of CFETS that has Shanghai as the main center and adopts a membership system for computer networking across the country.
For transactions conducted through CFETS, on-site transactions are combined with distance transactions, and traders authorized by member entities of the market make quotations through online transaction terminals. Two transaction modes can be chosen voluntarily. One is the quote-driven mode, which is automatically brought together by the computer system on the principle of giving priority to price and time. The other is the inquiry mode, featuring bilateral credit extension and settlement, from which a single, managed, floating rate of exchange based on market supply and demand is generated. Currently, the main transaction players of the market are the authorized banks for foreign exchange. With the foreign exchange control system in China relaxed, the main participants in the interbank foreign exchange market are gradually expanding from commercial banks to non-bank financial institutions. With regards to another type of foreign exchange business, transactions between different foreign currencies, domestic banks can freely participate in the transaction of international market without any policy restrictions. The interbank foreign exchange market is the main part of China’s foreign exchange markets at present and is also the focus of this chapter because, under the present Chinese foreign exchange control system, the development of the interbank foreign exchange market will be of great economic and policy significance.
1.1 Predecessor: The Foreign Exchange Swap Market
The development of China’s foreign exchange market is closely related to the development of China’s foreign exchange control system. Before the reform and opening-up of China’s economy, China implemented a highly concentrated planned economic system. Due to the shortage of foreign exchange resources, China had long exercised strict foreign exchange control. With the implementation of the reform and opening-up strategy in 1978, China’s foreign exchange control system has shifted toward a system which is compatible with the socialist market economy in an orderly way. The new system aims for a gradual weakening of mandatory planning and the cultivation of market mechanisms. This new system covers the following aspects:
- Foreign exchange-earning entities have been allowed to retain an appropriate proportion of their exchange earnings. Measures for foreign exchange retention were implemented in 1979 in order to reform the unified revenue and spending system in foreign exchange distribution, bring into play the initiative of foreign exchange-earning entities, and improve the distribution of foreign exchange resources. These measures specify that while foreign exchange is controlled and balanced by the state in a unified and concentrated way, with priority given to key projects, foreign exchange earnings from trade and non-trade channels could be retained in light of concrete situations, and part of the foreign exchange earnings could be retained by the foreign exchange-earning localities and enterprises in an appropriate portion to meet their basic needs for foreign exchange. The use of retained foreign exchange earnings must conform to state regulations, and if the entities enjoying retained foreign exchange earnings do not need foreign currencies themselves, they can sell them to those who are in need of them through the foreign exchange swap market.
- The number of financial institutions conducting exchange operations has increased. Before 1979, the foreign exchange business was managed by the Bank of China (BOC) in a unified way. To adapt to the new situation after China’s economic reform, competition mechanisms have been introduced into the foreign exchange business. Other state-owned banks, several commercial banks, and a group of non-bank financial institutions are permitted to conduct foreign exchange business. Also, foreign-funded financial institutions are allowed to set up agencies to operate foreign exchange businesses. All these efforts have contributed to a pattern of multiple financial institutions participating in the foreign exchange business.
- Foreign exchange control over domestic residents has been relaxed. Individuals who keep foreign currencies at home are allowed to hold and deposit the currencies in a bank, though they are not allowed to trade or carry them out of China without permission. Foreign exchange earnings procured by individuals can be retained in part or in full. As of 1985, foreign currency remitted to domestic residents or carried in from abroad can be retained in full and a deposit account can be opened with a bank. Beginning in November 1991, individuals with foreign exchange earnings can take part in the foreign exchange swap. Also, individuals going abroad to study, emigrate, visit family members, or support foreign relatives can apply for foreign currencies at the State Administration of Foreign Exchange (SAFE). Approval is based on the strength of exit certificates and relevant papers, and after approval, a limited amount of foreign currency can be purchased.
- Foreign exchange certificates have been issued for the convenience of non-residents beginning in 1980. To accommodate the needs of passengers and prevent foreign currency from circulation at home as well as the arbitrage of exchange and supplies, the BOC issued foreign exchange certificates in different denominations of RMB on April 1, 1980. Foreigners, overseas Chinese, residents from Hong Kong, Macao, and Taiwan, as well as personnel from foreign embassies, consulates, and delegations could exchange foreign currencies for foreign exchange certificates in line with the exchange rates of the bank and use them to pay for commodities, labor services, and other services at hotels, restaurants, designated shops, and airports. The unused foreign exchange certificates could be carried out of China or cashed. The entities receiving foreign exchange certificates were subject to the approval of SAFE and must deposit the foreign exchange certificates received in the bank and exercise separate management of revenue and expenditure. Where the entity receiving foreign exchange certificates exchanged them in the bank, it could retain part of foreign exchange earnings as stipulated.
The implementation of the foreign exchange retention system necessitated a foreign exchange swap. Therefore, the State Council approved the request of the BOC to launch the foreign exchange quota swap business in October 1980. At the end of 1985, Shenzhen took the lead in setting up a regional foreign exchange swap market, which was an intermediary specializing in foreign exchange swap business and confined to over-the-counter transaction. In 1988, Shanghai initiated the first open market of foreign exchange swap. The counter transaction of the original foreign exchange swap center was changed to a quote-driven transaction system based on the principle of openness and transparency. Afterwards, other regions followed suit and set up their respective foreign exchange swap centers. By the end of 1993, there were as many as 108 foreign exchange swap centers in provinces and municipalities across China. Under such circumstances, a foreign exchange swap price based on supply and demand was also generated in the foreign exchange swap market in addition to the listed price retained for non-trade receipts and payments as decided by the State Council in 1981, resulting in a dual rate system—the official rate and the market rate
The establishment of the foreign exchange swap centers marked the formation of China’s foreign exchange swap market, and fueled the further development of the foreign exchange swap business. However, the coexistence of several foreign exchange swap centers gave rise to some problems. Foreign exchange swap markets located in different places were isolated from one another, and foreign exchange funds could not be floated rationally. This, in turn, had led to irregular rates in the foreign exchange swap market.
1.2 The Formation of a Unified National Interbank Foreign Exchange Market
On November 14, 1993, The Decision of the CPC Central Committee on Some Issues Concerning Establishment of Socialist Market Economic Structure was adopted at the Third Plenary Session of the 14th CPC Central Committee. The Decision demanded that “the foreign exchange control system must be reformed and a managed floating rate system based on market supply and demand, and a unified standard foreign exchange market must be established to render RMB a convertible currency.” Based on this, China’s foreign exchange market entered a brand new stage of development as China’s foreign exchange system underwent major reforms in the following aspects:
- The system of bank exchange settlement and sales has been implemented, foreign exchange turnover and retention have been eliminated, and a mandatory plan for the use of foreign exchange, as well as the examination and approval system, have been phased out. As of January 1, 1994, the system of retention, turnover, and quota control over all types of foreign exchange had been eliminated and the system of bank exchange settlement and sales was implemented for foreign exchange revenue and the spending of domestic institutions under current accounts. Apart from goods under import quota control, goods to be managed as special imported products, and goods subject to an automatic registration system, foreign currencies had to be purchased at the authorized bank on the strength of import licenses, certificates or import registration forms, corresponding import contracts, and valid commercial invoices (invoices, freight bills, and collection vouchers) compatible with the method of payment. Other uses of foreign exchange for goods and incidental charges for trade, as well as the non-trade business use of foreign exchange for external payments that are in conformity with the state import regulations, had to be cashed at an authorized bank on the strength of the contracts, agreements, invoices, and the payment advice of foreign institutions. To concentrate foreign exchange for a guaranteed supply, the foreign exchange revenue of domestic institutions under current accounts must be transferred to the mainland promptly and sold to an authorized bank at a market price. However, for foreign exchange to be retained pursuant to the state regulations, a foreign exchange account may be opened with authorized banks. Meanwhile, the issue of foreign exchange certificates was suspended and those in circulation were to be used by December 31, 1994. Remaining certificates could be exchanged for U.S. dollars or converted into RMB before June 30, 1995, at the BOC.
- On January 1, 1994, the official rate and market price of RMB were combined and a single, managed, floating rate system based on market supply and demand was instituted. At the time, the rate was US$1 to RMB 8.70, which had been decided by the then market supply and demand. The PBOC publishes the rate every day, and the purchasing and selling prices of foreign currencies may be floated within a given margin.
- A unified, standardized, and highly efficient foreign exchange market has been established. As of January 1, 1994, with the withdrawal of Chinese enterprises from the foreign exchange swap center, the authorized bank of foreign exchange became the main player of foreign exchange transactions. On January 1, 1994, the unified national interbank foreign exchange market began to operate, and its operational platform—the China Foreign Exchange Trade System—was also set up in Shanghai, which was linked to all sub-centers across the country. On April 4, the trading system of the China Foreign Exchange Trade System was officially put into operation, adopting the membership system, and the system of matchmaking transaction and concentrated settlement. The PBOC can intervene, where necessary, in the foreign exchange market, according to its goals for macroeconomic policy, to adjust the market supply and demand and stabilize the RMB rate.
The establishment of the China Foreign Exchange Trade System signifies that the development of China’s foreign exchange market has entered a new stage. Organizationally, the China Foreign Exchange Trade System differs from the former foreign exchange swap center as it is linked to the computers of 36 sub-centers through satellite and ground communication networks across the country. Members in each center can quote the price or rate of exchange, and close a deal by concentrated matchmaking on computers, giving priority to price and time. As an interbank foreign exchange market, it is also different from overseas foreign exchange markets because it serves China’s system of exchange settlement and sales, and provides services to cover positions for the exchange settlements and sales of each bank. In terms of the fixed exchange place, such as the stock exchange, the interbank foreign exchange market is tangible. But, as the interbank foreign exchange market is a system that handles transactions through a computer network, it is also similar to the international mature foreign exchange market with the features of an invisible market.
The introduction of the above measures for the reform of the foreign exchange control system, plus the market-oriented services provided by the unified national foreign exchange market, helped China smoothly realize the conditional convertibility of RMB under current accounts in 1994. On this basis, other restrictions on foreign exchange under current accounts were further lifted in 1996. On December 1, 1996, China declared that convertibility of RMB under current accounts had been achieved, indicating a significant step forward in RMB convertibility.
Improvements have also been made in the mechanism for setting the Renminbi exchange rate. After the unification of the exchange rate on January 1, 1994, China began to carry out a single, managed floating rate based on market supply and demand. The PBOC publishes the middle price of the market transaction of the Chinese currency against four major foreign currencies, such as USD, EUR, HKD, and JPY, according to the weighted middle price generated in the interbank foreign exchange market on the previous business day. The buying and selling price of RMB against the U.S. dollar in the interbank foreign exchange market can be buoyed within the margin of 0.3% or so of the middle price of the market transaction that is published by the PBOC. The buying and selling price of HKD and JPY can be floated within the margin of 1% or so of the middle price of the market transaction, and that of EUR within the margin of 10% or so. The authorized bank of foreign exchange sets the rate within the specified range of rate fluctuation and executes foreign exchange transactions with its clients. The buying and selling price of USD spot exchange listed by each bank is not to exceed the middle price of market transaction published by the PBOC by 0.17% or so, and those of EUR, HKD, and JPY should not exceed the middle price by 1% or so. For the rates of foreign currencies other than the above four, the difference in the buying and selling rate shall not exceed the middle price by 0.5% based on the middle price of the USD market transaction and middle cross rate on the international foreign exchange market. For transactions in excess of US$1 million, the bank can close a deal with clients through negotiation within the specified range. The buying price of USD and HKD in cash listed by each bank should not exceed the middle price of purchasing and selling spot exchange by 0.75%, and the buying price of EUR and JPY in cash should not exceed the middle price of the purchasing and selling spot exchange by 1%. The selling price of all the currencies in cash is the same as the price of selling spot exchange. The PBOC exercises macro-control over the Renminbi exchange rate and make necessary interventions in the market to maintain a reasonable and stable rate.
1.3 The Role of the Interbank Foreign Exchange Market
The establishment of the unified interbank foreign exchange market is of great significance to China’s economic development. First, it has helped set a unified national Renminbi exchange rate with relative stability. Second, it has promoted the steady growth of China’s state foreign exchange reserve. By the end of 1993, the state foreign exchange reserves only amounted to US$21.2 billion, while by the end of March 2006, the amount had surged to US$875.1 billion, up 41 times in 13 years. Third, it has created an operational platform and transmission channel for the implementation of the monetary and foreign exchange policies formulated by the central bank. Fourth, it has rendered great support to the implementation of a system of exchange settlement and sales. Fifth, it has created sound market conditions for the further reform of the foreign exchange system.
The development of the interbank foreign exchange market has played a proactive role in supporting China’s economic reform and opening-up. The achievements scored in the development of China’s foreign exchange market are obvious. Over a short period of around a dozen years, China’s foreign exchange market has expanded from a small, isolated, single-variety, and irregular foreign exchange swap to a large, diversified, concentrated, and unified one.
2.1 The Operating Mechanism
The establishment of the interbank foreign exchange market in 1994 was a decisive step for China’s foreign exchange market to move toward becoming an international standard market. In selecting the market mode, full consideration has been given to the principles of gradual progress and controllability. Priority has first been given to meeting the bank’s needs for cover position in exchange settlement and sales. On the basis of the swap market, a transaction mode of concentrated, quote-driven, matchmaking deals and concentrated settlements has been developed. From then on, China’s foreign exchange market entered a new and steady stage of development.
The concept of electronic transaction was introduced from the very beginning of the establishment of the interbank foreign exchange market. China’s foreign exchange transaction system was established only one year after Japan’s first electronic foreign exchange transaction system, MINEX, and the present leading global electronic brokerage system (EBS) for spot exchange transactions. China’s foreign exchange transaction system adopts a mode of independent quotation, matchmaking deals, and concentrated settlements. It also mainly implements a mechanism for setting the price driven by purchase orders, which is in conformity with the main characteristics of the leading electronic brokerage system worldwide. Currently, the main difference between China’s interbank foreign exchange transaction system and electronic brokerage systems of other countries lies in its integration with the function of concentrated settlements, which is compatible when the main market player relationship is not established on equal footing in the present Chinese foreign exchange market and the credit extension mechanism between financial institutions is incomplete. Additionally, concentrated settlement is becoming an orientation for the development of settlement modes in the international foreign exchange market. This mode has the following characteristics in its concrete operation:
- The implementation of a membership system. All the financial institutions and their branches, established with the approval of the PBOC and allowed to conduct foreign exchange business, can apply for membership in the China Foreign Exchange Trade System. Members are divided into two types: self-operating members and agency members. The agency members can only engage in agency business (trading of foreign exchange on behalf of traders), while self-operating members can engage in self-operating business (normal trading of foreign exchange for its own business) and agency business concurrently. By the end of 2005, the interbank foreign exchange market had 385 members in total, most of whom were self-operating members.
- A modernized electronic trading system. China’s interbank foreign exchange market executes concentrated transactions, by the use of modern computer and communication technologies, through the electronic trading system networked across the country. In the initial period, the authorized foreign exchange bank had to assign qualified traders to conduct site transactions at the trading hall of sub-trade centers in central cities across the country. Later on, distance transaction was gradually popularized. At present, all the interbank foreign exchange transactions are handled at distance, where traders can make quotations in their own dealing rooms without going to an authorized trading place, and the foreign exchange market is completely invisible.
- The matchmaking transaction mode. The interbank foreign exchange transaction adopts a quote-driven mode of independent quotation and matchmaking deals, and the electronic trading system makes a match for quotations for the trade of foreign currency on the principle of prioritizing price and time. In the circumstance where the main market participants differ greatly from one another in actual strength, this transaction mode embodies fairness, impartiality, and optimized pricing of foreign currency transactions.
- Local and foreign currencies for foreign exchange are settled in a concentrated way. The Renminbi funds are settled through the settlement system of the PBOC and foreign exchange funds are transferred abroad through the bank of deposit. The settlement speed of both foreign exchange and Renminbi funds are T+1, meaning that the transaction concluded on the day is valued on the following working day simultaneously.
2.2 Operation of the Interbank Foreign Exchange Market over the Years
Services have diversified
In 1994, when the interbank foreign exchange market was just established, only USD and HKD could be transacted. In 1995, the exchange of JPY for RMB was added. In April 2002, the Euro was added for exchange with RMB. In June 2002, intermediary business for borrowing and lending in foreign currencies was introduced, providing market members with multi-channel transaction services. In 2002, the market and commerce system was implemented on a trial basis for the transaction of minor currencies to raise the rationality of quotation and market liquidity. In February 2003, the foreign exchange transaction time was extended from half a day in the morning to a whole day. In October 2003, two-way transaction in the foreign exchange market was implemented to facilitate members’ cover position and fund dispatches. In 2004, the BOC Hong Kong and the BOC Macao participated in the transaction of exchange settlement and sales, and the transaction platform was extended abroad for the first time.
In May 2005, spot transaction for eight foreign currencies was introduced to enrich the foreign exchange variety at multiple levels. In August 2005, forward foreign exchange transactions were launched in the market and the first foreign exchange derivative came into being in the interbank market. In early January 2006, the market and commerce system, and the inquiry transaction mode were introduced concurrently in the spot foreign exchange market. The middle price of the RMB rate was set in a new mode and the mechanism for setting the exchange rate for the RMB on the basis of market forces was further improved.
Market transactions have recovered after the Asian financial crisis
Since the establishment of the interbank foreign exchange market, the transaction volume has risen continuously as a whole, but due to the Asian financial crisis, business volume declined for a time. As seen in Figure 6.1, after 2000, foreign exchange transaction volume enjoyed a rapid growth in momentum again.
The exchange rate of RMB has risen stably
After the establishment of the interbank foreign exchange market, the managed floating exchange rate mechanism of the Renminbi ran steadily and, as a whole, the exchange rate of the Renminbi is heading for a rise while keeping stable. Since the interbank foreign exchange market went into official operation on April 1, 1994, the market-weighted rate of the Renminbi against the U.S. dollar has dropped gradually from the initial 8.6988:1 to 8.2716:1 on May 15, 1995. This was followed by small margin devaluation in 1996 as the exchange rate once stood at 8.3338:1 on April 3. For the
following seven years, the rate of the Renminbi to the U.S. dollar remained at about 8.2800:1.
On July 21, 2005, the PBOC carried out a major reform of the mechanisms that set the exchange rate for the Renminbi. The main objective was to implement a managed floating rate system based on market supply and demand, and regulate by reference to a basket of currencies. Based on the estimated rational equilibrium of the exchange rate, the RMB rate against the U.S. dollar appreciated by 2% on the same day, reaching 8.1100:1. The transaction price of the U.S. dollar against the Renminbi in the interbank foreign exchange market can still fluctuate within the middle price issued by the central bank, but by a margin of not above 0.3%. The transaction price of non-USD currencies against the Renminbi can fluctuate at the middle price of the currency issued by the central bank within an increased margin of 1.5% or so. Also, it had been stipulated that beginning from July 22, 2005, the central bank would publish the closing price of the transaction currencies, including the U.S. dollar against RMB in the interbank foreign exchange market as the middle transaction price of the currency against the RMB on the following working day. On September 23, 2005, the central bank published the new exchange rate management system again, stipulating that the floating margin of the transaction price for non-USD currencies, including EUR, JPY, and HKD, against the Renminbi in the interbank spot foreign exchange market would rise from 1.5% to 3%. Restrictions on the price differential margin of non-USD currencies, as listed by the bank to traders, have been abolished, and the bank would set the rate of non-USD currencies against the Renminbi independently. On December 30, 2005, the exchange rate of the Renminbi against the U.S. dollar in the interbank foreign exchange market closed at 8.0702:1, with an appreciation margin of 7.23% compared to the rate at the initial period of the interbank foreign exchange market development (see Figure 6.2).
Note: Before July 22, 2005, the central bank used to issue the weighted middle price for the RMB rate against the transaction currencies, including the USD in the interbank foreign exchange market as the middle price of the transaction currency against the RMB on the following working day. Beginning from July 22, 2005, the central bank has published the closing price of the transaction currencies, including the USD against the Renminbi in the interbank foreign exchange market as the middle transaction rate of the currency against the Renminbi on the following working day. Correspondingly, the price shown in the figure should be adjusted from the daily weighted middle price to the closing price.
Market membership has increased and diversified
In 1994, when the interbank foreign exchange market was initiated, there were 303 market members and, up to December 2005, the number of members grew to 385. Members included the central bank, four state-owned commercial banks, 11 joint-stock commercial banks, three policy banks, 41 city commercial banks, 189 authorized branches of commercial banks, 189 foreign-funded banks, two trust investment companies, and 25 rural credit cooperatives (including rural commercial banks). Clients in the interbank foreign exchange market include various Chinese and foreign financial institutions, half of which are foreign-funded banks (see Figure 6.3).
While the RMB spot exchange settlement and sales market has developed rapidly, other foreign exchange sub-markets have also been established. At present, there are three sub-markets, namely, the interbank borrowing and lending market in foreign currency, the interbank foreign currency buying and selling market, and the interbank forward foreign exchange market.
The foreign currency borrowing and lending market
In order to raise the foreign currency operational efficiency of domestic financial institutions and expand their financing channels, the Trade System launched the foreign currency borrowing and lending business on June 3, 2002. Before this, the surplus short-term foreign currency funds of domestic financial institutions were either idle or deposited abroad at lower interest rates, whereas financial institutions that were in need of foreign currency funds could only get them from the international market at a high cost. The establishment of the foreign currency borrowing and lending market has joined the supply and requisitioning parties of the foreign currency funds, increased the income of the supply party, and raised the efficiency of foreign currency fund applications.
The interbank foreign currency borrowing and lending business has played a unique role in increasing the market transaction efficiency, enhancing market liquidity, and promoting market development with its unique currency broker business mode. First of all, in the foreign currency borrowing and lending broker business, a neutral third party of some influence in the market has been introduced into the transaction as a witness of the deal. This makes up for the imperfection of China’s interbank market credit system to some extent. Second, as the information medium of both trading parties, the currency broker eliminates the asymmetric command of information between market participants, offers members all-round and real market information, and raises the possibility of closing the deal. Third, the currency broker also eliminates the mismatch in the quantity of supply and demand by pooling supply and demand in every respect, and working as a bridge between big and small institutions to merge the transaction intentions of small and medium financial institutions into a whole. The broker also breaks up the transaction intentions of big financial institutions from the whole into parts to raise the success rate of market transactions. Fourth, the currency broker’s participation eliminates the negative effect of the inconsistency of the market position upon the transaction and creates favorable conditions for equal transactions.
The foreign currency buying and selling market
On May 18, 2005, the Trade System introduced the spot transaction of eight foreign currency pairs to develop and improve China’s interbank foreign exchange market, enrich the transaction variety, and overcome the limitations of China’s small and medium financial institutions in their direct participation with foreign exchange transactions in the international market due to their low risk ratings and size restrictions. This action added another type of foreign currency trading market to China’s foreign exchange market. The foreign currency buying and selling market was developed through cooperation with the world-famous financial information company, Reuters, on the basis of extensive market investigation and research. An electronic concentrated quote-driven transaction mode driven by multiple market makers’ quotations was adopted. The first advantage of this mode is that each financial institution regards the transaction center as a rival in form and does not have to extend credit to the rival one by one, thereby thoroughly solving the problem of credit obstacle in the foreign exchange market. The second advantage is that the mode features high efficiency, eliminates the process of mutual inquiry between rivals, and meets the transaction demand of the participants in the shortest possible amount of time, thereby preventing market risks. The third advantage is that the market makers participating in the quotation are well-known big banks that, with abundant resources, are active in the international foreign exchange market, and their quotations are very competitive. This has enabled the domestic, especially the small and medium financial institutions, to promptly enjoy preferential prices that are fully synchronous with the international foreign exchange markets.
Forward foreign exchange market
China’s forward foreign exchange business began in April 1, 1997. With the approval of the State Council, the BOC piloted the forward exchange settlement and sales business through the counter. Afterwards, the CBC, ICBC, and ABC, as well as three joint-stock banks, joined the pilot program, although these banks belonged to the forward foreign exchange retail sales market.
China’s interbank foreign exchange forward business went into official operation on August 15, 2005, marking a significant step in the development of China’s forward foreign exchange market. With the further reform of China’s exchange rate regime and the continuous improvement in the mechanisms for setting the Renminbi exchange rate, the rate fluctuation becomes normal in the foreign exchange market. The broad market participants, especially commercial banks and other financial institutions, face greater exchange risks. The interbank forward foreign exchange business provides market participants with an effective means to hedge against exchange risks and plays a vital role in enhancing the risk management of market players, intensifying the market function in the process of setting the exchange rate for Renminbi, and guiding the market toward a reasonable rate.
3.2 A General Survey of the Transaction Variety in the Interbank Foreign Exchange Market
The present interbank foreign exchange market offers the following business items to its members:
Renminbi to foreign currency spot transactions
Membership composition: The interbank foreign exchange market implements a membership system. All banks, non-bank financial institutions, and non-financial enterprises that are qualified for interbank foreign exchange spot transaction, as stipulated by the regulatory body, can file an application to the Trade System for membership to enter the interbank spot foreign exchange market for transaction.
Transaction mode: The interbank foreign exchange market sets up an electronic quote-driven transaction system and an inquiry system for transaction. The former closes a deal through matchmaking on the basis of independent quotations by members on the principle of giving priority to price and time. The latter can facilitate technically members’ direct consultation about trading factors, including currency, exchange rates, and amounts on the principle of bilateral credit extension and settlement. Members can decide the inquiry or quote-driven transaction mode at their own discretion.
Transaction time: Monday to Friday (Beijing time); quote-driven transaction (9:30 a.m. to 15:30 p.m.); inquiry transaction (9:30 a.m. to 17:30 p.m.) (closed on public holidays).
Variety: Spot transaction of the Renminbi for USD, HKD, JPY, and EUR.
Setting exchange rates: As of January 4, 2006, the middle price of the Renminbi exchange rate against the USD had been set in a different way from the previous practice of determination on the basis of the closing price generated by quotation matching in the interbank foreign exchange market. The Trade System makes an inquiry of all the market makers in the interbank foreign exchange market before the opening quotation each day and regards the quotations of all the market makers as the calculation specimen of the middle price of the Renminbi exchange rate against the USD. After excluding the maximum and minimum quotations, the remaining quotations of the market makers are mean-weighted to obtain the middle price of the Renminbi exchange rate against the USD on the same day, and the weight is determined by the Trade System in line with the composite index of the bidders, including the transaction volume and quotation in the interbank foreign exchange market.
Settlement methods: The Renminbi/foreign currency spot quote-driven system adheres to the principle of “concentration, two-ways, and balance for settlement.” The Trade System handles the settlement of the Renminbi and foreign currency for its members on the settlement day. The settlement speed is T+2, with the settlement of Renminbi fund handled through the PBOC payment system and that of the foreign currency fund through the settlement system abroad. For the inquiry system, the fund is settled by both trading parties themselves in line with the contract notes generated by the system. The settlement speed can be T+2, T+1, or T+0, as agreed by both parties.
Foreign currency to foreign currency spot transactions
Transaction mode: The business of buying and selling foreign currencies adopts the mode driven by the market makers’ quotations. The market makers offer the buying and selling prices for each currency pair from which the trading system selects the optimum buying and selling price, publishes it in real time, matches the optimum market maker’s offer and the transaction request of the member banks on the principle of giving priority to price and time, and feeds back the transaction information to both parties in real time. The member banks close a deal by such means as a click of the offer, limit order, or RFQ inquiry.
Transaction players: Financial institutions that are approved by the regulatory departments to conduct foreign currency business are divided into two categories: market makers and member banks.
Transaction time: Monday to Friday (Beijing time); 7:00 a.m. to 19:00 p.m. (not open in official holidays).
Transaction currencies: EUR/USD, AUD/USD, GBP/USD, USD/ JPY, USD/CAD, USD/CHF, USD/HKD, and EUR/YEN
Settlement methods: The Trade System settles accounts for foreign currency deals on the principle of concentration and balance. Concentration means that the market makers and member banks regard the Trade System as the rival and settles accounts for the deal with it. Balance means that the market makers and member banks settle accounts with the Trade System in terms of the net balance of the transaction amount for the same currency on the same value date. The settlement speed is T+2.
Foreign currency to foreign currency forward transactions
Transaction mode: Both parties handle transactions through the inquiry transaction system of the Trade System. Both parties decide on the transaction currency, amount, maturity, exchange rate, and delivery arrangement through consultation. To make clear the rights and obligations of both parties, members of the forward foreign exchange market should sign a trader’s agreement on interbank forward foreign exchange.
Settlement methods: Both parties of the deal can adhere to the principle of bilateral settlement, namely, the mode of full-amount delivery of the principal at maturity or the mode of differential delivery between the stipulated forward transaction price at maturity and the spot transaction price at maturity. To hedge against default risks and ensure the performance of a forward foreign exchange transaction contract, a member can set the margin in light of the credit standing of the rival through consultation, which shall be in the custody of the Trade System on his behalf.
Transaction players: Members of the Trade System are those who hold qualification certificates for conducting the transaction business of financial derivatives issued by competent authorities. SAFE exercises legal-person-record control over the main participants in the interbank forward foreign exchange market.
Transaction time: Monday to Friday (Beijing time); 9:30 a.m. to 17:30 p.m. (not open on official holidays).
Local and foreign currency information intermediary service
To meet the demand of different members, especially the small and medium financial institutions, and supplement the electronic transaction mode, the Trade System launched the foreign currency information intermediary service in June 2002.
The Trade System can seek potential business rivals by telephone, fax, and the Internet and make market analysis to promote business conclusion on the commission of the financial institutions. The financial institutions with legal person status, and their authorized branches that are eligible for market financing and foreign currency borrowing and lending business, can immediately become the traders of the information intermediary service after signing an Intermediary Service Agreement with the Trade System
Currently the intermediary currencies for foreign currency borrowing and lending are chiefly USD, EUR, JPY, and HKD, and the maturity is less than one year for the time being.
3.3 Latest Changes in China’s Foreign Exchange Market
Over recent years, the development of China’s foreign exchange market has accelerated remarkably. In 2005, the Chinese government initiated a major reform initiative on the Renminbi exchange rate in accordance with the principles of initiative, controllability, and progressiveness. This included an alteration of the Renminbi exchange rate and, more importantly, the constant improvements in the formation mechanism for the exchange rate for the Renminbi.
After the reform, the exchange rate of Renminbi is no longer pegged solely to the USD. Instead, a basket of currencies are formed by selecting some main currencies and imparting them with corresponding weights in line with the actual situation of China’s foreign economic development. At the same time, in light of the domestic economic and financial situation, and with the market supply and demand as the base, fluctuations in the multi-lateral exchange rate index of the Renminbi are calculated with reference to a basket of currencies to exercise management and regulation of the Renminbi rate and keep it basically stable at a rational and balanced level. This reference to a basket of currencies shows that the fluctuations in the exchange rate between foreign currencies affects the Renminbi rate, but it does not mean that China pegs the Renminbi to a basket of currencies. The market supply and demand should be regarded as another major basis on which a managed flexible exchange rate is set.
In selecting a basket of currencies and determining the weight China considers its major trading countries or regions, and their currencies for China’s international payments under current accounts1. Here, the weight of the commodity and service trade should be taken as the main basis. In general, the currency of the trade partners whose annual bilateral trade volume with China exceeds US$10 billion should not be neglected. At the same time, due consideration is given to such factors as the currency structure of foreign debt sources, foreign direct investment, and the currency structure of
1 Based on the speech of Zhou Xiaochuan, governor of the PBOC, on August 10, 2005, at the unveiling ceremony of the board of Shanghai headquarters of the PBOC.
some voluntary transfer projects under current accounts. Regulation by reference to a basket of currencies in setting the Renminbi rate conforms to the trend toward the diversification of China’s foreign economic and trade relations, and the diversified development of the international economic and financial systems. The implementation of the managed flexible rate system based on market supply and demand as well as regulated by reference to a basket of currencies can better mirror the change in Renminbi in relation to main currencies, respond to the unstable USD more favorably, reduce the fluctuation in multi-lateral rate of Renminbi, and maintain the overall stability of China’s foreign economic and trade environment. This further promotes a general balance of international payments and contribute to the sustained, coordinated, sound, and fast development of China’s national economy.