A Year of Smooth Implementation of the Reform of the RMB Exchange Rate Regime

Appendix of Monetary Policy Report, Quarter Two, 2006

 

On July 20, 2006, the reform of the RMB exchange rate regime had been smoothly implemented for one year. According to the State Council's overall plan and guided by the principle of reform in a self-initiated, controllable, and gradual manner, the People's Bank of China has sought to improve the managed floating exchange rate regime, to promote foreign exchange market development, and to improve the foreign exchange management policy environment. Based on market supply and demand and with reference to a basket of currencies, the managed floating exchange rate regime has functioned smoothly. As one of the important institutional establishments to improve the socialist market economy system, the RMB exchange rate regime reform has achieved its anticipated results.

 

I. Improving the managed floating exchange rate regime

 

The reform is a system engineering aimed to establish a managed floating exchange rate regime, which includes a RMB exchange rate formation mechanism based on market supply and demand with reference to a basket of currencies as well as reform of the central bank's foreign exchange open market operations. In line with the principle of reform in a self-initiated, controllable, and gradual manner, the PBC has further improved the managed floating exchange rate regime step by step. 

 

Enhancing the flexibility of the RMB exchange rate. After July 21, 2005, on the basis of the existing spot foreign exchange market structure, the PBC widened the floating band of the RMB exchange rate against non-US dollar currencies in the inter-bank foreign exchange market, improved the management of foreign exchange quotations at bank counters, enlarged the bid/offer spread of the quotation of the RMB to the US dollar exchange rate, and removed control of the bid/offer spread of the RMB exchange rate against non-US dollar currencies at bank counters. As a result, at the micro level, economic entities adapted to a more flexible RMB exchange rate, and a smooth transition in a RMB exchange rate formation mechanism was achieved.

 

Improving the RMB spot rate formation mechanism. On January 4, 2006, the PBC reformed the structure of the inter-bank foreign exchange spot market and introduced OTC transactions to the inter-bank spot market after the smooth functioning of the new RMB exchange rate formation mechanism for almost half a year. Financial institutions were encouraged to innovate financial products on the basis of effective risk control so as to meet corporations' and individuals' diversified needs in foreign exchange-related risk management and investment. At the same time, market makers were introduced to enhance the financial institutions' pricing capacity, provide liquidity through the market makers' price quotations on a continuous basis, smooth out market price volatility, and enhance trade efficiency so as to support the RMB spot rate formation mechanism based on market supply and demand with reference to a basket of currencies.

 

In the new market framework with both OTC transactions and automatic price-matching transactions, the PBC reformed the RMB's central parity formation in line with international practice in determining a benchmark interest rate and exchange rate, and authorized the China Foreign Exchange Trade System (CFETS), as a market intermediary, to calculate and release the daily central parity of the RMB exchange rate. In particular, the central parity of the RMB exchange rate against the US dollar is derived as a weighted average of quotations of all market makers in a sample, while the central parities of the RMB exchange rate against the euro, the Japanese yen, and the HK dollar are calculated by the CFETS based on the central rate of the RMB against the US dollar on the same business day as well as the exchange rates of the euro, the Japanese yen, and the HK dollar against the US dollar at 9am of the same business day in the international foreign exchange market. The representativeness of the central parity of the RMB exchange rate was improved in the new market framework.

 

Improving the RMB forward rate pricing mechanism. On August 10, 2005, the PBC established an inter-bank RMB forward market with a view to formulating a domestic RMB forward rate. At the beginning of 2006, when the market-maker system was introduced, the PBC moved foreign exchange purchase and sale position management from a cash basis to an accrual basis, enabling market makers to hedge their forward foreign exchange positions in the spot market so that the market makers could offer interest rate parity quotations on the forward market. On June 2, 2006, the PBC extended the management of purchase and sale positions on an accrual basis to all designated foreign exchange banks to further improve the RMB forward exchange rate pricing mechanism, along with the introduction of inter-bank foreign exchange swaps on April 24, 2006, so that the domestic market could play a dominant role in the determination of the RMB forward exchange rate.  

 

Reforming the open market operations of the central bank in the foreign exchange market. In line with the new foreign exchange market structure and with reference to the practice of the advanced central banks in the world, the PBC established a foreign exchange primary dealer system and issued the Guidance on Market Entry of Foreign Exchange Primary Dealers on June 2, 2006. The foreign exchange primary dealer system helps to transmit the central bank's policy intention in foreign exchange open market operations, and to facilitate rational market transaction activities through influencing market expectations, so as to promptly stabilize the foreign exchange market at low operational costs, to realize high efficiency in foreign exchange open market operations, and to strengthen market-based central bank open market operations. This is also an institutional preparation for the central bank to gradually make its way out from the foreign exchange market in the future when the time is right.

 

II. Flexibility of the RMB exchange rate gradually increased with movements in both directions

 

Since the reform of the RMB exchange rate regime, the flexibility of the RMB exchange rate has clearly strengthened. On July 31, 2006, the central rate of the RMB against the US dollar, the euro, and the Japanese yen stood at 7.9732 yuan per US dollar, 10.1699 yuan per euro, and 6.9477 yuan per 100 Japanese yen respectively. Between the exchange rate regime reform on July 21, 2005 and July 31, 2006, the accumulative appreciation of the RMB exchange rate against the US dollar was 3.8 percent, the accumulative depreciation of the RMB exchange rate against the euro 1.5 percent, and the accumulative appreciation of the RMB exchange rate against the Japanese yen 5.2 percent. In particular, the peak and bottom of the central parity of the RMB exchange rate against the US dollar were 7.9732 yuan and 8.1128 yuan per US dollar respectively. Affected by trade surpluses and movements of major currencies in the international market, the central parity of the RMB exchange rate against the US dollar surged above 8 yuan per US dollar for the first time on May 15. RMB exchange rate movements since the reform of the exchange rate regime have fully reflected features of the managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. The average daily fluctuation of the central parity of the RMB exchange rate against the US dollar increased from 0.02 percent between July 21, 2005 and end-2005 to 0.04 percent since the beginning of 2006, with the largest fluctuation in a single business day reaching 0.21 percent, more than two-thirds of the largest daily fluctuation band of the RMB exchange rate (i.e., 0.3 percent). The RMB exchange rate also reflected the movements of major currencies in the international foreign exchange market, as 73 percent of the business days since the reform of the exchange rate regime have witnessed the RMB exchange rate moving in the same direction as the exchange rate of the euro, the Japanese yen, the Korean won, the Singapore dollar, and the UK sterling in the international foreign exchange market.  

 

III. A foreign exchange market system was basically established with further improvements in market infrastructure

 

Building a foreign exchange market will lay a foundation for the reform of the RMB exchange rate regime. A deep and broad foreign exchange market is a precondition for forming an adaptable and equilibrium exchange rate; a sound and efficient foreign exchange market is the basis for transmitting an exchange rate signal and for optimizing the allocation of foreign exchange resources; a foreign exchange market with diversified products can provide various risk-management tools for economic entities and therefore ensure the smooth implementation of the RMB exchange rate regime reform. The RMB exchange regime reform is an important driving force behind the development of a foreign exchange market. The reform has brought market supply and demand into the process of exchange rate formation and directly promoted the development of a foreign exchange market; at the same time, the advantages of government-led institutional innovation have been given full play in the reform of the exchange rate regime. Based on the pace and program design of the exchange rate regime reform, development of a foreign exchange market and an orderly relaxation of foreign exchange controls have been coordinated in an overall manner to ensure steady progress in building a foreign exchange market.

 

In the year under review, China has established a foreign exchange market system comprised of a retail market and an inter-bank wholesale market with various transaction modes and a variety of basic foreign exchange instruments, including spot, forward, swap, etc. First, a multi-tiered foreign exchange spot market system is in place, dominated by the OTC market with various transaction modes and a linkage in price movements. In June 2006, trading volume in the inter-bank foreign exchange market increased significantly compared with that before the reform, with the share of OTC transactions in the inter-bank spot foreign exchange market exceeding 97 percent. The RMB exchange rate in the OTC market fluctuated with the change in supply and demand around the central parity of the RMB exchange rate, while the exchange rate in automatic price-matching transactions was linked to it very closely. Second, a large variety of financial products were sold at bank counters; the scope of the forward foreign exchange purchase and sale business was enlarged, and transaction maturities were further diversified; pilot RMB forward and swap transactions against the RMB and interest rate swaps were launched, benefiting enterprises and individuals with a more comprehensive, flexible risk management mechanism. Third, participants in the inter-bank forward and swap market continued to increase and trading was brisk. At end-June 2006, the number of participants in the inter-bank forward market increased by 48 to 62 compared with that in August 2005 when the RMB forward market was launched, with the monthly transaction volume surging over 100-fold; participants in the inter-bank swap market against the RMB numbered 56, 2 more than in April 2006 when the RMB swap market was launched, with the monthly transaction volume increasing over 10-fold.

 

Fresh progress was achieved in building a foreign exchange market infrastructure. On April 5 2006, an agreement was reached between the CFETS and the Chicago Mercantile Exchange (CME) for the CFETS to provide a technical platform and clearing services for domestic financial institutions and investors that trade non-RMB- related exchange rate and interest rate products of the CME.

 

IV. Creating a favorable foreign exchange management policy environment for market supply and demand to play a fundamental role

 

According to the requirement of the new RMB exchange rate regime, based on the continued improvement in the managed floating exchange rate regime, a favorable policy environment should be created to give full play to supply and demand in the foreign exchange market. With the approval of the State Council, the PBC gradually relaxed foreign exchange administration. First, limits on the foreign exchange accounts of enterprises under the current account were raised several times; enterprises with authentic trade activities were allowed to purchase foreign exchange in advance to pay foreign counter parties; enterprises' foreign exchange accounts under the current account were managed on a recording basis, and foreign exchange purchase and payment procedures for trade of services were simplified; the foreign exchange purchase quota for individuals was raised along with the implementation of annual aggregates management; foreign exchange purchase and payment procedures for individuals under the current account were streamlined. Second, some foreign exchange policies governing overseas investment were adjusted to facilitate cross-border operations of domestic corporations and to allow domestic investors to invest in overseas markets with their own foreign exchange, or with foreign exchange purchased with RMB and domestic foreign exchange loans. Starting from July 1, 2006, the foreign exchange purchase quotas for overseas investment in different regions were removed and domestic investors could make overseas payments for pre-investment expenditures with their own foreign exchange, or with foreign exchange purchased with RMB or domestic foreign exchange loans. Third, the approval rights governing overseas guarantees, share buy-backs by domestically-registered overseas listed companies, foreign exchange sales, purchases, and payments by securities, trusts, finance and financial leasing companies, and overseas listed companies submitting social security funds with foreign exchange proceeds from the sale of state-owned shares were decentralized to local foreign exchange administrative authorities; the management of special foreign exchange accounts of foreign investors was improved; the approval procedures for cross-border transfers of personal wealth were simplified; balanced management of overseas financing guarantees provided by banks to overseas investment companies was implemented. Fourth, overseas wealth management businesses provided by domestic banks and fund management companies on behalf of their clients and overseas securities investment by insurance companies were expanded to promote an orderly and balanced movement of foreign exchange.

 

V. Further improving the RMB exchange rate formation mechanism

 

In line with the overall plan of the State Council and based on the principle of self-initiated, controllable, and gradual reform, the PBC will continue to improve the reform of the RMB exchange rate regime reform, develop a foreign exchange market, improve foreign exchange management, and promote various reforms in an orderly fashion. First, market supply and demand should be given a fundamental role in the RMB exchange rate formation to enhance exchange rate flexibility and to maintain exchange rate stability at an adaptive and equilibrium level. Second, efforts should be made to promote development of the foreign exchange market, improve risk measurement and risk-sharing mechanisms, facilitate diversification of market structures and trading modes, strengthen the financial institutions' self-initiated pricing and risk-control capacities, and encourage financial institutions to conduct financial innovation based on sufficient risk control measures so as to provide more risk-management products and to increase investment channels. Third, efforts should be made to reform foreign exchange management to facilitate trade in goods and services, gradually change from compulsory purchase and sale of foreign exchange under the current account to voluntary purchase and sale, create a foreign exchange management policy environment that facilitates enterprises going abroad, speed up improvements in short-term cross-border capital movement monitoring and an early-warning system, and protect the financial security and stability of the country. 

 

Source: www.pbc.gov.cn