China's FX market: An international perspective
by Ma Guonan, Senior Economist, Representative Office for Asia and Pacific, BIS
The RMB FX market: international comparison
Global FX turnover is huge but declining; China's FX market is small but growing fast.
1. Estimating daily turnover of RMB
a. RMB turnover reported in BIS survey did not include offshore NDF and, apparently, customer transactions turnover understated and comparisons skewed
b. Today average daily RMB turnover could easily exceed US$1 billion:
-Reported onshore inter-bank spot: $400mn ($191mn in April 2001 survey)
-Corporate spot market: $300mn (estimated)
-Onshore outright forwards: $30mn (estimated)
-Offshore RMB NDFs: $500mn, double the volume a year ago (market reports)
2. Why the RMB onshore interbank market shallow?
a. Absence of high-frequency cross-border flows
b. Absence of inter-bank FX swap trading
c. Concentration of big banks (esp Bank of China) and their tendency to net out positions internally before trading in the FX market
d. Prohibition until recently of two-way trade by a bank in the same trading session
Split onshore and offshore markets
a. China has successfully unified its domestic RMB inter-bank market since 1994
b. But capital control and FX regulations split the onshore/offshore FX markets
c. BIS surveys indicate cross border trade is some 60% of total global FX turnover
d. A fast growing offshore RMB non-deliverable forward (NDF) market
e. Potential interactions between onshore and offshore markets
1. Globally, rising importance of FX swaps
2. A spot-oriented market in China
a. Only spot transactions at the inter-bank market
b. A nascent outright forward market onshore between banks and corporate players, based on real-demand principle
- Estimated daily turnover of some $30mn currently
- 10% of the spot trade at the inter-bank market
c. Missing inter-bank FX swaps market
d. Forward currency positions are covered through spot trade: maturity mismatch?
A mostly dollar-traded FX market
A relatively big central bank role
1. Bank of China is reported to account for half of the foreign currency selling in the onshore inter-bank FX market
2. The PBC has become a major and big dollar buyer in the inter-bank market lately
3. Its FX reserve accumulation is equivalent to big share of the inter-bank FX turnover this year
-The ratio averages 25% for 1995-2003
-The low of the ratio was 10% in 1998
4.China's central bank role is large relative to other major emerging FX markets
Why the big dollar sales to the PBC?
1. Lower US dollar than renminbi interest rates favour
a. Reduced dollar holdings by residents
b. Increased dollar liabilities by residents
c. Sped-up conversion of dollar export revenues into RMB and lengthened financing of dollar-denominated imports
2. Market speculation of RMB appreciation
a. Recent NDF RMB rates point to appreciation expectations
b. USD weakness against Asian currencies, politics and domestic economic strength
1. China's leaky capital control
a. Large interest spreads, reinforced by expectations of RMB appreciation
-Discourage dollar-holding
-Encourage dollar borrowing and cross-border arbitrage
-Provide incentives to circumvent control
b. Leaks and possible mechanisms for irregular cross border capital flows
-Leads and lags, indicated by
*A widening gap between the custom-based trade balance and the BoP-based trade balance
*Large inflows under errors and omissions
-Big increases in remittances inflows
2. In spite of slowing capital inflows, capital controls still effective
a. The old FX regulation system was mainly geared towards preventing dollar outflows and encouraging inflows
b. Signs of a more balanced FX management regime in the making:
-Large-scale inspections on bank FX compliance
-Dollar loan-deposit ratio is peaking
-More restrictions on converting dollar loans into RMB
c. Capital control reduces cross-border mobility of capital
d. Said to be effective when interest rates on same currency differ onshore and offshore
e. Covered interest parity rests on free capital mobility and market-based interest rates:
RMB forward premium (annualised)= RMB interest rate - USD interest rate
f. Implied offshore RMB interest rate
-In presence of effective capital control, onshore and offshore markets segment and yields differ
-Implied RMB interest rate abroad = USD interest rate abroad - offshore RMB forward premium
F = S (1+r)/(1+r*), where
F = Offshore RMB forward rate (measured by NDF)
S = Spot RMB/USD rate
r* = USD LIBOR
r = NDF implied RMB interest rate offshore
3. Capital control and market pressure
a. The gap between "implied" offshore RMB interest rate and RMB interest rate in China suggests
-Effectiveness of capital control
-Direction of market pressure
b. Before 2001, that implied RMB interest rates offshore were noticeably higher than onshore rates suggested capital controls effective in limiting capital outflows
c. Now lower offshore RMB interest rates suggest capital controls effective in limiting capital inflows into RMB assets