WELCOMING A NEW ERA IN THE DAVELOPMENT OF CHINA’S FX MARKET

Along with the establishment and growth of China's interbank FX market, the China Foreign Exchange Trade System(CFETS) has experienced about ten years of continuous development.

Reviewing the development of China's FX market

Course of China's FX market development China began to utilize a FX earning retaining system in the late 1970s, and FX swap markets were built up in various regions. In 1994, China's FX administrative system experienced large-scale reforms in which FX retaining, submitting and quotas were abandoned and the FX purchase and sale system was put into effect. With the setting up of a national unified interbank FX market, which radically changed the situation of market segregation and dual RMB exchange rates, the CFETS came into being. Following the guidelines of the People's Bank of China (PBC), we took on a number of responsibilities such as providing a FX trading system as well as organizing interbank FX trading, clearing, and information services.

This interbank FX trading system has been operating steadily throughout the last decade. Market trading volumes have increased continuously and RMB exchange rates have appreciated steadily, stabilizing around 8.27 yuan per dollar from 1998 on. In 1994, the annual turnover of the interbank FX market was US$40.84 billion; this number increased over twofold to US$97.19 billion in 2002. And by end-November 2003, the amount traded reached US$131.15 billion.

Achievements in the Development of the China FX Market

China's interbank FX market has played and will continue to play an indispensable role in many aspects

1. Forming a unified base rate of the RMB, and driving the process toward RMB convertibility

Before the exchange rate unification in 1994, RMB official exchange rate coexisted with swap rates, which varied in different regions. After the unification of the rate, a single managed floating exchange rate system was set up based on market supply and demand. At this time, a unified base rate for the RMB began. The RMB became convertible on current account after two years of smooth operation in the interbank FX market.

2. Providing efficient services to market members and supervisory authorities

The interbank FX market provided the designated FX banks with arrangements to square their FX positions derived from the retail selling / buying FX business, and promoted the reasonable flow of FX funds among regions and banks. It provided the supervisory authorities with real time market information, based on which the authorities could carry out specific inspection on designated FX bank's business of buying and selling foreign currencies.

3. Stimulating change of macro-economic adjustment from direct measures to indirect measures

With the interbank FX market, the central bank no longer stipulated exchange rates directly, but rather adjusts the rates indirectly through open market operations on the market. The experience the central bank learned in the FX market can also be used as a reference for making adjustments in other markets as well.

4. Providing valuable experience for the building of the nationwide unified money market

In order to solve the problems seen in 1996 of the segregation of funds by different localities as well as the overly high funding risks, the PBC, seeing the successful experiences of the FX market, decided to open the interbank lending market servicing all financial institutions electronically on the CFETS framework. After that, a national interbank bond market was established in 1997. In June 2003, www.chinacp.com.cn - a basic platform for paper market - was launched taking the successful experience of the RMB, FX and information systems. The above two markets developed rapidly in recent years, with total transaction volume reaching 12 trillion yuan in 2002, exceeding China's same-year GDP; and the annual turnover of 2003 is expected at about 17 trillion yuan. Paper market members reaches 884 within months.

What we have learned

Being the market organizer and service provider, we have learned some valuable lessons:

1. The orientation of FX market development must accord with the improvement of exchange rate formation and RMB convertibility. At the same time, the perfection of the rate forming mechanism as well as RMB convertibility also require the continuous growth and improvement of a FX market with Chinese characteristics.

2. The FX market development model must accord with the conditions of the country and take the stage of China's financial industry development adequately into account. Being a developing country, China has a financial system possessing considerable fragilities. There is no external rating that can provide grounds for credit line between domestic financial institutions, and their internal risk control and management still has a long way to go before matching marketization requirements. The present "matching and centralized clearing" model of the interbank FX market provides an even and efficient competitive field for market members. Over 99.95 percent of all transactions were cleared in a timely fashion during our ten years' experiences without clearing risk, credit risk and systematic risk.

3. The construction of FX market has to make full use of modern technology and go with the trends of "electronicization" seen in the international financial markets. Ten years ago, China's interbank FX market introduced an electronic trading system acclaimed both domestically and internationally, adopting a system that utilized advanced computer and telecommunication technology. The system backs up data both in Shanghai and Beijing as well as the public network and financial satellite networks at the same time. Based on this back-up, a nationwide real-time electronic trading system can work smoothly. Members are free to quote through on-site or distant trading terminals. The distant connection can be realized through DDN, framerelay or dial-up. Different levels of market demands are satisfied using an array of technical measures and trading modes.

4. Innovation is the inexhaustible impetus of FX market development

Following the guidance of the administrative authorities, the CFETS achieved innovation on several market fronts, methods and market regulations, providing services with high quality and efficiency. In recent years, especially after China's entry into the WTO, the CFETS accelerated business development and technical innovation. In 1994, there were only US dollar and HK dollar traded on the market. Japanese Yen trading was later added in 1995. In 2001, we launched a new edition of the FX trading system that features a new style of service, technology, and design. Euro trading was introduced in 2002. We also experimented with market-maker system for HKD and EUR in order to activate market trading and enhance fund liquidity. Additionally, we began to provide FX funding intermediary services for members. And beginning 2003, our trading hours have expanded from half-day in the morning to a full day. Two-way trading was also launched to help members square up their funding positions, leading to an overall improvement in the trading mechanisms of the FX market.

Opportunities and challenges faced by China's FX market

It is realized that the first twenty years of the 21st century will be a crucial strategic period for China's FX market.

Unprecedented opportunities faced by the FX market in its development

1. The building of a well-off society will develop a solid foundation for FX market development.

The target of developing a well-off society by the year 2020 was promulgated at the CPC sixteenth convention, and China's GDP is expected to be four times that of 2000. A perfected socialist market-oriented economy and a more activated and open financial system will be put into effect at that time. The rapid growth of the aggregate economy and the continuous expansion of external economy will no doubt lay a solid foundation for the development of the FX market.

2. Deepening trends of RMB convertibility will trigger further development in the FX market. According to an announcement recently issued by the PBC regarding Hong Kong banks conducting RMB business, the clearing banks in Hong Kong will become members of the CFETS, which means that the CFETS will provide the platform for Hong Kong banks to even up their RMB/HKD positions. This will be the first time for the CFETS to expand its trade network abroad, and will directly widen the trade base for the domestic interbank FX market. It is safe to predict that the increased internationalization of the RMB will create a new path for China's FX market.

3. The increased participation of market members is the driving force for further development of the FX market. As China liberalizes the foreign trade operation sovereignty for all companies, the amount of foreign currencies held by individuals and enterprises will increase quickly. With more and more new city commercial banks, rural commercial banks and foreign banks coming into the FX market, they will raise new requirements of using this market for achieving high liquidity, making profitable investments and evading exchange rate risks.

4. Turning Shanghai into an international financial center is providing new opportunities for the development of the FX market. In the process of building Shanghai into an international financial center, we need to attract various financial institutions and establish a complete financial market system. Measures adopted to pursue this goal will create a sound external environment for the development of the FX market.

The development and service of the FX market is facing greater challenges

1. The challenges from economic integration and financial globalization With China's entry into the WTO, the opening-up process has entered a new stage, in which the RMB is becoming an important currency for pricing, payment, transaction and settlement in both Asian and international FX markets. China's financial institutions should be able to provide diversified services for domestic enterprises to go abroad. China's interbank FX market should also take up more challenges, follow closely its clients, get itself more and more interpreted with the international community, and establish a uniform platform dominated by RMB-related financial products capable of trading, clearing and information offering. We have noticed the trend that most transactions in international FX markets tend to concentrate in the major electronic trading systems, and that the powerful market forces favor those who enter the arena first, while holding back those who come in later.

2. The challenge from modern computer and telecommunication technology IT technology shades the distinction between traditional OTC markets and exchange markets. These two transaction methods are now merging, and with the development of new technology, there will be new transaction methods that come into being. The market participants' request for lower costs and higher efficiency forces the market organizer and service provider to adopt to the new situations and meet the requirements by adopting the latest technologies to complete transactions.

3. Challenges from system reform

In European countries and the USA, there are trends for turning exchanges into companies, aiming to enhance competitiveness by establishing new governance structure and internal control systems. As the middleman for the FX market, the CFETS also faces challenges from more opening-up and competition. Only by conducting feasible structural reforms and generating win-win conditions for all parties can the trade system well match the needs for market development.

Prospects for the development of China's FX market

Guidelines of China's FX market

Protect the national economic security and guard against financial risks, to be compatible with the opening-up process of the financial industry and RMB full convertibility arrangement, promote the perfection of RMB exchange rate forming mechanism, give full play to the basic role of the FX market in FX resource allocation, and meet the increasing demand for instruments of liquidity, profitability and capacity of risks evasion.

Development goals for market intermediary institutions

The goal is to push for the development of China's FX market in a planned and sequenced manner base on the principle of helping domestic financial institutions to go into the international arena, facilitating the supervision and adjustment of the financial authorities, and keeping away and dissolving systematic risk more efficiently. We are aiming at making the interbank FX trading system an efficient and open global platform combining the functions of FX spot and derivative products as well as clearing and information services. We should keep abreast of times, follow the nation's arrangement of actively cultivating the FX market, and raise our service levels, all with the goal of establishing a competitive and open service system with Chinese characteristics, a system that will see the co-existence of diversified trade bodies, multiple trading methods and varied trading tools, and can help meet the demands of members of different levels by using a wide array of technologies and trading methods.

Some thoughts on developments in near future

1. Strengthening FX market infrastructure construction

It is first necessary to give full play to the intermediary role of the CFETS, to raise its trade efficiency and lower the trade cost through adopting advanced IT technology to its electronic trading platform. Safety of the system should be enhanced, and API tailored for member institutions should be provided to facilitate back-office processing. Voice brokering has to be improved to expand and deepen the interbank FX lending market, and brokering service of other FX products should be explored. Secondly, in introducing agent trading system, non-banking financial institutions like financial companies and insurance companies should be allowed to enter the market through agents. Thirdly, in light of the international trend of centralized and specialized clearing, a specialized clearing house should be set up to improve the risk-aversion mechanism. PVP operation mechanism can effectively eliminate time span risk in FX clearing. Through the form of interests group, systematic risk of the FX market can be effectively prevented, while all risks and returns shared. Lastly, efficient and quality service will be provided for foreign financial institutions to enter the market, so as to expand the trading and clearing functionality of the FX market.

2. Improve the pricing mechanism and risk aversion mechanism of the FX market

First, we should introduce market maker system into the USD/RMB transaction to improve market liquidity and enable the market rate to well represent market supply and demand. Second, with the progress of Renminbi convertibility, diversify the products traded on the market, and timely launch interbank forward FX trading based on which other risk-prevention instruments can be gradually introduced. Third, we should call for the building of external rating system for financial institutions, so that bilateral or multilateral credit lines can be set up, market credit risk aversion mechanism can be improved, and healthy operation of the FX market be guaranteed.

3. Establish a domestic cross-trading FX market

Establishing a brand new interbank FX market, one that starts with spot transaction of foreign currency pairs, could help create a complete domestic FX market system. The market could help meet the increasing investment and financing demand and risk-evasion requirements in the domestic market, lower the foreign fund operation cost for financial institutions and facilitate the supervision of the financial authorities. The major features of this new type of FX market include: (1) It's connected with global FX markets, operates in accordance with international practice, and boasts the function of investment, financing and risk-evasion; (2) It covers both OTC products and standardized contract products; (3) It's cost competitive; (4) It operates through multiple trading modes, including both a electronic platform and voice services; (5) It boasts the functions of trading, clearing, information providing, statistic analysis, risk-control, filing and real-time monitoring; (6) Its flexible organization mode meets requirements of market members.

4. Further regulate market operation rules and reporting system

First, market operation should be regulated in terms of market access, trading and clearing, and market exit and penalties, and market transparency should be further improved. Second, through taking advantage of the electronic trading platform in collecting real-time market information, a reporting system should be formed under which FX trading information is automatically transmitted into the information management system of the supervisory authorities through data interface to be verified against the information reported by commercial banks. Third, precaution index system should be designed to stop in time market suspicion, prevent fraud and safeguard the market equity.

5. Enhance exchange and cooperation at home and abroad

The future FX market of China will be an open global market. The CFETS looks forward to enhancing exchange and cooperation with both domestic and foreign trade systems as well as market intermediaries in the aspects of human resources, technology and products.