OPTIONS AND MEASURES FOR FURTHER DEVELOPMENT OF CHINA’S FX MARKET

Current situation and existing problems of China's FX market

The establishment, reform, and development of China's FX market is a natural outcome of the deepening marketization and globalization of China's economy and finance. The China Foreign Exchange Trade System (CFETS) established in 1994 marks the forming of a national unified interbank FX market operating with market principles - a platform for domestic financial institutions' FX sale and purchase, clearing and settlements, and information services. Facing the growing financial situation and market demands, the CFETS, with the aim of serving financial institutions and ensuring the stable and orderly operation of finance and the market, reformed and innovated in the aspects of market structure, trading varieties, and trading hours, play an important role in perfecting the market. Over the past ten years, the market with its expanding turnover and comparatively stable RMB exchange rate has effectively promoted the business operation of financial institutions and the reasonable allocation of the country's FX resources.

As one of the big four state-owned commercial banks in China, the Agricultural Bank of China (ABC), supported by the banking industry at home and broad, has obtained considerable growth in international business under the guidance of the People's Bank of China and the State Administration of Foreign Exchange. At the end of October this year, the ABC's FX assets hit US$20.7 billion, including US$8.5 billion worth of overseas FX assets. The balance of FX deposits in the ABC was US$ 9 billion, and outstanding FX loans reached US$6.4 billion. The ABC has established correspondent bank relationships with 773 banks in 92 countries and regions. In 2002, the ABC handled US$ 37.7 billion worth of FX sales and purchases, and in the first 11 months this year sales and purchases reached US$48.2 billion. The forward FX sale and purchase introduced in April 2003 has seen a rapid growth with a turnover topping US$ 1.3 billion by the end of November. In the past decade, the ABC ranked second among market members in terms of volume of FX purchases and sales.

According to our experience in the market over the past decade, the establishment and development of the platform of the CFETS has played an irreplaceable role in promoting the business operation of financial institutions, and the growth and innovation of domestic FX market, as well as maintaining the stability of macro economy and financial order. The design of the basic framework is reasonable for the interbank FX market.However, objectively speaking, the FX market is still in an initial stage as compared with international standards. As a market participant, we find the following problems.

First, considering the nature of the market, China's FX market is not yet a market in its real sense to transfer and dissolve exchange rate risks. Instead, it is merely a place to adjust positions in domestic and foreign currencies.

Second, the current FX market lacks a price forming mechanism that is driven by market forces and the RMB exchange rate lacks elasticity. Market prices do not fully reflect the market supply and demand, but rather deviate from market demand and supply.

Third, the comparatively limited trading varieties, to some extents, fail to meet the demand of financial institutions and their clients in managing financial risks. Currently, the interbank FX market only deals with four spot trading varieties. Trading varieties, such as currency pair, forward, futures and options, all have yet to be introduced. The forward FX sale and purchase introduced by the ABC this year can only be covered through spot transactions or interbank lending, so, the lack of forward business in the interbank FX market affected banks' business of forward FX sale and purchase.

Fourth, market liquidity, in particular that of non-USD currencies, is comparatively low, and the trading for them is inactive. In the trading of USD against RMB, the central bank, as the ultimate undertaker of market prices and trading, acts as a market maker providing the liquidity of USD/RMB trading. But in the trading of RMB against JPY, HKD, and EUR, the lack of market makers has resulted in poor liquidity and a comparatively small size of transactions. Besides, the principle of real demand for trading in the CFETS has excluded financial trading in the market, thus affecting the turnover and activity in the market to a degree.

Fifth, trading cost in the market is comparatively high and the market efficiency has yet to be improved. With the current 0.3¡EPOëEHO commission rate, the buy - sell spread is computed at 50 bps. The comparatively high trading cost, to some extent, dents banks' enthusiasm for trading, and accordingly affects market efficiency.

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Options for further development of China's FX market

With China's gradual fulfillment of its commitment to its WTO entry, the opening of the financial industry has been accelerated and the level of RMB's regionalizaiton and globalization has been gradually raised. Such circumstances objectively necessitate a highly effective FX market with diversified trading varieties, consummate functions and mechanism that can be organically linked with international markets.

In the past decade the CFETS has preliminarily established a national unified trading network, thus accumulating abundant market experience. Therefore, in terms of the policy option for the construction of domestic FX market, the CFETS should be further constructed, via innovations of mechanism and organization, into a unified large platform of China's FX market linking China and global FX markets.

In the design of the large market platform, four interdependent sub-platforms need to be set up for product innovation and transaction, price forming and quoting, fund clearing and information service.

1. Platform for product innovation and transaction

Diversified products must be introduced for market participants to have a wider range of choices, and also for an effective and mature FX market to play its role of transforming and dissolving exchange rate risks. As China furthers its economic openness, both domestic and foreign-funded enterprises will see great growth in foreign trade, foreign investment and financing, and meanwhile the fluctuation range for RMB exchange rate will be widened and RMB interest rates will be more liberalized. Under the circumstances, FX market participants need various FX products in risk management. The CFETS, therefore, should develop into a product innovation platform conforming to growing market demands for standard and non-standard innovative products of different kinds. Now conditions are mature for the introduction of currency pair, FX futures and FX options. Development and innovations must also be carried out in the derivatives of RMB against foreign currencies.

In the next place, a trading platform should also be built up for these products. Standard products can trade via exchanges while non-standard products may be traded through money brokerage companies. Market makers for certain products make two-way quotes through this platform to maintain market liquidity, while other participants trade with these market makers on the platform.

2. Platform for exchange rate forming and quoting

A key indicator for the efficiency of financial market is whether or not the market can form reasonable prices really reflecting supply and demand while also being sensitive to available market information. Since the forming mechanism of foreign currency exchange rate is quite mature, the CFETS should be built into a large platform to form and adjust RMB exchange rate. And a quoting platform must be developed being interactive with quotes in international FX markets.

3. Platform for clearing

Without a unified FX clearing system in the country, banks generally use accounts opened with correspondent banks abroad for FX clearing. Overseas clearing, with its long time and high cost, has been a great waste of resources for domestic banks. Additionally, the development of international FX market shows that the CLS (continuous linked settlement) is very likely to monopolize trading and clearing of FX markets in the near future. So the CFETS can make use of its own advantages to set up a national unified FX clearing system in China, so as to shorten clearing time, lower clearing cost, raise clearing efficiency, and grasp advantages in the competition with CLS at least in the field of RMB clearing. Such a platform for clearing will also provide vigorous supports for the further development of the domestic FX market.

4. Platform for information service

Major providers of financial information in the world now offer only incomplete information on Chinese financial market particularly on exchange rates, interest rates, and treasury bonds. The CFETS, with its network and trading data, can compile and release useful information to market participants and supervision authorities for their reference.

Measures for further development of China's FX market

According to the principle of step-by-step growth, the development of China's FX market should not only meet the development trend in international markets by absorbing advanced experience from developed countries' financial markets, but also tally with China's current economy and finance, in particular, the reform of RMB exchange and interest rates and the process toward RMB convertibility. The development of China's FX market should focus on competition and efficiency, as well as cooperation and risk control.

1. Organizational innovation should be accelerated so as to create a competitive organization for trading, money brokerage, clearing and information service.

In the 1990s, market brokers including stock exchanges in western countries experienced a trend of restructuring toward corporation. It has turned out that incorporated intermediaries can facilitate technology advancement and market competition and help improve operational efficiency and service level.

In terms of innovation of mechanism and organizational structure, the CFETS may form partnerships with leading domestic banks, and take the form of membership or corporation to set up an intermediary organization with scientific governance and effective internal control for trading, money brokerage, clearing and information services.

2. Market-maker system should be introduced to enhance market liquidity and improve price forming mechanism.

A highly efficient market needs high liquidity, which is generally offered by market makers via two-way quoting. Currently, liquidity is comparatively poor in China's interbank FX market, which adopts a trading system of one-way quoting and matching in priority of price and order. To be more efficient, the domestic FX market has to cultivate market makers with commercial banks as the major player, and the central bank intervening and regulating in the FX market through the market makers. In this way, market makers can at any time adjust bid or offer rates and change bid/offer spread, thus bettering the price forming mechanism in the market.

3. An electronic market should be promoted to meet international FX markets.

The e-trading system should be constantly improved after studying the development of international e-brokerage, so as to bring the domestic FX market in line with international standards. Partnerships should be established with the FX markets in New York, London, Paris and Tokyo, so as to enhance the opening of China's FX market to the outside world.

4. Product innovation should be strengthened in order to initiate new products and services to meet market demands.

If innovation in organizational structure is realized and the market has a comparatively consummate micro structure and advanced infrastructure as the guarantee, product innovation then should be strengthened in order to introduce new products or services according to the real situation and demands in the domestic FX market. Since basic products, derivative products, and products complicated in structure all have been rather mature among foreign currencies, the focus for innovation in the domestic FX market should be RMB forwards and derivatives.