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The Institutional and structural problems of China's foreign exchange market and implications for the new exchange rate regime.

After briefly reviewing the historical development of China's foreign exchange market, this article examines the structural characteristics of the inter-bank market, describes its current structural problems as well as its institutional constraints and explores the delicate relationship between improving the foreign exchange market structure and reforming the RMB exchange rate regime. The inter-bank market is characterised by lack of market depth, limited transaction types and restricted participation with highly concentrated trading. The compulsory foreign exchange purchase and sales system distorts market supply and demand while the rigid exchange rate regime reduces the role of the Central Bank to one of passive intervention.

Two months after China's foreign exchange market added eight foreign exchange pairs to its inter-bank trading family, the People's Bank of China (the Central Bank) announced a reform of the RMB exchange rate regime featuring a two per cent appreciation of the RMB against the US dollar and a basket peg. (1) The regulators' intention to divert attention away from speculation on the exchange rate level and focus on improving the exchange rate formation mechanism seems to have resulted in many moves to overhaul China's foreign exchange market. The relationship between market structural improvement and reform of the exchange rate regime has become increasingly important to China as it works towards a more flexible exchange rate regime.

A substantial body of literature has taken shape on China's foreign exchange (FX) market itself, (2) or in connection with issues such as the convertibility of the RMB and the liberalisation of current and capital accounts. (3) However, in-depth analyses of the foreign exchange market's structural characteristics are rare. Chen Haiwei estimates China's foreign exchange market concentration and attributes the high concentration to FX control measures, limited convertibility of RMB, market entry restrictions and historical institutional arrangements. (4) He characterises the FX market structure as a closed monopoly. In recent years, some descriptive analyses of market structures have been noted in the literature. Ma et al. compare China's FX market with major world markets and find the Chinese market to be small, segmented and concentrated in US dollar trading with a nascent forwards market but missing a swap market. (5)

Wang Xin identifies several structural problems such as the small trading volume, high market concentration, poor liquidity, limited transaction instruments and significant settlement risk. (6) He traces the problems to a "super stable" RMB/US dollar exchange rate and points out that in China, for increased flexibility of the exchange rate, the FX market must expand considerably from its current depth and scope. While observers outside China have complained about the misalignment of the RMB exchange rate level and have called for a more radical approach to achieving exchange rate flexibility, domestic scholars and policy makers have preferred to exercise caution. Zhang Jikang argues that China's FX market should be developed gradually, controllably and optimally under the premise of stability. (7) Ba Shusong suggests a reform of the FX market with respect to its operations, transaction platform, competition rules, market entities and targeted functions. (8) This paper goes further than previous work by relying on quantitative data, for the ten years since the current exchange rate system was established in 1994, to systematically analyse the structure of China's FX market and assess its performance. (9) The basic premises are these:

* China's FX market has developed under an institutional framework involving a compulsory FX purchase and sales system, a de facto pegged exchange rate and inconvertible RMB under the capital account. (10) As these institutions cannot be changed quickly, the Chinese Government has moved gradually to reform the FX market at a pace more broadly commensurate with the economic reforms in general.

* While the broader institutional framework governs development of the FX market, the state of the FX market in turn influences external institutions. International experience has shown that while exchange rate rigidity hinders development of an FX market, a deep and liquid FX market plays an essential role in paving the way to achieve a more flexible exchange rate arrangement. (11) The adjustments made in July 2005 signal that institutional restrictions such as a rigid exchange rate and other FX regulations will be gradually phased out and China's FX market will be given more latitude to gain momentum. Meanwhile, China's move to a more flexible exchange rate formation mechanism requires a sound FX market as its foundation. The current structural problems in this FX market may jeopardise or delay future exchange rate reforms.

* The current FX market was designed to serve the policy purposes of the compulsory FX purchase and sales system and also the de facto pegged exchange rate. It has been used mainly by China's Central Bank, the People's Bank of China (PBOC) as a platform to achieve the desired exchange rate level, and thus there has been a pro forma market with non-market operations and a non-market exchange rate formation mechanism. This market served its purpose well and the non-market mechanism worked reasonably well within the broader institutional environment such as the state-owned enterprises (SOE) and banking sector. However, given the current SOE reforms, banking reforms and most importantly, a more flexible exchange rate regime as well as future liberation of the capital account, the standard of judging the effectiveness of China's FX market should also be changed depending on whether the market adopts a market operation and whether or not the exchange rate is determined by a market mechanism that establishes a balance in the country's international payments and provides a stable platform for gradual liberalisation of the capital account.

Historical Development of China's Foreign Exchange Market

Pre-1979: Strict Central Control

Before 1979, China had a highly centralised regime governing the supply, demand and allocation of foreign exchange. All FX earnings (mainly export proceeds) had to be surrendered to the state-owned banks and PBOC. All FX expenditures (i.e., for imports or non-trade purposes) had to be approved under the confines of the national FX plan which leaned towards the state sector. (12) There was no market element in the formation of the exchange rate which was fixed to the British pound from 1952, then to a basket of international currencies from 1973.

1979-93: FX Retention and Swap

Liberalisation of FX use began in 1979 with an earnings retention scheme designed to encourage exports. Under this scheme, exporters were entitled to retain a share of their FX earnings, initially with respect to exports above some quota but from 1998 according to the full measure of exports. From 1981 to 1984, exchange rates were set differentially for trade and non-trade activities. (13)

The first sign of an actual FX market in China appeared in October 1980 when retained FX claims became transferable, first through the swap service launched by the PBOC, then in provincial swap centres and finally in an integrated nationwide swap market. (14) The late 1980s saw the expansion of FX swap activity with the number of market participants increasing and swap exchange rates becoming more flexible. By the end of 1993, there were 108 local swap centres and 18 markets had joined the nationwide system. A mechanism for forming a market exchange rate had thereby been established in coexistence with an official pegged rate.

The development of the swap market with its diversity of swap rates had its own problems, including discrimination, rent-seeking and unauthorised actions. Nevertheless, it acted as a transitional device to lay a foundation for the emergence of a true FX market in China. The 1979-94 period also saw frequent adjustments to the official exchange rate with a devaluation trend of the RMB against the US dollar. (15) After gradual devaluations of the official rate, the PBOC was well prepared to unify the exchange rates and reform the exchange rate regime.

1994 and Post-1994: Compulsory Settlement on a Centralised Platform

The year 1994 was a turning point in China's FX reform. In that year, the system of FX retention and submission that had existed for 15 years was replaced with a compulsory settlement system under which foreign exchange earners were obligated to sell their FX to state banks while foreign exchange users could buy it subject to conditions. The "single managed floating exchange rate regime based on market supply and demand" was adopted. On 4 April 1994, the China Foreign Exchange Trading System (CFETS) began operations, signifying the launch of a unified national inter-bank FX market. The government's FX management method was also adjusted to rely more on systematic economic and legal measures in contrast with the former command approach. New rules governing the purchase of FX by individuals for overseas visits, study or other personal needs had taken effect on 1 April. These rules have been relaxed gradually over time with the upper limit on individual purchases raised to $8,000 from an initial $600 per person/visit as of August 2005. The success of the 1994 reform enabled conditional convertibility of the RMB under the current account and brought a real FX market into existence.

Reform continued under the basic framework of the FX purchase and sale system after 1994. In 1995, China ended the circulation of foreign exchange certificates. In July 1996, the FX transactions of Foreign Invested Enterprises (FIEs) were integrated into the FX purchase and sales system, allowing FIEs to buy foreign currency freely on the inter-bank market. On 27 November 1996, China formally notified the International Monetary Fund of the RMB's convertibility on the current account. Qualified Chinese companies were allowed to open FX settlement accounts to retain a proportion of FX earnings from current account transactions in 1997. Yen trading was added in 1995. The PBOC's forward FX purchase and sale experiment was launched in 1997.

The Asian Financial Crisis interrupted China's aggressive reform timetable. A series of regulations were enacted and clarified by the PBOC to strengthen the responsibilities of the State Administration of Foreign Exchange (SAFE) with respect to falsely obtaining FX, failing to surrender FX, illegal arbitrage and so on. (16) The swap centres were closed on 1 December 1998, with all FX transactions thereafter integrated into the FX purchase and sale system.

In 2001, trading in dollar-denominated B shares on China's stock market was opened to Chinese nationals (having formerly been limited to foreign passport holders) with necessary currency exchange supported by CFETS. Trading in Euros was introduced in April 2002. Then in October 2002, all enterprises that qualified for conducting international business or had regular FX incomes from current account transactions, were allowed to open foreign currency accounts to hold up to 20 per cent of their previous year's FX income. Two-way trading was permitted from October 2003 with trading hours extended from a half to a full day.

The year 2005 was another landmark in the development of China's FX market policy initiatives with the trading of eight foreign currency pairs in the inter-bank market in May that year. The RMB was revalued with a 2 per cent appreciation against the US dollar, and the peg to the US dollar was replaced with a reference to a basket of currencies in July. The July reform was followed by successive reform measures in August (17) to enlarge the scope of forward FX purchase and sales and swaps between the RMB and foreign currencies, (18) to invite non-financial enterprises and non-bank financial institutions to participate in the inter-bank market, to add RFQ (Request for Quote) trading mode into the current auction market and to introduce inter-bank FX forward and swap trading as well as a market making system. In addition, a long expected market maker system for USD/RMB trade was finally introduced in November 2005 based on the CFETS platform. (19)

Current Foreign Exchange Institutions

Market Composition

China's FX market is composed of the inter-bank or wholesale market and the retail market (see Figure 1). Major parties involved in the FX market are: (a) the CFETS which functions as the trading platform for the inter-bank market and is responsible for clearing the market and providing the supervisory authorities with market information; (b) the PBOC and the SAFE as regulatory authorities: the PBOC authorised SAFE to regulate the inter-bank spot and forward markets and regulate the retail market through the SAFE; (c) designated FX banks and other non-bank financial institutions and non-financial enterprises authorised by the SAFE to engage in foreign exchange business; (20) (d) enterprises that earn and spend FX; (21) and (e) individuals who have FX trading needs. The nature of the current inter-bank FX market is for designated FX banks to square their FX positions derived from retail FX business after maintaining an allowable FX working position. (22) The inter-bank market makes use of organised exchange trading with orders matched by an electronic trading platform while retail transactions between banks and their customers are carried out in an over-the-counter (OTC) market. In this paper, discussion of the market structure focuses primarily on the inter-bank market.


The Trading Platform: Should the CFETS be Transformed?

CFETS is a membership-based exchange with a nationwide real-time electronic trading system. With an "auction market" trading mechanism similar to an electronic broker, members make back-to-back (anonymous) quotes on the trading platform either through on-site or distant trading terminals. (23) The electronic trading platform automatically enables real-time matching of orders. The clearing function is integrated into the CFETS platform, providing members with centralised, two-way, netting/clearing of RMB and foreign currencies.

This market infrastructure was originally put in place to serve the needs of compulsory FX settlement and to facilitate the PBOC's absolute control of the market. The financial institutions served by the inter-bank market have long been required to square their FX positions from retail trade on a daily basis, subject to an approved level of working balances. However, it now seems inevitable that voluntary FX settlement will be adopted, and the necessity for the CFETS to clear excess supply or demand will no longer exist. Thus, the question is whether or not this inefficient non-market-oriented trading platform should be retained once there is no longer a need for centralised and compulsory settlement of foreign exchange. Or, should China return to a conventional OTC market?

The pros and cons must be considered in order to make the decision. A trading platform such as the CFETS had its justifications in connection with a developing and fragile financial system. Risk management and pricing are not well-developed in China. The exchange model and automated trading system provided by the CFETS substitutes a centralised credit system for bilateral credit lines to overcome the risk pricing problem. (24) With adoption of an OTC market organisation, bank fragility would pose problems for market operations.

The standard OTC dealer market based on RFQ enables freedom in choosing counter-parties, broad market access and continuous trading, all generally believed to bring about fairness and consistency in pricing. However, advances in telecommunications and information technology have already led to a large share of trading being snapped up by electronic brokers such as the Electronic Broking Services Ltd. and Reuters offering lower transaction costs and tighter dealer spreads through the use of STP (Straight-Through-Processing) and CLS (Continuous Linked Settlement) as well as greater transparency in pricing. According to the Bank for International Settlements (BIS) 2001 Survey, up to 70 per cent of spot FX trading in the major currencies was being traded on electronic broking systems. (25) The CFETS platform functions similarly to electronic brokers and may fit the future trend in global FX markets. However as an administrative unit of the PBOC, the CFETS suffers from inefficiencies born of monopoly and a non-market orientation. The CFETS is used by the PBOC to control the market and is exposed to neither competition nor supervision by its members.

In summary, recent policy moves offer a clue that the PBOC will not easily let go of the CFETS as the trading platform in the inter-bank FX market. The existence of such a platform will ensure further reforms in the FX market be carried out under the PBOC's scrutiny and control. In the meantime, the CFETS must undergo major transformation with respect to market-orientation, services offered, technology, efficiency and risk management. The possible direction of reform will lean towards boosting volume by enriching transaction types and incorporating elements of the dealer market such as the RFQ or market-maker into the current CFETS platform so that China's inter-bank market will indeed become a mixed market with a centralised auction market and a parallel dealer market for certain transactions. There is a large chance that the CFETS will continue to function as a transaction and information platform for the FX market but that it should become a more independent market platform in the sense that its current supervision function required by the PBOC should be phased out in the future.

FX Market Activity

Market Turnover: A Shallow and Narrow Market

Average daily turnover in China's inter-bank FX market is very low compared to that on the world's major markets (see Table 1). However, China's market is growing quickly with daily turnover up by 177 per cent in 2004 relative to 2001, and by nearly half in 2001 relative to 1998. By contrast, all major markets except Japan experienced a decline in turnover between 1998 and 2001, with recovery following in 2004. (26)

The small scale of China's FX market is attributable in part to institutional factors. Restrictions on FX holdings for both commercial banks and the public figure significantly in limiting the development of the market. So too, does concentration of FX trading among a few large banks which balance trading internally, turning to the inter-bank market just once a day to re-establish their reserves at the allowable level. Indeed, until October 2003, buying and selling during the same trading session was prohibited. Market development is also inhibited by controls on capital account transactions, approval requirements for financial institutions to engage in FX business and the limited scope of products and currencies.

The recent dramatic growth in China's inter-bank market follows a sluggish start in the 1990s (see Figure 2). The years 1997 to 1999 actually showed a downturn from which the market did not re-emerge until 2001. This downturn is attributable in part to the adverse impact of the Asian Financial Crisis but also to a broad-based inspection campaign carried out by SAFE to ferret out the purchasing of FX under false pretences and other illegal market activities. With recovery of domestic economic growth, China's admission to the World Trade Organisation (WTO) and improvement in the foreign trade and investment balance, the market picked up momentum entering a period of fast growth from 2001 to 2004, averaging 50.3 per cent per year. Market turnover reached a new height of USD209 billion in 2004 with a daily average of USD830 million. Besides the economic fundamentals, this sharp increase in market turnover was also driven by short-term factors on the supply side including faster settlement of export revenues due to the 3 per cent reduction in the export tax rebate in 2004, speculation on RMB appreciation, banks reducing their FX working positions to relieve the RMB demand pressure, overseas listed companies repatriating capital raised in stock listings and Qualified Foreign Institutional Investors (QFIIs) converting foreign funds for investment in China's stock market.


The rising turnover in China's inter-bank market coincided with rapid growth in balance of payments flows (see Figure 3). Under the compulsory FX purchase and sales system, the inter-bank market functions solely for banks to net out FX positions derived from retail trade. This retail trade is in turn driven by bank customer activity captured on the current and capital accounts. In recent years, short-term capital inflows have played a major role in feeding the increase in supply on the FX market.


The July 2005 reform heralded reforms in the RMB exchange rate regime. With more flexibility in the exchange rate formation mechanism being introduced in the future, China will be expecting larger variations in its FX market. A small and shallow market is certainly no boon to smoothing exchange rate variations. This may add to the authorities' concern about allowing further flexibility in the exchange rate regime and cause delay in the reform timetable. On the other hand, without a more flexible rate, a truly deep market is hard to achieve.

Market Scope: Mainly a Spot Market Dominated by RMB/ USD Trading

China's FX market is limited in product scope to mainly spot trading in US dollars. For a long time since its establishment, the inter-bank market offered only spot transactions. Inter-bank forward and swap transactions were finally introduced in August 2005. In the retail market, the PBOC was allowed to offer forwards beginning in 1997, with the other banks following suit after 2002. Presently, forwards exist in eight currencies (US dollar, Hong Kong dollar, Euro, yen, pound, Swiss franc, Australian dollar and Canadian dollar) and 14 different terms from seven days to 12 months. FX swaps in the retail market were not allowed until August 2005. (27)

From the inception of forward transactions in 1997, the PBOC's trading volume rose to a peak of USD11.5 billion in 2000 (see Figure 4). This growth reflected a need for businesses to hedge against currency risks during a period when the RMB was under pressure to depreciate in the wake of the Asian Financial Crisis. However, rather than devalue, the PBOC responded to the crisis by tightening the floating band. This led to a highly stable relationship between the RMB and the US dollar (see Figure 5). Under such conditions, the need to hedge risk diminished and the forward market contracted. The BOC's forward trading volume declined by about two-thirds from its peak to USD4.9 billion in 2002.


The offshore market in RMB trading shows a much higher share of trading in forwards (including non-deliverable forwards), indicating a demand for hedging instruments which China's domestic market is not able to serve. Compared with the global FX market (see Figure 6), the lack of product range in the Chinese market restricts overall growth in market turnover and limits the functions of the market, especially the risk-hedging function.

China's FX market is limited, too, by its trading concentration in the US dollar. When the inter-bank market was established in 1994, only the US dollar and Hong Kong dollar were traded. The yen was added in 1995 and the Euro in 2002. Eight foreign currency pairs started spot trading in May 2005. (28) The US dollar, however, remains the overwhelmingly dominant currency, accounting for 97.8 per cent of total turnover in 2004.

The dominance of the US dollar actually strengthened during the late 1990s, and was little influenced by the introduction of the Euro in 2002 (see Figure 7). The high concentration in US dollar trading is not inconsistent with the important role the dollar plays in global trade and investment as a vehicle currency (see Figure 8). Further, given the highly stable RMB/USD exchange rate, conducting their affairs in dollars allows those engaged in international business to minimise exchange risk. Having come to take stability of the exchange rate for granted, market participants do not net out their open positions immediately, but rather minimise transaction costs by netting out positions internally. Therefore, US dollar domination of the FX market is also a factor in the low level of overall market activity.


Great expectations had been attached to the introduction of new currency pairs, especially the Euro/RMB pair. In fact, however, the Euro has not come to play an important role in China's FX market neither in terms of increasing market turnover, nor in terms of influencing the formation mechanism of the RMB/USD rate. The reason is that the RMB/Euro rate is determined indirectly by the Euro/USD rate vis-a-vis the stable RMB/USD rate. Since banks in China can obtain a better Euro/USD rate in the international market, when they have open Euro/RMB positions they first convert Euros to dollars in the international market, then trade the RMB/USD position in the domestic inter-bank market instead of directly trading Euro/RMB positions.

The US dollar domination in China's FX market reflects market participants' dependence on the PBOC to clear the market under the rigid exchange rate regime. Lack of motivation to hedge two-way exchange risks has also prevented participants from building up professional skills in FX risk management and retarded the development of FX derivatives. This may turn out to be one of the most important fragilities when departure from the current peg brings in more variations in the rates.

In sum, China's inter-bank FX market is currently mainly a spot market. Forward and swap transactions have just emerged with trivial volume so far. Even with the introduction of eight foreign currency pairs in 2005, the domination of RMB/USD trading is unlikely to change in the near future. The lack of diversity with respect to transaction types restrains market turnover and limits liquidity.

Market Participants and Concentration: Restricted Market Entry and High Concentration

Though membership in the CFETS reached 366 by June 2005, market activity remained highly concentrated among a small number of members. Only designated banks licensed by the PBOC and the SAFE to conduct retail FX trade are eligible to become members in the CFETS. The only non-bank financial institutions which belong to the CFETS are two trust and investment companies (see Table 2). This contrasts with the diverse body of market participants in the global FX market which includes dealers and non-financial entities as well as banks and non-bank financial institutions. The global FX market has seen an increasing share of turnover being seized by trading between banks and other financial institutions which stood at 33 per cent in 2004. (29)

China's FX market is characterised by approaching monopoly especially on the buying side. Although nearly half of the CFETS' 366 members are foreign banks, their trading volume amounts to only a small portion of the total. In 2004, domestic banks' net sale of FX reached USD155.1 billion, nine times that of foreign banks. (30) Trading is dominated by the "Big Four" state-owned banks plus the China International Trust and Investment Corporation (CITIC). (31) These large banks are usually net sellers in the market with the other participants as net buyers. The PBOC, itself, was estimated to account for more than half of the net FX selling in 2002. (32) On the buying side, from 1995 to 2004, the PBOC's net purchase of FX accounted for 68 per cent of the total inter-bank market turnover (calculated from Figure 9).


In recent years, the PBOC has been obliged to undertake massive buying in the face of heavy supply pressure brought about by speculation on RMB appreciation and a relatively high interest rate paid on RMB deposits. The result has been an increase in official reserve assets to USD610 billion at the end of 2004, up USD324 billion in just two years.

Broadening market access to a wider range of institutions would increase turnover and diversify influences on supply and demand. This would aid the market clearing process and support the formation of a meaningful exchange rate, reducing the role of the PBOC. It would also spread the fixed costs of the trading platform among more members thereby lowering transactions costs. The expansion of the CFETS membership to include more foreign banks and small domestic banks as well as the recent official permission to include non-bank financial institutions and non-financial enterprises in the inter-bank market showed a trend in the right direction.

Problems in China's Foreign Exchange Market

Distorted Market Supply and Demand

Foreign exchange market institutions and choice of exchange rate regime bear integrally on one another. A more flexible exchange rate regime for China which is capable of generating an exchange rate consistent with balance of payments fundamentals cannot be achieved without a foreign exchange market in which supply and demand represent the true preferences of market actors. On the other hand, China's trouble-ridden exchange rate regime is itself to blame for many structural problems in the FX market. Thus, to start by fixing the cracks in market supply and demand would not only help tackle many structural deficiencies in the FX market, but would also be a crucial step toward disentangling the Gordian knot of the RMB exchange rate regime.

Three main problems exist with the market supply and demand for foreign exchange in China. First, supply and demand do not express the will of market participants, but rather follow from their compliance with regulations. Under the FX purchase and sales system, exporters and foreign investors must surrender at least 75 per cent of their FX earnings to the designated FX banks, and these banks in turn must sell their foreign currency receipts on the inter-bank FX market subject to an allowable working position. On the supply side then, neither the ultimate suppliers, i.e., exporters and investors, nor the designated banks that enter the inter-bank market have the freedom to choose their preferred levels of FX holdings. On the demand side, capital controls impede Chinese investment overseas and restrict FX use by businesses and individuals.

Second, in recent years a pronounced excess supply has emerged in China's FX market. This excess supply follows from mounting surpluses on both current and capital accounts (see Figure 10). The surplus on the current account has risen fairly moderately from a trough in 2001. Meanwhile, the surplus on the capital account has ballooned, fuelled by a continued strong inflow of FDI coupled with explosive growth in short term capital flows. In addition, the balancing item "net errors and omissions" has become a positive and growing force in the excess supply of foreign currency that must be absorbed by the PBOC. The imbalance in China's FX market is aggravated by the compulsory supply and impeded demand that is the product of the regulatory system. With a rising trade surplus, stable FDI inflows and strengthening short-term capital inflows powered in part by speculation on RMB appreciation and in part by higher interest rates on RMB deposits (see Figure 11), the gap between supply and demand is being driven ever wider.


Third, the supply and demand for FX are not fully reflected in the inter-bank market on the CFETS platform. This is because the large Chinese banks transfer a part of their position-squaring operations to Hong Kong or to the black market. Therefore, the excess supply of foreign exchange on the inter-bank market is not reflective of overall market conditions.

All in all, the distorted market supply and demand compromise the market's ability to yield a meaningful value for the exchange rate.

Passive Intervention of the PBOC

Surging excess supply in the FX market has put pressure on the RMB to appreciate. In order to maintain the pegged RMB/USD rate, the PBOC has had to intervene by purchasing large quantities of US dollars and then sterilise these purchases through the issuance of PBOC bills to control the money supply. The PBOC was forced to play the super market-maker role in the FX market. So far, the PBOC has been quite successful in keeping a tight rein on money supply growth through its sterilisation operations and in draining liquidity from the banking system (see Figure 12). Yet the PBOC's passive intervention could lead to problems.


First, supply and demand imbalances under a compulsory FX settlement system leave no leeway for the PBOC which must absorb the appreciation pressure. Second, the commitment to maintain stability in the RMB/USD rate results in high US dollar concentration in the FX market. Third, constant intervention in the FX market imposes high monitoring and administrative costs, rendering the PBOC unable to free itself from frequent operations in the FX market. Finally, PBOC sterilisation operations could lead to a vicious cycle pushing interest rates higher only to attract greater speculative inflows that must be purchased by the PBOC and then sterilised. As Figure 11 shows, the interest rate on RMB deposits has already been pushed above the US Federal Funds rate. The downside of this kind of passive intervention is that the PBOC loses independence in conducting monetary policy.

One way to relax the constraints on the PBOC would be to delegate the role of market-maker to one of the state-owned commercial banks. Any one of the "Big Four" could be considered for the role. This step could help provide liquidity in the market and ease the pressure on the PBOC.

China has been aided in maintaining its currency peg, in the face of sizeable balance of payments surpluses, by its use of capital controls. These controls have helped protect against the kind of large-scale capital movements that forced many Asian countries off their pegs during the Asian Financial Crisis. With the gradual easing of capital controls in China, not only does the currency face greater danger of "one way bet" speculative attacks, but independent monetary policy becomes more difficult to pursue. (33) In the past few years, expansionary fiscal policy has been the preferred approach to averting economic slowdown, but with the Chinese economy's continued robust growth cycle and a looming threat of inflation, monetary policy could be vital to achieving a soft landing.


From the market activities of 1994 to 2004, it can be concluded that China's FX market has the following structural features:

* low turnover

* heavy concentration in spot trading, with shrinking trade in retail market forwards, and trivial volume of inter-bank forwards and swap transactions

* US dollar dominance, with the Hong Kong dollar, yen, Euro and other foreign currencies accounting for minuscule market shares

* a membership-based exchange trading platform evolving towards a mixed trading mode including some features from dealer markets, with banks as the prevailing type of participants

* a high degree of market concentration on the sellers' side by the PBOC, and on the buyers' side by the PBOC

* simple function as the place for designated FX banks to net out open positions with limited capacity to serve investment or risk-hedging needs of FX users.

Recent policy initiatives, especially those of August 2005 addressed some of the structural problems in the FX market and will be expected to hasten the development of the inter-bank market in the long term. Yet the current structural features will not be significantly changed in the near future. The two institutional factors that most seriously constrain development of China's FX market are the compulsory FX settlement system and the rigid exchange rate regime. The dilemma for moving forward is that these institutional constraints and the structures in the FX market are inter-related, and liberalising on one front is difficult as long as the status quo maintains on the other. Specifically, the rigidity in exchange rate imposes limits on the growth and diversification of the FX market. But at the same time, allowing more flexibility in the exchange rate requires a broader, more diversified, competitive and efficient market platform upon which the forces of supply and demand can determine the RMB value of foreign currency. A profound change in one institutional pillar or the other is required to break loose from the status quo.

Development of the FX market provides the needed foundation for any move towards greater exchange rate flexibility. Key elements of FX market development must include: supply and demand deriving from the economic choices of market actors; the trading platform functioning in an efficient market-oriented way; and convertibility of the RMB on the capital account being realised.

(1) In other words, China's monetary authorities are now determining the exchange rate level "with reference to" a basket of currencies. The relatively stable performance of the RMB/USD exchange rate since the July revaluation hints that the Central Bank has not carried out a full basket peg yet and the US dollar still dominates the determination of the RMB exchange rate.

(2) For research on foreign exchange market pressure and the Central Bank's intervention, see Zhu Jie, "China's Foreign Exchange Market Pressure and Central Bank Intervention: An Empirical Analysis", Shijie jingji (World Economy), no. 6 (2003). For research on foreign exchange market efficiency, see Yang Shengang and Lu Xiangqian, "Noise Trading, H Exponent and the Efficiency of China's Foreign Exchange Market", Hunan daxue xuebao 17 (Journal of Hunan University 17), no. 2 (Mar. 2003). For research on foreign exchange market concentration, see Chen Haiwei, "Market Concentration of China's Foreign Exchange Market", Caijing yanjiu 27 (The Study of Finance and Economics), no. 8 (2001).

(3) See for example: Zhang Zhichao, "Harmonious Development of the Foreign Exchange Market and Liberalisation of Capital Controls in China", International Seminar on China's Foreign Exchange Market Development, Shanghai, Dec. 2003.

(4) Chen Haiwei, "Market Concentration of China's Foreign Exchange Market". Market entry restrictions refer particularly to restrictions on foreign participation.

(5) Ma Guonan, Corrinni Ho and Robert N. McCauley, "The Market for Non-deliverable Forwards in Asian Currencies", Bank for International Settlements Quarterly Review, June 2004.

(6) Wang Xin, "Problems in China's FX Market", International Economic Review (2003): 11-2; Wang Xin, "Problems and Countermeasures in China's Foreign Exchange Market", China and World Economy 12, no. 1 (2004): 62-74.

(7) Zhang Jikang, "The Gradual and Optimal Development of China's Foreign Exchange Market on the Premise of Stability", Zhongguo huobi shichang (China Money), Feb. 2004.

(8) Ba Shusong, "The Development Trends in China's Foreign Exchange Market: Multiple Perspectives", Zhongguo huobi shichang (China Money), Mar. 2004.

(9) It is important to note that China's foreign exchange market and its exchange rate regime are undergoing constant transformation. Significant reform measures were introduced in 2005 to address some of the structural problems. It is unrealistic to expect any instant effects on the market structure features. The real effects of these policies remain to be observed over the next few years.

(10) These three institutional arrangements are the most important and direct ones governing the development of China's FX market. However, other institutional roots that have a connection with problems in this market such as the ownership nature of the enterprises, the status quo of the domestic banking sector and the lack of exchange rate risk management skills and tools should also be duly recognised.

(11) See Cem Karacadag, Rupa Duttagupta, Gilda Fernandez and Shogo Ishii, "From Fixed to Float: Fear No More", Finance and Development (Dec. 2004): 20-1.

(12) The FX plan was formulated by the State Planning Commission in consultation with the Ministries of Trade and Finance and the PBOC. See Zhang Zhichao, "Harmonious Development of Foreign Exchange Market and Liberalisation of Capital Controls in China".

(13) The exchange rate for trade activities was set at 2.8 RMB/USD while the official rate still stood at 1.5 RMB/USD. This practice was abolished as of 1 January 1985.

(14) Despite the name, the swap market provided spot transactions only.

(15) These adjustments were frequent, small and slow with mixed appreciation and depreciations but on the whole, the RMB had been devalued against the US dollar from the early 1979 level of 1.50 RMB/USD to 5.72 RMB/USD at the end of 1993. Six large official devaluations took place in 1981, 1984, 1985, 1986, 1989 and 1990.

(16) See State Administration of Foreign Exchange (SAFE) website, statistics section at <> [11 May 2004].

(17) Details of these policies can be seen in the "Notice of the People's Bank of China on Accelerating the Development of the Foreign Exchange Market" which was posted on the PBOC's website at <> on 8 Aug. 2005.

(18) In the retail market, this means between banks and their customers.

(19) Details can be found on the SAFE's website at <> [27 Nov. 2005].

(20) Currently, major participants in the inter-bank market are still designated FX banks but the market entry rules have been relaxed to encourage the participation of non-bank financial institutions and non-financial enterprises by the August 2005 reform measures.

(21) Items (d) and (e) are participants in the retail market.

(22) This allowable FX working position has to be verified and approved by the SAFE.

(23) Distance connections can be realised through Digital Divide Network, frame-relay or dial-up.

(24) Benefits from such a centralised credit system are however subdued by the fact that current market participants are mostly large banking institutions for which credit risk or transaction risk concerns are low.

(25) See Bank for International Settlements (BIS), Triennial Central Bank Survey of FX and Derivatives Market Activity in 2001 (see <>) [15 July 2004].

(26) According to the BIS, the main factors driving the fall in turnover were the introduction of the Euro, the growing share of electronic broking in the spot inter-bank market, consolidation in the banking industry and global concentration in the corporate sector.

(27) Details of the new regulations can be found in "Notice on Issues Regarding Expanding Designated Banks' Forward Purchase and Sales of Foreign Exchange Business to Customers and Launching RMB Swaps against Foreign Currencies" on the PBOC's website at <> [16 Nov. 2005].

(28) The eight foreign currency pairs include EUR/USD, AUD/USD, GBP/USD, USD/CHF, USD/HKD, USD/CAD, USD/JPY and EUR/JPY.

(29) Source: BIS, "Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2004" at <> [23 July 2005].

(30) See "Inter-bank Market Activity Report, 2004", China Money, no. 2, 2004.

(31) The "big four" refer to: the Industrial Bank of China, Bank of China, China Construction Bank and Agricultural Bank of China.

(32) See Wang Xin, "Problems in China's FX Market", International Economic Review (2003): 11-12.

(33) The "impossible trinity" holds that with free capital mobility, a fixed exchange rate and independent monetary policy cannot be realised simultaneously.

Zhang Jikang ( is Professor of Financial Markets and International Business at Fudan University, Shanghai. He is also a Senior Adviser to the China Foreign Exchange Trade System and National Inter-Bank Funding Center (China's foreign exchange and money markets, respectively).

Liang Yuanyuan ( is Research Assistant at the Center for European Studies, Fudan University. She has a Masters degree in Economics. Her main research interests are financial markets and corporate finance.
Table 1. Foreign Exchange Market Daily Average Turnover in
Selected Markets, 1995-2004 (USD billion/day)

 1995 1998 2001 2004

China 0.26 0.21 0.30 0.83
Hong Kong 90 79 67 102
Japan 161 136 147 199
Singapore 105 139 101 125
United Kingdom 464 637 504 753
United States 244 351 254 461

Note: For markets other than China's, daily averages are for
the month of April and cover spot, forward and swap transactions.
For China, volume is based on the entire year and pertains only
to inter-bank spot transactions.

Sources: CFETS, BIS, Triennial Central Bank Survey of FX and
Derivatives Market Activity in 2004 at <> [23 July 2005].

Table 2. CFETS Members by Institutional Type, January 2003 and June

 January 2003 June 2005

Wholly state-owned bank 4 4
Joint stock commercial bank 10 11
Policy bank 3 13
Urban commercial bank 22 39
Branch of commercial bank 108 109
Foreign bank 164 179
Trust and investment company 2 2
Rural credit cooperative 9 19
Total 322 366

Source: China Money, various issues.

Figure 4. Bank of China Spot and Forward FX Trading,

 Spot Forward

'97 138.2 0.8
'98 118.6 2.1
'99 120.1 3.7
'00 131.5 11.5
'01 152.1 8.6
'02 191.8 4.3

Source: Bank of China Annual Reports.

Note: Table made from bar graph.

Figure 6. Shares of FX Trading by Transaction Type in Global
FX Markets, 2004

Spot 35%

Forward 12%

Swap 53%

Source: BIS, Triennial Central Bank Survey of FX and Derivatives
Market Activity in 2004 at <www/> [23 July 2005].

Note: Table made from pie chart.

Figure 8. Currency Composition in the Global FX Market, 2004

US Dollar 88.7%
Euro 37.2%
Japanese yen 20.3%
Pound sterling 16.9%
Swiss franc 6.1%
Australian dollar 5.5%
Others 25.3%

Note: As each currency pair involves two currencies, the total
sums to 200 per cent.

Source: BIS Triennial Central Bank Survey of FX and Derivatives
Market Activity in 2004 at <> [23 July 2005].

Note: Table made from pie chart.
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Author:Jikang, Zhang; Yuanyuan, Liang
Publication:China: An International Journal
Geographic Code:9CHIN
Date:Mar 1, 2006
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