Information about Asia and the Pacific Asia y el Pacífico
Chapter

VIII Developments in the Exchange System

Author(s):
Marc Quintyn, Bernard Laurens, Hassanali Mehran, and Tom Nordman
Published Date:
September 1996
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The Chinese exchange system has changed at an accelerating speed during the past fifteen years from one in which access to foreign exchange was highly restricted and the exchange rate was administered to a system wherein foreign exchange is available to bona fide buyers at a market-determined rate. Developments in the foreign exchange system were also characterized by initial local experiments that were in the process transplanted to the entire economy.

Early Stages: Regulated Exchange Rates and the Foreign Exchange Plan

When China assumed its seat on the Executive Board of the International Monetary Fund in 1980, the external value of the renminbi was linked to a basket of internationally traded currencies. The weights in the basket were based on the relative importance of currencies in China’s external transactions and on the relative values of these currencies in international markets. All spot transactions were performed at the rates derived from the value of the basket, although rates for currencies other than the U.S. dollar were changed only when the calculated rate diverged from the previously published rate by 1 percent or more; for some other currencies, the incremental limit was lower. All spot transactions on a given day were performed at the published rates.

Foreign exchange transactions were usually based on a foreign exchange plan, prepared by various ministries. The Bank of China (BOC) was responsible for implementing the plan, and all transactions were performed in accordance with it. At the beginning of 1981, an internal settlement rate was introduced, at which all purchases of foreign exchange had to take place. All national enterprises engaged in foreign trade were required to execute their purchases of foreign exchange from the BOC at this rate. The rate was computed by adding an equalization price to the official rate. At the end of 1981, the official buying and selling rates were ¥ 1.7411 per U.S. dollar and ¥ 1.7499 per U.S. dollar, respectively. At the same time, the internal settlement rate was ¥ 2.8 per U.S. dollar. The official rate was used for non-trade-related transactions.

On January 1, 1981, an experimental trading system was established by the BOC in a few cities, such as Beijing, Guangzhou, Hefei, Shanghai, and Tianjing. Domestic enterprises that were permitted to retain foreign exchange in the form of retention quotas were permitted to sell this foreign exchange to other domestic enterprises authorized to buy it. The BOC acted as broker for these transactions and levied commissions of 0.1–0.3 percent on both sides of the transactions. The BOC did not trade in this system for its own account and was not permitted to assume foreign exchange positions. All these transactions were executed at the internal settlement rate of ¥ 2.8 per U.S. dollar. At an early stage, forward rates (which were not based on interest rate differentials) were also published for 15 currencies. It is not known to what extent transactions actually took place at these rates.

At the beginning of 1985, the use of the internal settlement rate was discontinued, and all transactions were to be executed at the official rate published by the State Administration for Exchange Control (SAEC), the agency charged with implementing and enforcing exchange regulations on behalf of the People’s Bank of China (PBC). At the beginning of 1986, the exchange regime was changed from one of pegging to a basket to a system of managed floating.

Swap Centers and Retention Quotas: First Step Toward Market-Determined Rates

In November 1986, Chinese enterprises and foreign investment corporations in the four Special Economic Zones (SEZs) of Shantou, Shenzhen, Xiamen, and Zhuhai were permitted to transact foreign exchange in Foreign Exchange Adjustment Centers (FEACs) at rates agreed between buyers and sellers.56 Initially, the trade volume in these so-called adjustment or swap centers was small. Trade took place at a rate that was somewhat depreciated in relation to the official rate. In Shenzhen, for example, the exchange rate depreciated from ¥ 5.5 per U.S. dollar to about ¥ 6 per U.S. dollar during 1987 (Chart 12).

Chart 12.Foreign Exchange Rates

(In renminbi per U.S. dollar; end of period)

Sources: International Monetary Fund, International Financial Statistics; and Chinese authorities.

In early 1988, all domestic entities that were allowed to retain foreign exchange earnings were also allowed to trade in the centers, and, by October 1988, 80 swap centers had been established. The rate continued to depreciate in relation to the official rate. At the same time, foreign exchange retention quotas for enterprises in several industrial sectors and in some regions were liberalized.

The official exchange rate remained unchanged at ¥ 3.72 per U.S. dollar from July 5, 1986 to December 15, 1989, at which time a 21.2 percent depreciation of the renminbi was announced. At the end of 1989, the exchange rate of the renminbi against the U.S. dollar was 4.72. In the swap centers, the renminbi depreciated against the U.S. dollar from ¥ 5.25 in the first quarter of 1987 to ¥ 6.7 in the first half of 1989 before appreciating until reaching ¥ 5.4 per U.S. dollar by the end of 1989 (Chart 12).

In February 1989, regulations were issued by the SAEC regarding the use of foreign exchange purchased at swap centers. Imports of inputs for agriculture, textiles, and technologically advanced and light industries were to be given priority. Purchases of foreign exchange for a wide range of consumer goods were prohibited. Meanwhile, although the BOC was still China’s specialized foreign exchange bank, an increasing number of other institutions were authorized by the SAEC to handle specific transactions. At the turn of the decade, more than 100 institutions were authorized to handle various types of foreign exchange transactions.

The right to trade in retention quotas was extended in early 1988 to all domestic entities engaged in foreign trade, including those entities that were permitted to retain foreign exchange earnings. Private individuals were also permitted to purchase foreign exchange through authorized banks. The retention quota system is reviewed in Box 7.

Branches of the SAEC, operating on behalf of the associated branches of the PBC, intervened from time to time to stabilize prices in the swap centers. Decisions to intervene were taken locally at the branch level, independent of the SAEC and PBC headquarters. The foreign exchange used in these interventions was drawn from local stabilization funds that had been created through earlier purchases of foreign exchange and retention quotas in the local swap centers. The foreign exchange part of these stabilization funds was usually held by local branches of the BOC.

By the beginning of August 1992, some centers had fully computerized their dealing systems. The computer system simulated a typical “open outcry” arrangement.57 At other centers, participants watched bids and offers placed on a large screen. Effectively, there was not much difference between dealing under these two arrangements. Bids and offers were matched on the basis of price and time.58 Dealing ended when no matching orders to buy and sell were entered on the system within a 30-second period. There was no interference by authorities in the pricing or dealing process.

Box 7.The Retention Quota System

Under the retention quota system, China maintained a multiple exchange arrangement. An administered official exchange rate was used for the foreign exchange plan, the surrender of foreign exchange, and the purchase of foreign exchange with retention quotas. However, the actual effective exchange rate received when surrendering foreign exchange or paid when acquiring foreign exchange depended on the quota and cash retention systems. The retention quota rate and the cash exchange rate usually were different from the official exchange rate. These rates could also diverge substantially among centers in different parts of the country.

Under the retention quota system, Chinese enterprises were required to surrender their foreign exchange to authorized banks for renminbi at the official exchange rate. These enterprises were then allocated a certain percentage of surrendered foreign exchange in the form of retention quotas. Foreign-funded enterprises (FFEs) could choose whether to retain foreign exchange or receive retention quotas. The quota retention account was a book entry, denominated in U.S. dollar, that showed the holder’s right to purchase foreign exchange at the official exchange rate for approved imports or debt service, up to the amount in the account. Retention quotas were usually approved automatically for payments under the trade plan; they were granted for imports over and above the plan with the approval of the State Planning Commission and the Ministry of Foreigh Economic Relations and Trade (MOFERT). Retention quotas had no fixed maturity, and they could be traded at prices reflecting supply and demand throughout the swap centers.

On the presentation of evidence of the surrender of foreign exchange, MOFERT verified the amount of retention quotas to which an enterprise was entitled, as well as the percentage distribution of retention quotas to the state, the local authorities, and foreign trade companies. The percentages were predetermined by the State Council and varied by commodity and over time. In 1992, part of the retention quotas made available to the state were purchased at a premium equal to the monthly weighted average of the rate in the swap market.1 As a consequence, the actual effective exchange rate for the conversion of export proceeds into renminbi was a weighted average of the official and swap market exchange rates, which varied by commodity and over time. FFEs (wholly foreign owned and joint ventures) were permitted to retain all of their export earnings and to transact the foreign exchange in the swap centers. Retained foreign exchange had to be deposited in accounts with one of the authorized banks.

On an experimental basis, Chinese enterprises in Shanghai and some other coastal regions were also permitted to retain the same percentage of foreign exchange as they would have received in quotas. Retained foreign exchange could be purchased and sold through the swap centers by these enterprises. Authorized banks could, without additional approval by the State Administration for Exchange Control (SAEC), inititate import payments directly using the retained foreign exchange when presented by these enterprises with import authorizations from MOFERT. These Chinese enterprises could continue to use their accumulated retention quotas but could not receive additional quotas. This cash retention scheme did not extend to local authorities.

Using the retention quota system, an exporter of general commodities initially received 100 percent in renminbi at the official rate for a surrender of 100 percent of foreign exchange. At the same time, the exporter also received—and could retain or sell in the swap marlet—retention quotas equivalent to 40 percent of the foreign exchange surrendered. The remaining 60 percent of retention quotas were allocated directly by the SAEC in the following way:

  • Retention quotas equivalent to 30 percent of the total were purchased by the PBC at the prevailing swap market rate for quotas. The renminbi proceeds of this purchase were transferred to the exporter’s renminbi account.
  • Retention quotas equivalent to 20 percent were credited to the Central Government’s quota account.
  • Retention quotas equivalent to 10 percent were credited to the local authorities’ quota account.

The exporter, therefore, was effectively reimbursed at the swap market rate for 70 percent of export proceeds, either in the form of the official rate plus quotas (40 percent of the proceeds) or in the form of the official rate plus allocation and resale of quotas at the market rate (30 percent of the proceeds).2

As of July 1, 1992, the PBC started selling the quotas that it had bought at the market rate to importers through the swap market at the prevailing swap market rate. As a result, the Government’s access to foreign exchange at the official rate fell from 50 percent to 20 percent.

1 Retention quotas made available to local authorities were puchased at the official exchange rate.2 This example of an exporter of general commodities would have applied to 70–80 percent of exports; foreign-owned and joint-venture enterprises could retain 100 percent of export proceeds in cash.

Settlement Procedures

The buying and selling of retention quotas and foreign exchange were conducted through the accounts of the swap centers. On the day of the trade, the buyers and sellers made transfers to the swap center: buyers transferred the renminbi counterpart and sellers the retention quotas or the foreign exchange. In some centers, the renminbi accounts of the sellers and the quota or foreign exchange accounts of the buyers were credited on the next day. A penalty of 0.003 percent a day was charged for any unsettled amounts. In still other centers, the accounts of local customers were credited on the second day after trading; the crediting of the accounts of customers from outside the center could take up to one week.

Regulation of Swap Center Trading

Initially, there were no generally applicable regulations for the swap centers, as each center issued or applied its own variety of regulations. Effective April 14, 1993, the SAEC sought to rectify this situation by issuing operational regulations for the swap centers. The explicitly stated main purpose of these new regulations was to promote flows or arbitrage between centers. Another important provision explicitly forbade transactions bypassing the swap markets. The SAEC at this time also had the power to control market access on the basis of a “guiding priority list.” Trading arrangements in the swap centers are reviewed in Box 8.

The volume of turnover grew by some 30–40 percent annually over the five years up to 1992, when turnover reached $25 billion. However, growth was much slower in 1993. In that year, the market developed in distinctly different phases. January and most of February were still characterized by expansive economic policies and a rapidly growing economy, and demand for foreign exchange increased rapidly as a result of the boom in investments and imports. The swap rate continued to rise throughout most of this period, from some ¥ 7.0 per U.S. dollar in early January to about ¥ 8.4 in the third week of February. The continued depreciation of the renminbi in the swap markets led in late February to the imposition of an administrative cap by the SAEC on the swap rate at about ¥ 8.2 per U.S. dollar, in an apparent contradiction of the swap market regulations. This cap remained in place until the end of May. During this period, most sellers withdrew from the market, and turnover fell sharply. Instead, black market activity intensified, and the rate in that market depreciated to about ¥ 11.0 per U.S. dollar. The swap rate hovered around ¥ 8.0 in most centers.

The next stage in swap center trading in 1993 began with the lifting of the cap on the swap rate on June 1. Following the lifting of the cap, the swap rate depreciated almost immediately to about ¥ 10.0 per U.S. dollar; for the rest of June, the rate remained about ¥ 10.5 per U.S. dollar in most centers, close to the black market rate. The last stage of development during this rather unsettling year began with the announcement of a tightening of financial policies at the beginning of July. The appointment of a new governor of the PBC also raised strong expectations in the market of a change in policies. Therefore, the PBC intervention in the swap markets on July 5, 1993 had a powerful impact on rates. In one week, the renminbi appreciated from about ¥ 10.7 per U.S. dollar to ¥ 8.5 per U.S. dollar. The mood in the market was positive, reinforced by expectations of further changes in emphasis in policy implementation. Public statements were made by PBC officials to the effect that the renminbi exchange rates would be unified within five years. However, there was no observable convergence of swap rates among the different centers in 1993, and arbitraging the differences remained difficult or impossible despite the regulations intended to facilitate this.

Reform Plans and Reforms Since 1993

Reform Plans

In March 1993, the State Council decided that the SAEC should function under the leadership of the PBC. As a result, the SAEC no longer reports directly to the State Council but through the PBC. The potential for conflicting or overlapping functions and measures in foreign exchange matters between these two bodies has thus been reduced.

The major concern of the Chinese authorities continued to be the divergence of rates among the different swap centers and the difficulty of arbitraging these divergences. The answer to this problem was therefore seen as the integration of the regional markets into one national foreign exchange market. With this integration, the difference between the official and swap exchange rates would be reduced, and exchange rates would be unified within five years. After the unification of the exchange rates, the PBC would establish a central target or reference rate. The SAEC would intervene, when necessary, to keep the market rate within a predetermined range in relation to the reference rate.

Box 8.Trading Arrangements in Swap Centers

The regulations governing the operation of Foreign Exchange Adjustment Centers (FEACs) were determined by local branches of the State Administration for Exchange Control (SAEC) and varied from one center to another. Typically, a transactor in the swap center needed the approval of the local branch of the SAEC organizing the center. This approval was granted automatically to members of the exchange. An agent who wished to trade in an FEAC other than the local designated center needed the approval of the SAEC that organized the local center; the Shanghai SAEC, however, granted this approval automatically. Quota accounts that were traded in FEACs had to be held with the local SAEC organizing the center. Therefore, sellers of quota accounts from outside the local area had to transfer their quota accounts in advance to the SAEC organizing the center.

A swap center would typically be used by brokers, jobbers, and dealers. However, depending on the location of the center, their functions could be different.

Brokers were financial institutions authorized to deal in foreign exchange by the SAEC. The brokers acted only as agents and were not permitted to transact for their own accounts.

Jobbers were foreign trade and joint-venture companies with large volumes and frequent exchange transactions. In some centers, they were known as dealers. These jobbers/dealers were allowed only to trade for their own accounts.

In a special arrangement, 46 dealers represented local FEACs in the National Foreign Exchange Adjustment Center (NFEAC) in Beijing. These dealers traded only on behalf of the local FEACs and not on behalf of specific customers. The dealers could also send their orders to the NFEAC through brokers. The 46 FEACs covered all provinces and important cities; other FEACs could send orders indirectly to the NFEAC by passing their orders to one of the 46 FEACs represented on the NFEAC. The purpose of this arrangement was to create a channel for redistributing funds among centers; as a practical matter, however, it was rarely utilized.

A fixed commission of 0.15 percent was paid on each transaction by both buyers and sellers in both exchanges. Part of this amount (one third in the case of the NFEAC) was returned to the brokers, and members charged no additional fees to their customers. Trading hours varied but were usually in the morning. In the more active centers, trading hours were eventually extended until the end of the day.

The integration of regional markets was needed to achieve two goals. First, the flow and allocation of foreign exchange funds among regions was to be promoted through the market mechanism. Second, in order for the authorities to be able to intervene effectively in exchange markets, there should be a single observable exchange rate in the market, as intervention is very difficult when centers’ rates diverge.

To achieve this integration of markets, all regional swap markets were to be amalgamated into a single center, located in Shanghai. This city was seen as the natural center, as it was at the leading edge of economic and financial development in China and the authorities foresaw that it eventually would evolve into an international financial center. The organization that was to handle this single market was to be called the China Foreign Exchange Trade System (CFETS). The regional swap markets would be branches of Shanghai’s swap center. The SAEC headquarters in Beijing would set the operational rules for the market and advise on policy, while market interventions would take place in Shanghai. This plan was developed by the SAEC and approved by the PBC. As the old telecommunications infrastructure in China would not have been able to accommodate this kind of arrangement, it was envisaged that the regional swap centers would be linked to the market in Shanghai via satellite. The satellite network would be used for quotations, information, and renminbi settlements.

The market would continue to be based on the electronic trading system already employed by the more advanced swap centers, in which priority in transactions is given to price and time. In these centers, as explained above in footnote 58, a higher buying price has preference over a lower one, and a lower selling price over a higher one. Earlier price quotations have preference over later ones. In the envisaged integrated system, bids and offers would be submitted only to the Shanghai market, and local dealing would be neither permitted nor possible. Buyers and sellers in centers outside Shanghai would be linked electronically online to the Shanghai market. Information about rates and transactions would be fed back to the regional centers, where buyers and sellers would have the same information as if they were physically present in Shanghai. There would be no control in the system over deals between licensed participants, and deals could be struck between counterparts in different parts of the country.

To minimize interregional settlement flows, each regional center would at settlement first net the renminbi leg of all transactions at a given price for that region. The net outstanding at that price level would then be settled with the Shanghai center, which would become a counterpart to each transaction and the clearing center for the market. To protect the Shanghai center from the risk of settlement failures, foreign exchange funds to be sold would be credited to the center’s foreign exchange account before being offered for sale on the market.

Only the Shanghai center would hold accounts abroad. All payments of foreign exchange to and from customers’ foreign accounts would be effected through the Shanghai center’s foreign accounts. The satellite network would be used only to carry information to domestic buyers and sellers about foreign exchange payments, while actual settlement would take place through transfers between foreign accounts. The Shanghai center’s foreign accounts would legally be part of the PBC’s balance sheet. Renminbi settlements and transfers of quotas were to take place over the satellite network.

The integration of the regional markets was to be implemented in three stages. First, 18 swap centers that already employed the electronic trading system would be linked to the Shanghai center by June 1994. These centers covered some 70 percent of the total swap market. The communications and computer system for operating the Shanghai exchange would have a parallel backup system in Shanghai, as well as a second backup in Beijing. Second, an additional 18 centers would be linked to Shanghai by the end of 1994. It was envisaged that by that time all major provinces, municipalities, and economic zones would be connected to the market. Third, another 34 centers would be added by June 1995, after which 70 centers, accounting for 95 percent of transactions, would be connected to the market, effectively creating a single national exchange market.

No transactions were to be permitted outside the swap centers, although such a rule might not be fully enforceable. Trading would initially take place in both cash and quotas, although it was foreseen that quotas would soon be phased out. Forward transactions would also be developed. Banks would in the future be permitted to deal for their own accounts.

Implementation

As it turned out, progress on these issues was much faster than had been foreseen only six months earlier. On January 1, 1994, the official and swap market exchange rates were unified at the prevailing swap market exchange rate; the issuance of retention quotas was terminated, and it was decreed that outstanding quotas could be converted at the end-1993 official rate until the end of 1994; the priority lists that governed the provision of foreign exchange and regulated market access were abolished; and the requirement to obtain prior approval from the SAEC for the purchase of foreign exchange for most trade and trade-related transactions conducted by domestic enterprises was rescinded. On April 1, 1994, the CFETS became operational, creating an integrated system of foreign exchange trading centralized in Shanghai. The system is fully computerized, and all 24 major regional trading centers have been linked to the center through satellite and land-based connections. The CFETS offers, as planned, trading and settlement services to its members, which comprise domestic banks (both head offices and branches can be members), foreign banks, and a number of non-bank financial institutions (NBFIs). Trading is primarily conducted in renminbi against the U.S. dollar, although the renminbi is also traded against the Hong Kong dollar and—more recently—the Japanese yen. The 24 regional trading centers (including Shanghai) represent 90 percent of foreign currency trading in China. The CFETS represents the wholesale part of the foreign exchange market in China. It can be regarded as an interbank market in the sense that most of the participants are banks, although they do not trade directly with each other as in a conventional interbank market.

Trading is fully computerized and carried out through computer terminals connected to the CFETS in the regional centers. Members have no trading facilities in their own offices.59 Once a bid and an offer have been matched, the CFETS becomes the counterpart to the trade and assumes responsibility for settlement. Buyers and sellers thus do not know with whom their bids or offers were originally matched.60 Settlement takes place on the following business day. The CFETS (essentially, the PBC), by assuming responsibility for settlement, also assumes the credit risk of each transaction. So far, there have been only short delays—at most of a few days—in settlements, owing to human errors or technical problems. For the purpose of enforcing proper settlement procedures, the SAEC has the authority to impose penalties on members that fail to meet their payment commitments, and, in serious cases, the SAEC may terminate membership. No funds have been set aside to cover the potential losses associated with possible payment defaults.

Turnover in the CFETS market has averaged over $200 million a day. Although many domestic and foreign financial institutions, including the specialized banks, about 10 provincial banks, more than 100 foreign banks, and about 300 NBFIs, are authorized to deal in foreign exchange, the market is nonetheless dominated by one single bank, the BOC. By virtue of its size, and because only two of its branches have dealing rights, the BOC internally nets a large number of transactions that thus never enter the market.

Foreign exchange transactions conducted through centers not linked to the CFETS use the reference rate of the previous day, with no margins applied. The local SAEC branch stands ready to absorb excess supply or demand at the reference rate while covering itself through the CFETS.

Current regulations do not prohibit forward transactions involving the renminbi and the U.S. dollar, but no forward trading involving these two currencies has taken place so far. This lack of activity may be due to the remarkable stability of the exchange rate, which has steadily appreciated by some 3 percent since late 1994. Earlier, also, there was no domestic money market to help banks determine their marginal cost of domestic funds. The recently emerging domestic interbank market may support the hedging of forward operations; it is not clear, however, whether banks would be free to engage in hedging operations in foreign money markets.

The Present Exchange System

Domestic and Foreign-Funded Enterprises (FFEs)

Domestic enterprises are required to conduct their sales and purchases of foreign currency through authorized financial institutions. The exchange rates used by the banks for purchases and sales of foreign currencies have to be within a maximum spread of ±0.25 percent of the previous day’s reference exchange rate, as published by the PBC (the weighted average of the previous day’s CFETS transactions). Thus, domestic enterprises cannot buy or sell foreign exchange at that day’s current market exchange rates. Exchange controls for bona fide current transactions are delegated to the banks, and purchases of foreign exchange by domestic enterprises require no prior approvals from the SAEC; banks verify the nature of the transactions on the basis of documents provided by the enterprises.

FFEs are allowed to retain up to 100 percent of their foreign currency receipts without time limit on foreign currency accounts with banks in China. They may also purchase or sell foreign exchange directly from the CFETS and are thus able to deal at current market exchange rates. These enterprises may also, if they choose to do so, deal through banks and receive treatment identical to domestic enterprises. Earlier, FFEs had to apply for approval of each transaction; however, this rule was simplified in 1995, and FFEs need only submit an annual foreign exchange plan. Within the scope of this plan (once it has been approved by the authorities), FFEs are free to enter the foreign exchange market.

Domestic enterprises are charged up to a 0.25 percent spread for foreign exchange purchases from banks, while FFEs pay only a 0.15 percent fee for their transactions through the CFETS. The settlement period is also different for domestic enterprises and FFEs. When transactions are conducted through the retail market (with banks), settlement takes place on the same day, while transactions of FFEs through the CFETS are settled on the following business day.

Domestic and Foreign Banks

In China’s foreign exchange market, different regulations also apply to domestic and foreign banks. Domestic banks may both buy and sell foreign exchange for their customers, but foreign banks may only sell foreign currencies against the renminbi in the CFETS market (these banks’ renminbi accounts are maintained with the PBC). However, this limitation does not apply to transactions of foreign banks on behalf of FFEs. Foreign banks are not allowed to operate in the domestic money market.

The cost of transacting in the CFETS market depends on the nature of the foreign currency transaction. When a designated bank buys or sells foreign exchange in the market for its own account, the bank is charged a 0.03 percent commission, while transactions on behalf of customers are charged a 0.15 percent commission. Two thirds of the revenue from such a commission goes to the CFETS, and one third to the bank.

The wholesale market does not provide for direct dealing between banks, and market making—two-way quotations to other dealers—is presently not possible. Transactions between the CFETS and banks (wholesale market) are settled differently than transactions between bank customers (the retail market). While wholesale market transactions are settled on the next business day, retail market transactions are settled on the same day. Because of this unusual feature, retail transactions have a shorter settlement period than wholesale transactions. Banks therefore cannot cover their retail transactions in the wholesale market on the same day, which is the way that markets normally function. This difference in settlement practices also makes efficient position and risk management in banks difficult. Banks have to hold liquid funds idle to meet the unforeseen contingencies arising from retail transactions, which effectively forces them to assume a foreign exchange risk position. In addition, foreign banks are limited to performing foreign exchange transactions for the accounts of FFEs, which usually are sellers in the market.

Domestic banks are required to hold a minimum amount of liquid foreign exchange assets to ensure that they have adequate liquidity to meet their obligations in foreign currencies. Banks have to cover any shortfalls in these funds on the next day; however, if foreign exchange holdings exceed the limit, banks are supposed to sell the excess in the CFETS market. The liquidity limit does not apply to foreign banks and NBFIs. There are no other limits that regulate the foreign exchange positions of these institutions.

Interventions by the PBC

The PBC is committed to maintaining a stable exchange rate in the foreign exchange market through interventions in the CFETS aimed at containing the appreciation of the exchange rate. The interventions, which are carried out in Shanghai, are triggered by deviations of the exchange rate of the renminbi against the U.S. dollar in the CFETS market during trading hours (a ±0.3 percent day-to-day fluctuation margin is allowed).61 The need for interventions in the foreign exchange market during the following day is estimated on the basis of information about banks’ purchases and sales of foreign exchange in customer transactions. Because the PBC is an ordinary member of the CFETS, other market participants do not know when the central bank is active in the market.

Prudential Regulation

Effective July 1, 1993, instructions were issued by the SAEC to banks and NBFIs on licensing, capital requirements, operational and control practices, and risk limits in foreign exchange operations. These regulations are based on old accounting concepts that require a complete separation of renminbi and foreign exchange capital and business. Therefore, while they oblige banks to follow prudent operational and control procedures, they are not applicable to risk management in an environment in which banks adopt international accounting practices. Neither can they be applied to foreign banks in China, if and when these are authorized to engage in renminbi operations. In the present environment, therefore, banks are subject to unmonitored exchange rate risks.

Current regulations provide for licensing of foreign exchange operations, general prudential regulation, including onsite inspections by the SAEC of banks’ and NBFIs’ foreign-currency-denominated assets and liabilities, and reporting to the SAEC. Under these regulations, which cover Chinese financial institutions’ foreign currency operations only in China, foreign exchange business and transactions are treated almost as if they were performed by separate institutions. Foreign-owned financial institutions’ operations in China, as well as Chinese financial institutions’ branches and subsidiaries abroad, are regulated by the PBC.

Although all the regulations entered into force as of July 1, 1993, they have been implemented only gradually. This situation could create problems if a legal dispute about the status and enforceability of the regulations were to arise. Taken together, however, the regulations represent a major step toward introducing modern prudential regulatory principles into Chinese banking, even though the regulations unfortunately cover only foreign exchange operations. The one critical element lacking in these regulations is a limitation of exposure to exchange rate risk.

Under the regulations, a bank’s foreign exchange business must be completely separated from its domestic currency business, it must have capital in foreign exchange, and it must comply with prudential rules based on its foreign-currency-denominated assets and liabilities only. Profits and risks are also measured in foreign currency, usually U.S. dollars. The SAEC regulations apply only to Chinese-owned institutions operating in China. Foreign financial institutions in China are jointly supervised by the PBC and the authorities of the home country. Branches of Chinese financial institutions established outside the country are regulated by the PBC, while the foreign exchange activities of the head office and domestic branches of these institutions are regulated by the SAEC. Close cooperation between the two supervisory institutions is therefore required.

The status of bank branches has also in a broader sense been an important element in the evolution of the financial system in China. As pointed out in Section III, branches of financial institutions used to enjoy such a high level of autonomy that, although they appeared to be slightly less independent than fully owned subsidiaries, they did not easily fit the definition of bank branches as understood in industrial countries. The new commercial banking law should normalize that situation.

Under the new regulations, capital denominated and paid up in foreign exchange is required before any financial institution can engage in foreign exchange transactions. This requirement establishes a minimum capital base, which will expand subsequently in two ways. First, a mandatory reserve has to be built up with the after-tax profit. At least 50 percent of this profit must be set aside until the total of capital and reserves equals three times the minimum capital. Even after this requirement has been met, at least 10 percent of the profit must still be set aside in the reserve, which may subsequently be incorporated into the capital. Second, capital is built up through a prudential ratio in the regulations requiring the foreign capital base to be equal to at least 8 percent of foreign currency assets. The foreign exchange capital may be denominated and paid in any foreign currency, but the minimum required is expressed in U.S. dollars.

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