On Friday, China's central bank, the People's Bank of China (PBOC) executed an inaugural foreign currency swap with ten of the country's domestic banks, including the four state-owned commercial banks that dominate the banking system, and a number of policy banks. Under the terms of the $6 billion deal, which is to be repeated on a fortnightly basis, the Chinese central bank sells the dollars at the prevalent spot rate to the domestic banks, which will swap the dollars back into Rmb in 12 months time, at a rate set at Rmb 7.85 to the dollar.
This rate compares to a spot rate of 8.0805 and a non-deliverable forward rate (used by offshore investors to hedge their Yuan positions) of 7.76 before the announcement and 7.78 after the announcement. The swap rate, which is 2.86% lower than the spot rate to the dollar, is being closely watched as an indicator of the government's intentions regarding the currency.
This follows the currency reforms in July, which saw the government shift from the Rmb-dollar peg to tying the Rmb within a narrow band to a basket of major currencies. Opinion is split as to whether the swap rate indicates the setting of a floor or of a ceiling to the currency's future movements.
The NDF rate rose to 7.78 after the announcement, with some traders saying this reflects sentiment that the central bank is guiding expectations towards only a mild revaluation of the dollar by year-end. But one trader says that the narrowing of the NDF rate over the onshore rate was because the swap deal provides an obvious arbitrage to banks, since the price at which they can buy dollars offshore is lower than the rate at which they have to sell back to the central bank. It was this realization that caused the spike in the offshore rate, because the markets are not very liquid.
Others argue the rate should be seen as an indicator of further likely strengthening (ie as a floor), and possibly also as a way of providing some yield to the Chinese banks. China's banks are being squeezed by deposit rates of around 2.25%, compared to money market rates, which are just over 1.5%.
Money market rates are so low because of the liquidity caused by the large forex inflows. Frank Gong, JPMorgan's China economist, who foresees the Rmb strengthening by 13% by the end of 2006, adds that although the central bank will lose money on the swap the more the currency appreciates, this does not rule out that the Rmb will be allowed to strengthen.
"The central bank has $800 billion in foreign reserves, so it will take a loss whatever happens. For the central bank, strengthening the banks is a policy not a commercial issue," he says.
Claudio Piron, JPMorgan's Asia FX strategist says he believes the significance of the deal is that it provides another way for the central bank to manage liquidity. "The central bank has withdrawn Rmb out of the system via the swap, so this is an alternative to issuing more bills and further driving down interest rates," he notes.
As to whether or not the 7.85 level set for the deal indicates the potential for further revaluation, Piron takes the view that the level was chosen precisely to prevent further speculation; indeed, possibly even to set a benchmark for the currency in the absence of reliable interest rate indicators on the mainland.
"The difference between the swap rate to the spot rate (2.86%) is roughly the same as the difference between Chinese interest rates and US interest rates. So a speculator would not gain anything by betting on the Rmb," he says.
Observers agree that in any case the swap is an important step in the liberalization of China's capital account. Thanks to the existing currency arrangement, Chinese companies are not exposed to much currency risk, since the Rmb only fluctuates in a narrow band against a basket of currencies. The downside of this arrangement is that foreign governments, especially in the US, view the level at which the Rmb trades against them as being too low, thereby creating large trade and current account deficits with China.
The Chinese government has been under intense political pressure recently to either sharply revalue the currency and/or to allow market forces a greater say in the level at which it trades. If China is to allow market forces a greater say, it needs to introduce the appropriate tools to its companies and banks for hedging foreign currency risk. On Thursday evening, the central bank also announced that it was looking to set up a market making system in dollar-Rmb trading, indicating that it is actively setting up the infrastructure for forex trading.
"The authorities did this deal in order to nurture the swap market by providing liquidity; it's a matter of teaching them how to do it for when the currency becomes more flexible," says Andy Xie, China economist at Morgan Stanley, adding that the Chinese banks will not be permitted to simply swap the dollars back into Rmb. In developed markets such deals do not normally involve the central bank.
Typically, an exporting company might do a deal with an importing company since one receives dollars while the spends dollars. Both parties will take their own positions on the future of the currency, while in China everybody takes their lead from the government.
JPMorgan's Gong points out that the FX exposure of the Chinese four state-owned commercial banks especially needs hedging. Most of their tier 1 capital is in US dollars, from the total of $60 billion taken from China's foreign exchange reserves and injected into the banking system by the government over the past two years.
"Once the financial infrastructure is ready for the banks to hedge their positions, and the banks can effectively manage their interest rate risk, there will be no fundamental roadblock for the CNY to appreciate further," Gong concludes.