More Flexibility in the Foreign Exchange Market
Regulatory authorities have taken new steps to enhance the flexibility of the foreign exchange market and boost risk management at financial organizations. The most recent measure raises the lower limit on general foreign exchange market positions. While there is no fixed limit for the market as a whole,the State Administration of Foreign Exchange sets position limits based on each bank's own trading record as well as foreign exchange payments and receipts data. If,for example,there is an upper limit of US$1 billion and a lower limit of negative US$1 billion - there are in fact limits of long or short positions of $1 billion.
The move followed an increase in the upper and lower limits of such positions in foreign exchange settlement and sales in early 2015.
An official of the State Administration of Foreign Exchange said the expansion of the upper and lower limits in foreign exchange settlement and sales will enhance the market's "self-adjusting" capacity. It will accelerate the formation of a market which can determine prices,adjust for risk and find equilibrium levels. In so doing,it can help provide better financial services for corporates and other entities to guard against exchange rate risks.
Additionally,a method of what is called balance settlement for forward foreign exchange settlements and sales has been put in place. This has been added to full-amount settlement and the two are transaction mechanisms for market entities to manage cash flows in foreign currencies and exchange rate risk.
How should we view these developments? What effects will they have on foreign exchange trading and how are banks dealing with these changes. In order to answer these and other questions about foreign exchange market developments,China Forex interviewed Wang Ziming,exchange managing director with the Capital Market Division of the Bank of Montreal,and Li Liuyang,chief financial market analyst with Bank of Tokyo-Mitsubishi UFJ (China),Ltd.
China Forex: According to some estimates,the adjustment of the lower limit on general positions in foreign exchange settlements will add some US$100 billion to the foreign exchange market. What impact do you think this change will have on the market itself and the operations of participating banks?
Wang Ziming: The lower limit on general positions in foreign exchange settlements has been adjusted several times and by large margins,giving banks much more room to control risk. However,this kind of risk management should be based on the banks' own risk authorization. As authorities have pointed out,banks need to strictly abide by various management provisions of the financial management organizations,and effectively control risks in dealing in renminbi and other currencies. For banks,risk control and management in general positions in foreign exchange settlement and sales are a new subject requiring their attention.
Li Liuyang: The significance of expanding the lower limit on general positions in foreign exchange settlements lies in the increased autonomy for banks in managing foreign exchange risk and maintaining positions. Before the move,banks had to square their positions from clients in the foreign exchange market the same day. This meant that if market liquidity was tight,enforced squaring might create abnormal fluctuations in the exchange rate,and the bank could suffer losses. After the change,commercial banks were permitted to choose to square positions in accordance with their own profits or losses. The requirement for controlling risk,not only avoids abnormal fluctuations,but also provides a cushion for supply and demand in the foreign exchange market. Moreover,this can also increase the autonomy of commercial banks in managing the positions of their clients,and it could encourage banks to participate more actively in the market.
Aside from the convenience in position management,the increased lower limit on general positions in foreign exchange settlements also means commercial banks can hold more overnight positions. This way the supply and demand of the market can be stabilized and there will be fewer abnormal swings in the market.
China Forex: For the first time in the domestic market,banks can use the balance settlement method on forward foreign exchange settlement (and sales) for institutional clients. How does this work and what will be the effect of this change?
Wang: Balance settlement of forward foreign exchange settlements is settlement and clearing in accordance with the offset balance between the agreed forward exchange rate and the actual traded exchange rate,without settlement of the principal in the forward contract. In this way,clients can hedge exchange risks through forward settlement without using their principal. For clients,this allows them to hedge their exchange risks,and also hold onto their foreign exchange capital. From a macro view,this will be conducive to what is called "hiding foreign exchange reserves among the people," or shifting reserves from the central bank to private entities,so that clients can hold more foreign exchange while hedging risks.
As for balance settlement of forward foreign exchange settlements,how to choose a reference exchange rate is a topic that needs to be examined. In the offshore non-deliverable forwards market,the renminbi mid-rate is the reference price. However,clients and banks tend to apply the market price as the reference to settle exchange rate in domestic balanced settlements on forward contracts. At present,referring to the methods used for forward rates,the China Foreign Exchange Trade System applies four reference market prices at 10:00 am,11:00 am,14:00 hrs,and 15:00 hrs respectively. Clients can choose. Comparing the mid-rate with the market price,I believe the latter is more practical as a reference price,because it is a deliverable price. It can be applied by banks to their hedging positions. On the other hand,although the mid-rate is an important measure of the renminbi trend,there