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Louis Beckerling

Foreign banks operating in the mainland this week began offering yuan forward contracts to their corporate customers in China following the latest relaxation of currency controls by the People's Bank of China (PBOC).

The new service will for the first time allow businesses incorporated in the mainland to insure themselves with foreign banks operating in China against the risk of volatility in the yuan's exchange value and follows naturally on from the July 21 introduction of a wider trading band for the yuan.

Another small step, therefore, on the great (and long) march to a freely floating currency.

But don't expect that destination to be reached any time soon, bankers observe.

If anything, the sedate and measured pace at which the PBOC is proceeding should reinforce what ought to have been clear to its critics from the start, namely that it will set the agenda for change and err on the side of caution rather than rush into changes to its currency regime at the behest of impatient trading partners.

Thus, this week's move, as with the July 21 announcement, does more in the way of signal a willingness to countenance change, than actually deliver it.

In theory, the introduction in July of a managed float for the yuan (ostensibly now tied to shifts in the exchange rates of the currencies of its major trading partners) raised the prospect of currency volatility, which, again in theory, may be hedged by the onshore forward contracts permitted to China-incorporated businesses.

In practice, however, the exchange rate of the yuan has so far barely budged since its one-off 2.1 per cent appreciation triggered by the July move.

And although a number of foreign banks have already begun actively quoting forward rates, trading is thin and likely to remain that way until corporate customers feel a real need to hedge, say bankers.

The first tentative sign of things to come was reported this week by HSBC, however, which said it concluded its first hedging contract with a corporate customer yesterday and expected more to follow.

Bankers are not being drawn into speculating on the size of the market once it becomes fully functional, but broad-brush parameters may be drawn beginning with export receipts, which may be annualised from January to August data at about US$700 billion, and existing US dollar-yuan turnover through the official trading platform in the mainland of about  US$200 billion (excluding trades matched by banks).

The data suggests annual volumes for forex  forward contracts of about  US$50 billion.

A by-product of this week's developments, however, is the prospect that banks that take up the opportunity of providing those somewhat nominal forex forward contracts now may apply to the PBOC to begin offering forex swaps after six months or so, according to the PBOC.

Unlike a forex forward contract, which is essentially an agreement to exchange a currency pair in the future at an exchange rate fixed now, a forex swap involves transacting at an agreed rate in the future as well as a spot rate today.

The nature of the swap, therefore, requires the writer of the contract to link the price of the deal to the interest rates on the two currencies and, in the case of yuan rates, this presents an intriguing scenario of relating the much lower prevailing market rates, on say US dollar borrowings, to the higher administered rate on yuan borrowings. (At present, for instance, three-month US Libor is about 4 per cent, versus 5.22 per cent for yuan loans of the same tenor.)

Does that mean a China corporate may borrow in US dollars and save on interest bills by the arbitrage opportunity presented once swaps are allowed? (It would be shades of the practice in Thailand that eventually triggered a run on the baht and the ensuing 1997-98 Asian financial crisis.)

Unlikely, say bankers, as the PBOC will be alive to this prospect and deal with it pre-emptively - most likely by way of putting limits on the amount of spot yuan involved in the swap.

Once again, an advance in theory but carefully contained in practice.



Latest currency relaxation another advance ... in theory