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    The Chinese Yuan: Internationalization and Financial Products in China
    The Chinese Yuan: Internationalization and Financial Products in China
    The Chinese Yuan: Internationalization and Financial Products in China
    Ebook511 pages5 hours

    The Chinese Yuan: Internationalization and Financial Products in China

    By Peter G. Zhang and Thomas Chan

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    About this ebook

    Few topics have attracted as much attention worldwide in recent years as the RMB. These debates have gained added urgency in light of the financial crisis and the topic of RMB revaluation is now being actively debated in countries all over the world from Tunisia to the United States. This book explores the ever-changing role of the RMB and the related derivative products. However, it does so from a view that is heavily influenced by the fallout from the financial crisis as well as the in the context of the increasing maturity of the Chinese capital markets. The author has drawn on his experience as a regulator to provide invaluable views, insights and information on RMB derivative products and the development of this market going forward.

    Key topics include:

    • Overview of current China economy and its capital market
    • In-depth analysis on the China's banking system and foreign exchange system
    • Extensive analysis of on-shore and off-shore financial products in China
    • Explanation of the needs and reasons for RMB products innovation
    • Insights into the internationalization of the RMB

    Not only will this book leave its readers with a much clearer idea of the structure of China's capital markets but it also gives insights on the market going forward leveraged through Peter Zhang's many years of experience as both a senior banker and through his integral role in the key regulatory authority of the banking sector, the CBRC.

    LanguageEnglish
    PublisherWiley
    Release dateFeb 15, 2011
    ISBN9780470827406
    The Chinese Yuan: Internationalization and Financial Products in China

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      The Chinese Yuan - Peter G. Zhang

      Foreword

      The emergence of China as a leading exporter and factory to the world was arguably the most significant development of the late 20th and early 21st century. By opening the country to outside investment, and unleashing the potential of China's own entrepreneurs and state-owned enterprises, China's government has been able to achieve in thirty years what many developed countries have achieved over centuries.

      China's impressive economic achievements derived from the reforms of the 1980s and 1990s, were accompanied by government's management of the Chinese yuan (CNY) exchange rate and the country's capital account. As a consequence, the rapid growth of the export driven economy, has been accompanied by the United States trade deficit with China increasing from just US$6 million in 1985 to US$173 billion for the first six months of 2010.¹ Over this period, the exchange rate to the US dollar has gradually been adjusted from CNY1.50 in 1980 to CNY8.62 by 1994, favoring China's exporters, although more recently it has appreciated to CNY6.66. While in 2005 the peg to the US dollar was replaced by a market floating exchange rate referenced to a basket of foreign currencies, the peg was reintroduced in 2008 in response to the worsening global financial crisis. In June 2010, the CNY was allowed once again to float within a basket of foreign currencies but the boundaries remain tight, with its value significantly below the expectation of western countries.

      Despite these measures, the CNY has undoubtedly started down the path of internationalization. Recent steps include the setting up of a number of bilateral currency swap agreements which allow certain countries and areas, including Argentina, Belarus, Indonesia, Malaysia, South Korea and Hong Kong to exchange substantial amounts of their own currency into CNY at times when they are under strong selling pressure in the international markets. Another step towards internationalization are the pilot schemes for cross border trade financing which allow manufacturers and importers based in southern China to settle their cross border transactions in CNY. This step is important because it allows the manufacturers to transfer their foreign exchange risk to their overseas customers. Meanwhile, Hong Kong has been established as a test center for capital markets activities in CNY through the issue of CNY denominated securities by certain banks in Hong Kong, and China's agreement with the IMF in 2009 that China may use CNY to purchase special drawing rights. All the above arrangements have strengthened the influence of CNY internationally.

      While the above steps represent significant progress, there remains a significant length of road to be traveled before the yuan can be called a truly international currency. There are a number of reasons why China's government has not allowed the CNY to float freely and appreciate rapidly. One of the most important is the impact which any significant appreciation in the yuan would have on the already fragile export market which is still suffering from a combination of increasing labor and production costs, and weakened consumer sentiment in the developed west. Over the past few months, the calls for China to make further currency reforms have become even louder. There are also voices from within China who see appreciation of the CNY as being necessary to take some of the pressure off the asset bubbles which are becoming apparent in many areas of the economy, and in particular the property market.

      The arguments and counter-arguments concerning the respective merits of relaxing China's currency and capital account controls will be familiar to anyone who has opened a newspaper or watched a financial news program in the past 10 years. However, in analyzing the current role and performance of CNY dominated products in financial markets in China and overseas, the authors of this book have focused on the lesser-discussed aspects of this debate. Namely that while the years of government's management over the CNY have undoubtedly played an important role in China's recent economic successes, they have also contributed to the relatively underdeveloped state of China's financial markets. If China is to further liberalize its foreign currency markets, and allow the CNY to become an international currency, then it must as a matter of urgency improve the liquidity of CNY denominated financial instruments, and promote further innovation in CNY denominated financial products. With a broader range of CNY denominated financial products, Chinese companies and overseas investors will be able to more effectively control the increased risks which would arise from a relaxation of the controls over China's capital account and the exchange rate. Such innovation will also further support the government's stated strategy of establishing Shanghai as an international financial centre. Financial institutions in Shanghai will also be able to compete more effectively with their counterparts in New York or London.

      By providing readers with such an informative overview of the developments in China's financial markets to date, this book highlights the work which still needs to be done, and in doing so provides an effective roadmap for the future direction which further development of CNY-denominated financial products is likely to take.

      Simon Gleave

      Regional Head of Financial Services, KPMG ASPAC

      Head of Financial Services, KPMG China

      Endnote

      1. US Census Bureau Foreign Trade Statistics.

      Preface

      The Seventeenth Central Committee of the Communist Party of China (CPC), held in October 2007, called for the whole party and people of all ethnic groups to vigorously enhance the spirit of reform and innovation, thoroughly pursue rational development, improve the capability of independent innovation, and build an innovative country. The report of the Seventeenth CPC Central Committee pointed out that China should stick to the road of independent innovation with Chinese characteristics, and carry out independent innovation in various aspects of modernization. The report clearly requires the financial sector to sharpen the competitiveness of the banking, securities, and insurance industries.

      Sharpening the competitiveness of the financial sector is, in effect, increasing its innovative capabilities. China's economy has recorded remarkable achievements in 30 years of reform and opening-up, with its innovative capability being further enhanced each year. Though the pace of economic and financial globalization has been affected to varying degrees by the international financial crisis, the wheel will continue to move forward. Given the increasingly international status of its economy, China should look to identify gaps and areas for improvement in its current performance, comparing this both with its own historical achievements and with the performance of developed and developing countries.

      With the steady growth of China's economy and its higher global ranking, Chinese companies will gradually accelerate their expansion overseas and foreign enterprises will increase their investments in China. This will result in foreign currency business accounting for a higher proportion of China's financial sector. However, as the vast majority of the assets of Chinese financial institutions will still be denominated in Chinese yuan (CNY), the key to financial innovation in Chinese institutions in the foreseeable future will lie in innovating CNY products. With gradual progress in the internationalization of the CNY, demand for innovative CNY products from both Chinese and foreign investors will continue to increase. Financial innovation is all about innovative ideas, mechanisms, and risk management. Nevertheless, the performance and profitability of financial institutions depends on products and services; so financial innovation is, in effect, product innovation. Therefore, creating innovative CNY products is the key to China's financial innovation.

      China made tremendous progress in its economic development in the 30 years from 1978, when the reform and opening-up program began, recording an average annual real GDP growth rate of almost 10 percent. Even in 2009, when the world economy was in the grip of the global financial crisis, it achieved 8.7 percent growth, reflecting the effectiveness and timeliness of the various measures it had taken to combat the worst effects of the crisis.

      Besides the great achievements in economic development, China has also made good progress in developing its financial market in the past decade or so, particularly in the inter-bank marketplace, with more and more new products. The first new business in the banking industry was the foreign exchange forward settlement, launched in April 1997, after the People's Bank of China issued The Tentative Administrative Methods for Renminbi (CNY) Forward Settlement in January that year. CNY bond forwards, foreign exchange forward trading, foreign exchange swaps, interest rate swaps, and forward rate agreements were introduced in the inter-bank marketplace consecutively from 2005. These new products have developed reasonably well in the past few years, providing market participants with instruments to hedge foreign exchange and interest rate risk.

      Despite good progress in product innovation and market development in the financial market, financial futures are still absent from the organized exchanges, and options are absent from both exchanges and the inter-bank marketplace in mainland China. Although the above-mentioned over-the-counter (OTC) products have come into play in the past few years, market liquidity has been rather low, with international weights much lower than the corresponding GDP global weight for each of these products. Risk management cannot be practiced satisfactorily without there being sufficient liquidity for these instruments.

      Further, the financial market cannot serve the underlying economy well enough without sufficient development. For example, promotion of the CNY to settle international trade is highly necessary, and the experimental implementation of settlement in 2009 was very timely. Yet, the fact that settlement volume has not been significantly high implies that market foundations, such as CNY foreign exchange risk management, have to be strengthened. Thus, CNY foreign exchange forward and swaps markets need sufficient liquidity for market participants to hedge the related foreign exchange risk.

      The financial crisis has taught us many lessons since September 2008. Financial derivative products have been widely blamed for having caused the crisis, or at least made it worse. However, we have not seen any serious problems with any derivatives trading in any organized exchanges or most OTC derivatives (other than credit default swaps) worldwide, despite moderate declines in trading values of futures and options trading worldwide from the second half of 2008 and 2009. Futures and options trading in exchanges and most OTC derivative products have well-defined functions in the financial system and the whole economy, so that the underlying economy cannot do well without the necessary financial products and sufficient market liquidity for these products. China has achieved tremendous economic development in the last three decades and has developed its financial markets significantly. Yet many necessary financial products are still absent from the market and the liquidity of most existing segments of the financial market is relatively low. It is highly necessary for China to accelerate the development of its financial market in order to serve its economy better.

      While there have been many studies on different aspects of the Chinese economy, there are comparatively few on the current conditions of the financial market, particularly on the specific status of major components of the inter-bank market. The purpose of this book is to provide readers with a detailed description and analysis of the current status of Chinese financial markets, products, liquidities, and potential problems.

      The book is divided into four parts. Part OneI provides an introduction to the Chinese economy and financial markets, covering such aspects as the macroeconomy; the banking industry, and corresponding regulatory bodies; the capital market and corresponding regulatory bodies; and the foreign exchange system and China's international investment positions. Part TwoII introduces the major components of China's inter-bank market; the foreign exchange forward, and swaps markets; the CNY bond forward and interest rate swaps markets; forward rate agreements; and wealth management and other OTC products.

      Part ThreeIII covers offshore CNY products, principally those being traded in the Hong Kong Special Administrative Region. These include CNY non-deliverable foreign exchange forwards, CNY non-deliverable options, non-deliverable foreign exchange swaps, and non-deliverable CNY interest rate swaps. It also introduces H-share stock index futures and CNY bonds in Hong Kong.

      In Part FourIV, we explore CNY product innovation and market development in line with the increasing internationalization of the CNY in the coming decades. We analyze major international currencies and their major markets, and examine the current status of the internationalization process and the need for risk management. In the final chapter, we round things off by looking at the potential development trends for major CNY derivatives markets that will accompany the gradual internationalization of the CNY over the coming decade.

      In April 2009, the Chinese State Council released an important set of guidelines to accelerate its stated intention to build Shanghai into an international financial center by 2020 in line with China's economic status. International participation and the internationalization of the CNY are necessary conditions if this aim is to be achieved. We strongly believe that the Chinese financial market, particularly the inter-bank market, will grow steadily so that its major components will occupy similar weights in the global inter-bank marketplace to the weight that the Chinese economy will occupy in the world economy in the coming decades.

      We hope that this book can help readers understand the current status of the major Chinese inter-bank market and its future development. We wish to emphasize, however, that the views expressed are those of the authors alone, and not those of the institutions for whom they work.

      Peter G. Zhang

      with Thomas Chan

      November 2010

      Acknowledgments

      We would like to thank those who have contributed much research work for the completion of this book, in particular, Luo Pengyu of Bank of China, Zhang Zhiqiang of Zendai Investment Management Company, Ms. Ge Chongyang of China Life Asset Management Co. Ltd., Ms. Song Xiaoling of Goldman Sachs International Bank, as well as Du Han, Huang Xindong, Liu Huai-yuan, Sun Yinho, and Xiao Lijuan of the Graduate School of the People's Bank of China. We would also like to thank partners and staff of KPMG China. KPMG Partners Nelson Fung and Terence Fong provided invaluable advice and comments, while Wayne Tsang, Tom Jenkins, Michael Hurle, Fiona Yan, Maggie Ji, Ian Xu, Ryan Ren, Allen Cui, Christina Yu, Teresa Shang, Coco Yang, Andrew Chen, Ada He, Ivor Cheung, Isabel Wu, and Chris Guo all assisted with the editing and translation of the book.

      We hereby express our sincere gratitude for their contribution and professional work. At the same time, it is necessary to stress that all the views in this book are expressed in an academic context and do not represent the views of the units or corporations to which the above people belong.

      Part One

      The Chinese Economy and Financial Markets

      As the wheel of history has turned, Chinese culture has expanded from the Yellow River valley to the seven seas. At every phase of history, China has had to face other people and their cultures. Numerous contacts and exchanges, whether positive or negative, have brought about changes in the cultures of China and its neighbors. [D]uring this process the us and them have merged into a new us.

      From A Long River of History by Cho-Yun Hsu

      One of the important lessons to emerge from the recent financial crisis is that the entire purpose of the financial industry is to serve its underlying economy. The dangers of allowing the financial industry to stray too far from the needs of its underlying economy have been all too evident over the past few years. With this as our starting point, we begin by introducing the underlying Chinese economy and its major financial markets before examining the major products in the Chinese inter-bank markets.

      Chapter 1

      The Chinese Economy

      Since a country's economy involves many areas, a systematic and in-depth description and analysis of China's economy is beyond the scope of this book. In this chapter, we will focus on describing and analyzing the key aspects of the economy, including its tremendous achievements in the past 30 years and its current problems.

      Population and Human Resources

      Human resources are the most important components of economic development as people are the carriers of culture and genes, the subject of social production, practices and consumption, and the subject of succession, learning and innovation in thinking, science and technology. As long as there are people capable of embracing and learning from outstanding cultures created by peoples around the world, and with the courage to explore new territories, anything is possible.

      Population Growth Since the Reform and Opening-up

      In the 30 years following China's first census in 1953, the population grew from 594 million to more than a billion. Recognizing the potential problems associated with rapid population growth, in the early 1970s the Chinese government had begun to search for appropriate measures to control such growth. In December 1973, the State Council Leading Group Office of Family Planning proposed a policy of late, rare and low fertility. In September 1982, the Twelfth Central Committee of the Communist Party of China (CPC) confirmed family planning as a basic national policy. In the Constitution of the People's Republic of China passed by the National People's Congress (NPC) in December that year, the words China shall carry out family planning and control population growth to tie in with economic and social development were added. The family-planning policy, which has now been implemented for more than 20 years, has been a significant factor in controlling the growth of China's population.

      Effectiveness of Family-Planning Policy and Corresponding Problems

      Practice has proved China's family-planning policy to be very successful. As shown in Figure 1.1, after 1980, the annual population growth rate was controlled within 2 percent and, since 1998, it has been within 1 percent, far below the growth rate experienced from the 1950s to the 1970s. However, the family-planning policy has also had many negative effects, the most serious of which is the ageing of the population. The fifth national census conducted at the end of November 2000 showed that the number of people aged 65 and above had reached 88.11 million, accounting for 6.96 percent of the population, and people aged over 60 had reached 130 million, 10.2 percent of the population. By international standards, China has become an ageing society. According to one commentator, The speed of aging is faster than economic development in China, resulting in the phenomenon of ‘getting old before getting rich.’¹ A State Council white paper also reveals that, in the twenty-first century, the ageing of China's population is growing at an annual rate of about 3 percent.² By the end of 2005, there were some 144 million people over the age of 60, accounting for more than 11 percent of its population.³

      Figure 1.1 China's population and population growth rate, 1978–2008

      The ageing of the population will have a profound impact on China's economy, requiring further improvement in the social security and healthcare systems. Economists term the positive role of changes in demographic structure as the demographic dividend. An empirical study (Cai) shows that from 1982 to 2000, the demographic dividend contributed about 27 percent to China's economic growth. However, a research report published in late 2006 pointed out that demographic dividends would only contribute to China's economy for another five to 10 years.⁴ After the demographic dividend phase, China will enter the demographic burden phase, many features of which have been seen in the Japanese economy since the 1990s.

      Investment in Education

      Since the reform and opening-up in 1978, China has made great achievements in education. In the early stages of the reform period, the government was aware of the problems in the education system during the late stage of the Cultural Revolution (1966–76). In 1977, universities introduced a unified national entrance examination for high school graduates and students who had missed the chance to go to university during the Cultural Revolution. At the same time, a large number of students and scholars were sent abroad to study in developed countries and regions.

      In China's history, there have never been so many students admitted to such a wide range of vocational schools, colleges, universities and research institutes as there are now. As Table 1.1 shows, the number of college students at the end of 2008 was nearly 10 times the figure in 1991.

      Table 1.1 Annual enrolments of university students in China, 1991–2008.

      Though China's education system has developed rapidly since 1978, there is still a considerable gap in funding when measured against international standards. In 1999, the most recent year for which UNESCO statistics including China are available,⁵ total public expenditure on education in China was 1.9 percent, compared to 4.5 percent for Germany and India, 5 percent for Thailand and 5.1 percent for the United States.

      While China has undoubtedly made great strides in education in the past 30 years, many acute problems remain, including a lack of emphasis on vocational training. In addition, investment in human capital in different regions, especially the distribution between rural and urban areas in the same district, is uneven and inefficient. Local governments are the chief sources of education funding; however, the subsidies provided by many provinces are very low. Education penetration nationwide is uneven and expenditure per student varies greatly by region. The central government has recognized these problems and is expected to solve them gradually in the Twelfth Five-Year Plan from 2011 to 2016.

      Section Summary

      When Peter Zhang was sent to study in the United States in the late 1980s, he asked a Jewish-American friend whether he thought that Jewish people were smarter than others. He responded wittily that wisdom and beauty are distributed normally; thus there are handsome and intelligent individuals in every country. Based on this assumption of normal distribution, China, with the highest population base, should possess the world's largest reserve of human intelligence. This is why a large population is a valuable asset for China. For China's long-term economic and social development, it is vital that it develops, and uses, its intellectual resources, stimulates, creativity and explores, the potential of the entire community through establishing an education and training system that is more internationalized, innovative and in line with China's international economic status. The continued development of its economy requires the support of a certain level of labor force. Hence, it is necessary to maintain a certain level of population growth. Particularly with diminishing tangible resources per capita in the future, developing and using the nation's enormous human resources effectively for more efficient use of natural resources will become increasingly important and urgent.

      Foreign Direct Investment

      Since the reform and opening-up process began at the end of the 1970s, foreign direct investment (FDI) has played an important role in China's economic development. Since that time, China has gradually evolved from a closed, planned economic system to a market-oriented open economy with sustainable growth. As Table 1.2 shows, the amount of FDI inflow to China over the period from 1981 to 2008 reached US$877.4 billion. It is clear from the table that the FDI inflow experienced several growth phases: one in the early years of reform between 1981 and 1984, growing at an annual rate of 100 percent; another from 1991 to 1993 when the reform deepened and the socialist market economic system was established. From 1998 to 2000, following the East Asian financial crisis, China recorded less than 1 percent in annual FDI growth rate or negative growth. In 2005, the annual FDI growth rate was close to 20 percent, the highest in 10 years, chiefly thanks to foreign investment in the financial sectors, such as banking, insurance and securities. According to the FDI data of the Ministry of Commerce in 2006, total foreign investment in the financial sector in 2005 stood at US$12.083 billion. In anticipation of an appreciation of the CNY, a significant amount of hot money flew into China in the form of FDI in 2007, resulting in an annual growth rate of nearly 20 percent. With the onset of the international financial crisis in 2008, capital flew out of China, resulting in lower FDI growth in 2008 and a 2.6 percent decline in 2009. However, FDI recorded 7.7 percent growth in the first quarter of 2010 compared to the same quarter of 2009.

      Table 1.2 Foreign direct investment in China, 1981–2010 (US$ billion)

      International Trade

      The import and export markets have played an important role in China's economic growth in the past 30 years, especially over the most recent decade. This section introduces the development of China's foreign trade, and analyzes the impact of the import and export markets on China's employment, taxes, prices, international balance of payments and GDP.

      China's Import and Export Markets

      With huge FDI inflows and improved production and management capabilities, China's production capacity has been enhanced and increasingly internationalized, with foreign trade playing an ever more important role in the country's economic growth. Table 1.3 summarizes China's import and export data and the proportion of the total trade to GDP from 1979 to 2009.

      Table 1.3 Foreign trade in China, 1979–2010 (US$ billion)

      Growth of Foreign Trade and Dependence on Trade

      China's foreign trade in 1978 was a mere US$20.6 billion, and it took 10 years for the figure to exceed US$100 billion for the first time. Table 1.3 shows that it took only six years for this to double. In the three-year period from 1993–96, it rose from nearly US$200 billion to almost US$300 billion. Since joining the World Trade Organization (WTO) in 2001, the growth in China's foreign trade had accelerated noticeably to new levels almost every year until 2008. In 2009 total foreign trade recorded its first decline since 1999 because of the financial crisis, yet it returned to growth in the first quarter of 2010, with a quarterly growth rate as high as 44 percent in the first quarter of 2010 compared to Q1 2009.

      The level of dependence on foreign trade (that is, the proportion of foreign trade to GDP) in 1978 was a mere 9.6 percent. In 1994, the ratio topped 40 percent for the first time. Following China's entry into the WTO, the dependence on foreign trade rose continuously to above 60 percent from 2005 to 2007, before falling to 58.2 percent in 2008 and below 50 percent for the first time since 2003 because of the financial crisis in 2009.

      Table 1.3 shows the increasing impact of foreign trade on China's economy. From 1978 to 2008, China recorded an average annual growth rate of 17.9 percent in foreign trade, which was much higher than the corresponding GDP growth rate.

      Table 1.4 shows the

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