§ 4 China’s Foreign Exchange Market and Regulations

4.1 Overview of China's Financial Market

China has a relatively long history in FX compared to many developing markets and regions.The sheer size of China attract brokers from far and wide to this booming market.

In Aug.2010 China overtook Japan to be the world's second-largest economy.The general economy and fundamentals have been pushing the nation to economic glory.China is now the largest trading and industrial nation in the world.It is the largest trading pratner to about 130 countries.New cash for the public means new investment opportunities；China's vibrant financial markets have been growing to match with its economy.

China has two developed stock exchanges（Shanghai and Shenzhen）with over 3800 listed companies between them.Shanghai Stock exchange is the world's 3rd largest in terms of volumes.

FX trading first started in China as people were increasing their international usage and looking for investment opportunities with low capital entry levels and high growth returns.

Hong Kong-based brokers followed by more overseas brokers were the first to open up offices in Shanghai with local representative.The office would complete the account opening and trade life cycle for more clients.

Foreign brokers caught on to the large opportunities China offers；Forex Capital Markets（FXCM）set up a regulated entity in Hong Kong.UK-based CMC Markets followed FXCM by getting authorized by the China Banking and Insurance Regulatory Commission（CBIRC）to offer“non-business” related services to mainland China residents.CMC Markets already had an established client base trading FX，stock indices and major commodities via its London head office.

China has been hosting numerous finance and investment related expositions，including FX Expo and World Money Show China which were FX and derivatives based.

In addition to brokers，software vendors or resellers of platforms including Metaquotes and Vertex FX（from Hybrid Solutions）are active.Chinese-origin brokers who are acting as market makers have been increasing.Other noteworthy Chinese origin brokers include Hantec（Australia/UK），City Credit Capital（UK）and HenYep Markets.

China has recently allowed local futures brokers to trade in global futures contracts.FX as an asset class will continue to gain attraction from investors.The next phase of liberalization will be eagerly awaited by the market at large.

4.2 FX Evolution in China

As Deng Xiaoping initiated open-door policy，international trade mushroomed between China and rest of the world.International settlement from trades as well as foreign direct investment in special economic zone have been calling for more frequent exchange between Chinese yuan and other currency.Foreign exchange derivatives operations arose since 1980，by which，the government matched the buying and selling orders.

In 1985，a foreign exchange market substituted foreign exchange operations.The prevailing foreign exchange，the official rate，in the market was determined by government，which was higher than the rates caused the boom of black market at that time.

In 1989，an open foreign exchange market was introduced.Because of the overvalued official rates，many Chinese companies invested overseas，and there were serious capital flights.Therefore，the official CNY devalued by 33％ on 1st Jan.1994，and an interbank trading system，China Foreign Exchange Trade System（CFETS）has been set up to achieve a more market-oriented exchange rate.This system，then，linked 24 cities in China through satellite and ground communications with daily trading turnover of 270 million dollars.It is a sub-department of People's Bank of China（PBOC），and is also regulated by the State Administration of Foreign Exchange（SAFE）.

In 2005，Chinese authorities announced a switch to a new exchange rate regime innitiated Chinese yuan's liberalization as shown in figure 2-8.The exchange rate would be set with reference to a basket of other currencies allowing a movement of up to＋/－0.3％ within any given day.China thus has moved into a managed floating exchange rate regime based on market supply and demand with reference of a basket of currencies.

In 2005 the State Administration of Foreign Exchange decided to introduce the market maker system into the inter-bank foreign exchange market.The products being traded on CFETS include spot trading，deliverable forward contracts between CNY and USD，and currency swaps between CNY and other foreign currencies.

In the spot market，China imposed transfer restriction to control capital.Foreign transaction must be a current account transaction，i.e.linked to trading needs，otherwise，the trading party must prove that this capital account transaction is in line with capital control policies.In Oct.2005，China established onshore interbank foreign exchange forward market.China then introduced foreign exchange option trade in 2011.

On 11th Aug.2015，the People's Bank of China（PBOC），the central bank，announced that daily central parity quotes reported to the China Foreign Exchange Trade System before the market opens should be based on the closing rate of the inter-bank foreign exchange market on the previous day，supply and demand in the market，and price movement of major currencies.This change exchange rate regime could marketize the exchange rate，comply with IMF conditions to get CNY included in the SDR basket.China then continues in improving the market-based CNY exchange rate formation mechanism and speeds up the marketization of interest rates.The level of convertibility in cross-border capital and banking transactions is further enhanced.

In 2015，According to the initial foreign exchange rules，the People's Bank of China，set a midpoint for the USD/CNY exchange rate from which the currency could float up or down by a maximum of 2％.If quotes exceeds the limit，trading stops automatically.The new mechanism has the PBOC still setting the midpoint，but is supposedly based on the market movements of the previous day.

Since 4th Jan.2015，the foreign exchange market trading time was extended from 9：30 a.m.to 23：30 p.m.for CNY and other currencies exchange，and 7：00 23：30 for other currencies'exchange .

4.3 Interbank FX Market in China

China now has platform for FX trade among banks and companies.

The interbank FX market，consisting of the RMB /FX market，the foreign currency pairs market and foreign currency lending market，is the marketplace in which institutions conduct FX trading.The interbank FX market works on a membership and market-making system，and its participants include FX-designated banks，qualified non-banking financial institutions and non-financial enterprises.

China Foreign Exchange Trade System（CFETS）founded on 18th Apr.1994 is responsible for offering an integrated and efficient e-trading system for the interbank FX market.The system provides two trading modes，exchange trading and bilateral OTC trading，as well as functions such as single-bank platforms，trading analyses，market making interfaces and live communication tools.

CFETS supports：

① Spot trading facilities for CNY against 28 currencies；

② Forwards and swaps for CNY against 25 currencies；

③ Cross-Currency swaps for CNY against 7 currencies；

④ Foreign currency lending for 12 currencies；

⑤ Interbank OTC gold spot trading，and forwards and swaps with the cooperation of the Shanghai Gold Exchange.

Table 2-5 gives a summary of FX market in China.

4.4 Interbank FX Market Performance

1） Gap between onshore and offshore exchange rates

As China began to open up its economy，its currency has been frequently used in the international market to settle trade and financial transactions.

Hong Kong，which has served as an international hub for mainland China，is a great place for an offshore（CNH）market.Singapore，Taiwan China and London have since developed offshore CNH markets.

It began with the development of personal Chinese yuan banking business in 2004 when RMB deposits were allowed in Hong Kong.Bank of China（Hong Kong）was designated as the sole offshore CNH clearing bank in 2004.RMB deposits continued to climb，especially once the bond market was established in 2007.Bonds issued in RMB outside the mainland were dubbed dim sum bonds.RMB deposits continued to pick up with the launch of the trade settlement scheme in 2009 2010.

The offshore CNH doesn't fluctuate within a tight band like the onshore CNY.

And borrowing costs are much cheaper in the CNH bond market than in mainland China.In settling trade，many companies accept CNY payments from Chinese importers and change that into USD at the more attractive offshore rate.

2） Trading volume is growing

Table 2-6 shows a summary of foreign exchange market products traded in China from 2011 till 2020.Every aspect has been growing greathy and the pace of market openness has accelerated significantly.

Besides，the FX market members are enriched.Till Jul.2021 the RMB /FX market had 725 members among which there are 25 market makers，20 institutions were market makers for trial.

3） The FX Market Construction

The quotation mechanism of CNY central parity was improved and market's transition from fundamental role to decisive role achieved gradually.

The pace of FX market openness accelerated by expanding eligible overseas participants.Based on the sustained openness of the interbank FX market to CNH clearing banks，the overseas central banks and similar institutions were granted multi-channel and multi-way access into China's interbank FX market.By 2021，44 foreign banks and financial institutions have acquired membership and officially entered China Interbank FX Market ，plus 22 overseas clearing banks.

The mechanism innovation such as C-Swap and e-transaction in the FX market have associated FX market to moved forward continuously.The queue of CNY direct trading expanded.By the end of 2016，RMB established direct trading with 21 currencies，see Table 2-7 for details.

So far China has signed Currency Reciprocal Agreement with 39 countries' central banks.

4） FX Reform

China first announced Tentative Provisions on the Administration of Inter-bank Foreign Exchange market in 1996 and in 2008 published Regulations of the People's Republic of China on Foreign Exchange Administration.

By the end of 2010 China has published its first set of formal guidelines，governing marketmakers trading the Chinese yuan against foreign currencies.The guideline divides market makers into three types：yuan foreign exchange spot trading market makers，those for forwards and swap trading，and those for all business.It also requires a trial period before getting such status.The guideline took effect on 1st Jan.2011.Only banks can assume the role of market makers.

To minimize the risk of the extended foreign currency reserve，the Chinese central government began foreign exchange administrative reforms.The main areas of these reforms are：

① Foreign exchange in trade；

② Foreign exchange in external guarantees；

③ Foreign exchange in capital investments；

④ Foreign exchange law amendment.

After years' reform，despite the complex and volatile environment，China's foreign exchange market was generally stable.The CNY exchange rate remained stable，cross-border capital flows were in a reasonably and orderly manner，and the balance of payments was basically balanced.China's foreign exchange market now presents 3 characteristics：

① the exchange rate of CNY is expected to be relatively stable

The spot exchange rate of the CNY against USD rose and fell and maintained two-way fluctuations in different stages.The two-way fluctuations of exchange rate were affected by various factors，including mainly the international financial environment as well as the supply and demand of the domestic foreign exchange market.Professional indicators，such as foreign exchange forwards and options，have shown signs of reasonable divergence and relative stability in the market expectations for exchange rates.

② real economic activities promoted cross-border capital inflows

China's import and export of goods continued to maintain a relatively high surplus since 2019.It demonstrated the advantages of China's industrial and supply chains in the face of the pandemic.According to the data from the Ministry of Commerce，the actual use of foreign investment in China in 2021 stood at US＄173.5 billion，a year-on-year increase of 20％，which reached a historical high.It reflected China's good economic development prospects have strong attraction for overseas long-term capital.In addition，in 2021，foreign investors increased their holdings of domestic bonds by US＄166.6 billion，and CNY assets have become an important choice for foreign capital allocation.Real economic activities such as trade and investment have become the main driving force for cross-border capital inflows.

③ the external assets of China's private sector increased significantly

According to the balance of international payments（BOP），China's outbound investment，especially that of the private sector，increased correspondingly under the background of current account surplus and overall inflow of overseas capital.In general，China's private sector including enterprises and financial institutions had cross-border capital flows in and out，forming a pattern of independent balance of international payments. XK87daZu6I1ShMZhdy/d3wSq7LGBT6GvZ8O3sKKndHiGMQB8tpxCJPyN548bvS6C