Shanghai's free trade zone to spur China interest rate hedging market

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The Shanghai free trade zone (FTZ) could provide a boost to the interest rate hedging market in China as market participants are able to experiment with hedging market-driven rates in the new zone, according to observers.

China has established a number of special economic zones since Shenzhen in 1980 with a focus on manufacturing. The Shanghai FTZ, approved for establishment on September 29, 2013, has a focus on services ranging from shipping and financial services to cultural services.

The FTZ is expected to be a pilot case for complete liberalisation of the interest rates and capital account convertibility. Dariusz Kowalczyk, senior economist and strategist for Asia ex-Japan at Crédit Agricole in Hong Kong, in an October 9 note titled "Shanghai FTZ: Brave New World" says the Shanghai FTZ will significantly replicate the model of Hong Kong and Macau on the mainland in terms of its economic and financial infrastructure.

The conditions, then, are ripe for the growth of the interest rate hedging market on the mainland. Among 10 banks, Citi China and DBS Bank are the first two foreign banks to receive approval for setting up branches in the FTZ.

Neil Ge, chief executive for DBS Bank China, told reporters at a press briefing that the bank planned to offer interest rate hedging services in addition to debt capital markets and cash management services. DBS is expected to start offering these services in six months but declined to give further detail. Citi China declined to comment on its plans for offering rate hedging in the FTZ, citing a lack of specific rules on financial derivatives.

f the experiment is successful then Shanghai will become a major threat to Hong Kong as a financial centre

Although rules of the development of the financial derivatives market in the FTZ have not been released by the Chinese authorities, Frances Cheung, senior rates strategist for Asia ex-Japan at Crédit Agricole in Hong Kong, says the zone will serve as a catalyst for the implementation and acceptance of rate hedging at a national level.

"As market participants realise that interest rates are increasingly driven by demand and supply or benchmarked against the floating rate, they will engage in more hedging activities and move faster in terms of individual deals involving interest rate products," she says.

Interest rate reform in China has taken place piecemeal, with a slew of measures being released this year. The People's Bank of China removed the floor on lending rates in July this year after a 17-year hiatus on interest rate reform. The central bank is also expected to liberalise deposit rates this year and introduce Shibor-linked negotiable certificates of deposit to this end.

The China Securities Regulatory Commission (CSRC) allowed a restart in trading of Chinese government bond futures after an 18-year gap to allow better hedging of interest rate exposure. However, as banks are barred from participating in the market, the utility for hedging their interest rate exposures through this product is nonexistent.

Cheung says, however, that banks in the FTZ can be expected to utilise the existing nationwide single market for interest rate swaps (IRSs). "We already have a well-established IRS curve, interbank fixings like Shibor, and forward rate agreements. The interest rate reform is taking place on a nationwide basis and a separate rates market in the FTZ will not be feasible," she says.

This view is echoed by Raymond Yeung, economist at ANZ in Hong Kong, who says there is unlikely to be a separate benchmark rate for the FTZ given that it is only expected to last for three years.

"The direction of interest rate liberalisation will be the guiding principle for financial institutions when they lend and borrow with the corporate customers. We can expect a separate interbank market in the FTZ but a separate fixing doesn't seem likely," he says.

Yeung further says that likening the Shanghai FTZ to an offshore market on the lines of Hong Kong is premature because the dynamic between the RMB market in Hong Kong and the mainland is different from what can be expected from the FTZ and the mainland market.

As RMB deposits in Hong Kong are unevenly distributed, Yeung says, banks' lending rates in the interbank market are based more on their funding activities in the foreign exchange market instead of the deposit rates.

"It is unclear how the government plans to position the FTZ and whether it plans to take reference for rates from the funding conditions in the offshore markets. Interbank lending rates in Hong Kong, for example, are derived from the forex swap rates with little reference to the industry benchmark," he says.

According to Stephen Schwartz, chief economist for Asia for BBVA Research in Hong Kong, the inability of the regulator to keep the Shanghai FTZ separate from the nationwide financial system will limit its value as a testing ground for financial reforms. Schwartz says that without a rates market in the FTZ, separate from the rest of the domestic market, it is unclear how useful the FTZ might be for its intended cause.

"If there are leakages, then it is hard to see how financial liberalisation in the FTZ can advance the effort at a broader national level," he says.

He says, however, that the FTZ will allow local Chinese banks with little experience in interest rate hedging to build up their capabilities in a smaller market before rolling out the service nationally on the back of wider reform.

A Singapore-based head of rates structuring for an international bank says the FTZ's development is a laboratory for the Chinese authorities and despite uncertainty regarding the rate reform in the FTZ and its impact on the onshore market, the FTZ's potential to compete with other offshore centres is clear: "If the experiment is successful then Shanghai will become a major threat to Hong Kong as a financial centre."

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