China opens up renminbi swaps market

New angles

The People's Bank of China (PBOC) has loosened its tight grip on the renminbi derivatives market, removing restrictions on renminbi forwards and allowing banks to trade renminbi cross-currency swaps for the first time.

The rule change marks a huge step forward for China's local currency derivatives market, and comes hot on the heels of the long-anticipated revaluation of the renminbi. On July 21, the PBOC announced a 2.1% strengthening of the renminbi against the dollar, and declared the currency would move to a managed float linked to a basket of currencies.

The new rules, published on August 9, allow foreign and domestic banks with both renminbi spot foreign exchange and derivatives licences to offer renminbi forwards to customers. Once a bank has traded renminbi forwards for six months, it will be allowed to offer cross-currency swaps – the first time these instruments have been allowed in China. However, the new rules do not cover interest rate swaps, meaning banks can enter into a renminbi/foreign currency swap with an initial and final exchange, but without any interim exchange of interest.

The publication of the new rules has surprised bankers, coming so quickly after the renminbi revaluation, as well as a flurry of other recent rule changes. In June, the authorities expanded the number of currency pairs permitted to trade on China's interbank market and established a renminbi-denominated bond forwards market. "In terms of the exchange rate, the appreciation of the renminbi was forecast by our in-house research team, but the change of regulations on forwards was faster then we expected," says Dennis Wan, managing director and head of sales, credit and rate markets at JP Morgan in Hong Kong.

So far, 56 banks have won approval to trade derivatives from China's banking regulator, the China Banking Regulatory Commission, many of which also have spot foreign exchange licences. Banks do not need approval from the regulators to offer forwards and cross-currency swaps, but they do have to make separate filings with China's currency overlord, the State Administration of Foreign Exchange (Safe).

Previously, only a small number of banks were able to offer renminbi forwards. The Bank of China was granted permission by the PBOC to offer forwards in 1997 as part of a pilot scheme. This was extended to the other three state-owned banks – Agricultural Bank of China, China Construction Bank and Industrial and Commercial Bank of China – in 2003, before being extended to three of China's largest private-sector banks last year.

However, under the pilot scheme, forwards could only be used to hedge short-term trade-related exposures, with the size of the trade limited to the value of the imported or exported goods. In addition, the length of the contract could not exceed 12 months. Under the new rules, the cap on the maximum tenor has been removed, and the underlying hedged item can include all current account item transactions and some capital account item transactions, including the capital of a foreign-invested company.

The requirement that these instruments must be used as hedges by the client is still in force. However, the rules do not specify what would qualify as a hedge, nor what supporting documentation is required by dealers, says Chin-Chong Liew, a partner in the derivatives practice at law firm Allen & Overy in Hong Kong. "The rules say forwards must be used for hedging. Hedging can be an elusive concept that could be highly subjective and difficult to apply in practice. It would be helpful, as the market develops further, if there are indications or guidance from the regulators on what would qualify as a hedge and what would be deemed speculative."

In a separate ruling, published the day after the August 9 regulations, the PBOC declared that banks can also trade forwards and cross-currency swaps in the interbank market, providing them with an avenue to offset risk from customer deals. However, banks have to wait for six months until they can trade these instruments in the interbank market, even if they are already offering renminbi forwards to customers. "Our interpretation is that a corporate could go to some of the Chinese banks and conduct a cross-currency swap right away if these banks have done forwards for more than six months, and if they have made a filing with Safe. But they can't trade swaps in the interbank market for another six months," says Liew.

Uncertainty

However, there is some lack of clarity in certain aspects of the new regulations. In particular, dealers say there is uncertainty about how a dealer would settle a renminbi swap transaction if the corporate does not hold a renminbi account with the bank. In addition, there are uncertainties over the types of structures banks can offer clients. "You are not allowed to do an interest rate swap, but can you do a series of forwards?" asks Liew. "A series of forwards, if priced in the right way, is quite similar to an interest rate swap."

The introduction of a renminbi interest rate swaps market is likely to be the next step. Most dealers believe the Chinese authorities will monitor the development of the forwards and cross-currency swaps market before making further changes. However, given the speed of the recent developments, some say an interest rate swaps market could emerge within months. "The view is that they might allow interest rate swaps as well in the next few months. It looks like it could happen pretty quickly – like what has happened in the past few weeks," says Liew.

Nick Sawyer