CHINA'S FOREIGN EXCHANGE TRADING SYSTEM UPDATE

UNCLAS SECTION 01 OF 03 SHANGHAI 007091 SIPDIS SENSITIVE SIPDIS STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SF FRB FOR CURRAN/LUNG; NY FRB FOR CLARK/CRYSTAL/MOSELEY TREASURY FOR ADAMS, AND OASIA - DOHNER, BAKER, CUSHMAN USDOC FOR ITA A/DAS MELCHER, MCQUEEN NSC FOR HUBBARD AND TONG E.O. 12958: N/A TAGS: EFIN ECON PREL CH SUBJECT: CHINA'S FOREIGN EXCHANGE TRADING SYSTEM UPDATE REF: A. A) SHANGHAI 5846 ¶B. B) SHANGHAI 1356 ¶C. C) SHANGHAI 1355 U) This cable is sensitive but unclassified and for official use only. Not for distribution outside of USG channels. ¶1. (SBU) Summary: In a series of conversations in late October and November, China Foreign Exchange Trading System (CFETS) Vice General Manager Song Jianqi and Market Development Manager Justin Zhang discussed recent forex market developments, including continued gradual appreciation, increased intra-day volatility, growth of currency swaps (and death of forwards), and extension of hours for the matching exchange system. They also described some of the reforms CFETS planned to implement over the following six months, including a revision of CFETS fee-structure and migration to a new Reuters-based trading platform. Zhang said the State Administration for Foreign Exchange (SAFE) was considering a policy change to allow traders to hold net open positions shorting the dollar. Song said CFETS' agreement with the Chicago Mercantile Exchange (CME) to offer RMB-based derivatives was on track to begin in June 2007. Discussions with Shanghai forex traders will be reported septel. End summary. -------------- -------------- CFETS: MORE APPRECIATION IS MORE APPRECIATED, RIGHT? -------------- -------------- ¶2. (SBU) CFETS Song began an October 24 meeting with P/E Chief and Econoff by noting the continued appreciation of the RMB, quipping, "More appreciation is more appreciated, right?" He stated that the continued, gradual, and steady appreciation of the RMB demonstrated the successful working of the market in determining the value of the RMB. He further said that inter- and intra-day movements in the market demonstrated that the RMB was moving based on market news and policy changes. He noted that when Secretary Paulson visited China in September, the market reflected this with "more active trading within a larger band." ¶3. (SBU) Zhang stated that over-the-counter (OTC) trading (begun in January 2006),represented more than 90 percent of all spot exchange transactions by the end of October 2006. Nonetheless, CFETS would continue to maintain its more expensive matching exchange model for customers who were too small to have the technical know-how, infrastructure and credit history to engage in OTC trading. In fact, on October 1, it had extended the hours for the matching system (which previously closed at 3:30 PM) to coincide with those of the OTC market; i.e. both now closed at 5:30 PM. ¶4. (SBU) Zhang added that 80 percent of all foreign exchange (forex) trades handled by CFETS were done by its 15 Market Makers, 10 percent by the other 245 CFETS members, and the remaining 10 percent of forex trades were made through CFETS by other banks and institutions. Of forex trades made by market makers, 70 percent were made by the nine Chinese banks and 30 percent by the six foreign banks. When asked what the total volume of forex trade handled by CFETS, Song stated that CFETS was not authorized to release that information, but noted that daily trade volumes had doubled since January 2006. (Note: Standard Charted Stephen Green observed on October 26, that "probably only two people at CFETS know the answer to that question -- President Xie Duo and the technician who presses the buttons confirming each trade." End note.) ¶5. (SBU) CFETS outlined the "smooth market development" of its swap forex trading system. When swaps began, daily volume was about $20 million. During the third quarter, approximately $70 million worth was swapped per day. In October, total volume of currency exchanged through swaps was $400 million per day according to Song. International banks accounted for more than 50 percent of the swap market. Song added that when the People's Bank of China (PBOC) raised deposit and lending interest rates in August, this was reflected in swap points. When asked about the forward market, Zhang didn't provide specifics, but noted that volume had dropped off. He said that SHANGHAI 00007091 002 OF 003 was because it was easier to do a combination swap and OTC trade than to do a forward contract. -------------- CFETS TO REVISE ITS FEE STRUCTURES -------------- ¶6. (SBU) Claiming that CFETS was responsive to the needs of its consumers, Song said that CFETS would revise its current fee structure when its new trading platform was brought online in 1st Quarter 2007. He said that the new fees would be "more reasonable," with multiple rates based on trading volumes. The new platform, which Song and Zhang admitted would be a welcome replacement to the current unwieldy system, would be based on Reuters' software customized for CFETS by Reuters, with some "back office domestically-produced software." ¶7. (SBU) Song also explained the genesis of its current high-priced fee structure. He said that in the past, CFETS provided a number of free services to its member banks, but was only permitted by SAFE to charge for its forex services. By June 2006, CFETS had begun charging its members for all of its services, which included such things as RMB inter-bank lending and RMB bond trading. (Note: See HYPERLINK "http://www.chinamoney.com.cn"www.chinamoney. com.cn for more information on these services. End note.) Song noted that the new platform to be released next year would combine all of these transactions on one system. With a fee for service model in place, CFETS would be able to reduce its overall charges on forex trading. Song claimed that certain forex trading rates would be reduced by 30 times their current prices. -------------- THE LONG AND SHORT OF IT -------------- ¶8. (SBU) Song said that CFETS had heard many complaints from traders that the limitations preventing net open positions from shorting the dollar (or longing the RMB) were a significant problem in developing China's forex markets. As a result, he understood SAFE was considering a policy change to allow forex traders to take both long and short positions on the U.S. dollar. Song expected a ruling in the first quarter of 2007. -------------- - CFETS-CME: BEHIND SCHEDULE, BUT STILL ON-TRACK -------------- - ¶9. (SBU) Song stated that the CFETS-CME Memorandum of Understanding (MOU) to offer forex derivatives (ref C) was still on track, but that the U.S. Commodity Futures Trading Commission's (CFTC) approval process had somewhat delayed progress on CME's side. Song said that CFETS expected that the approval process would be completed by March 2007 and that CFETS and CME planned their launch for July 2007. He noted that CFETS already had sent one staff delegation to Chicago for training in October and planned to send two more before the launch. CME's Chief Operating Officer Phupinder Gill was scheduled to meet with CFETS President Xie Duo on October 25. In addition, CME had recently posted one of its staff, Mr. Hao Lian from CME's IT & Risk Management department, to be based at CFETS in Shanghai to act as liaison until the product launched. Zhang noted that CME's own RMB-based derivative products, listed in August, were not a competitive threat and had not been active. -------------- OFFSHORE RMB FORWARDS ARE NOT "SAFE"... -------------- ¶10. (SBU) According to press reports, on October 25, SAFE announced that Chinese institutions and individuals were barred from trading offshore RMB derivatives without SAFE's prior approval. Song explained that most such activity currently took place on Hong Kong's Non Deliverable Forwards (NDF) market, which allowed traders to speculate on the future value of the RMB despite its not being freely-traded in the international market. He said the policy change was intended by SAFE to bring SHANGHAI 00007091 003 OF 003 more of the RMB trading under its control. Song said this ruling would not affect plans for the CFETS-CME products, but refused to comment on what SAFE's announcement would mean for CME's already-launched RMB-derivative products. Zhang added that CFETS closely tracked the Hong Kong NDF market and was pleased to see closer correlation between it and the CFETS market. -------------- -------------- ...BUT RESTRICTIONS LEAD TO INCREASED RMB APPRECIATION -------------- -------------- ¶11. (SBU) On November 28, Zhang told Econoff that SAFE's October 25 statement restricting Chinese institutions from participating in the overseas (and Hong Kong) NDF market had been largely aimed at halting these institutions' profiting from cheaper price of the U.S. dollar on the NDF market than in China. He noted, however, the result had been, "when these traders withdrew from the market, it led to even more appreciation of the RMB." Zhang speculated that this appreciation had not been SAFE's intent. He added that while most of this arbitrage trading had halted, the resultant appreciation of the RMB had led to an increased profit margin for Chinese financial institutions and individuals willing to skirt the law. -------------- CFETS RELOCATED FROM BUND TO PUDONG -------------- ¶12. (SBU) CFETS, formally housed in a 19th Century classical building on the Bund that once housed the Guomindang's Central Bank, moved operations in September to its new campus, located at 1387 Zhangdong Road, Number 30 in Shanghai's Pudong New Area. CFETS is now located within a new office complex of three-story buildings that would not be out of place in any U.S. suburban high-tech industrial park. Song explained that CFETS occupied five of the buildings with plans to expand into two more. He said that one building housed its main offices, another building housed its computer mainframes and technical equipment, and the other three were used for its administrative and technical staff. CFETS was not entirely relinquishing control to its former prime location. After a two-year renovation, CFETS executives would return, but the majority of staff would remain in Pudong. -------------- - COMMENT: PLEASE DO NOT LOOK BEHIND THE CURTAIN -------------- - ¶13. (SBU) It is clear that CFETS administrators are doing what they can to lay the foundation for a fully-functioning and open forex system and are continually making adjustments, as reflected in plans to upgrade the trading platforms and fee structures to international standards. Song's assertion that CFETS responds to its customers demonstrates a willingness to learn and adapt. CFETS likes to claim that the value of the RMB is based purely on the functioning of the free market. However, the continued lack of transparency in the formula by which the RMB reference price is set every morning highlights the fact that it is China's political leaders who are currently setting the price, not the market. JARRETT