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Cablegate: Cfets Update On Fx and Bond Market Developments

VZCZCXRO5950
RR RUEHCN RUEHGH
DE RUEHGH #0247/01 1150617
ZNR UUUUU ZZH
R 250617Z APR 07
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 5749
INFO RUEHBJ/AMEMBASSY BEIJING 1011
RUEHSH/AMCONSUL SHENYANG 0592
RUEHGZ/AMCONSUL GUANGZHOU 0567
RUEHCN/AMCONSUL CHENGDU 0586
RUEHHK/AMCONSUL HONG KONG 0693
RUEHIN/AIT TAIPEI 0468
RUCPDOC/USDOC WASHDC 0141
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RHEHNSC/WHITE HOUSE NATIONAL SECURITY COUNCIL WASHINGTON DC
RUEHGH/AMCONSUL SHANGHAI 6138

UNCLAS SECTION 01 OF 04 SHANGHAI 000247

SIPDIS

SENSITIVE
SIPDIS

STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SAN
FRANCISCO FRB FOR CURRAN/GLICK/LUNG; NEW YORK FRB FOR
CLARK/CRYSTAL/MOSELEY
STATE PASS CFTC FOR OIA/GORLICK
CEA FOR BLOCK
USDOC FOR ITA DAS KASOFF, MELCHER AND OCEA/MCQUEEN
TREASURY FOR OASIA - DOHNER/CUSHMAN
TREASURY FOR IMFP - SOBEL/MOGHTADER
NSC FOR KURT TONG

E.O. 12958: N/A
TAGS: EFIN ECON PREL CH
SUBJECT: CFETS UPDATE ON FX AND BOND MARKET DEVELOPMENTS

REF: A. A) 06 SHANGHAI 7096
B. B) 06 SHANGHAI 7091
C. C) 06 SHANGHAI 2384

(U) This cable is sensitive but unclassified and for official
use only. Not for distribution outside of USG channels.

1. (SBU) Summary: China Foreign Exchange Trading System (CFETS)
President Xie Duo told Embassy ECON M/C Robert Luke on April 19
that CFETS continued to carry out policies to make China's
foreign exchange (FX) trading system more market-based and
efficient, including: increasing the number of over-the-counter
(OTC) spot FX market makers from 15 to 22; updating the formula
for calculating the opening price (central parity rate) of the
RMB; launching a new Reuters-designed trading platform; and
revising CFETS' fee schedule to adhere more closely to
international norms. A bank in Tianjin was being allowed to
hold net open positions shorting the USD on an experimental
basis. The People's Bank of China (PBOC) was promoting the use
of Shanghai Interbank Offering Rate(SHIBOR)-based products,
launched in January, to develop a domestic benchmark and yield
curve. The interbank bond market was now "very large for a
developing market," but the corporate bond market was still
underdeveloped. CFETS' application with the U.S. Commodity
Futures Trading Commission (CFTC) to offer Chicago Mercantile
Exchange (CME) products in China had run into regulatory
hurdles, making its hoped-for June 2007 launch unlikely. End
summary.

2. (SBU) CFETS President Xie Duo and Vice General Manager Song
Jianqi told visiting Embassy ECON M/C Robert Luke on April 19
that, over the past year, CFETS had carried out many
"interesting changes" in order to meet PBOC's "simple objective"
of "including more market-based elements" in China's foreign
exchange system. Xie said PBOC was not involved in CFETS' daily
operations or overtly setting the price of the RMB, but that it
was still able to "indirectly intervene." The RMB appreciated
to a new high against the dollar on April 20, closing at 7.7165.
This represented a total appreciation of 7.26 percent since
July 21, 2005.

-------------------------------
RMB FX Volume: Still Not Saying
-------------------------------

3. (SBU) As in past visits (Ref A), Xie declined to answer a
direct question about the total volume of FX trade through the
CFETS system. The PBOC had not yet publicly announced trading
data since it was worried that such information could prompt
"misunderstandings and market speculation," he said. According
to Xie, the volume of FX turnover was two times more in 2006
than it had been in 2005. Xie added that more than 90 percent
of spot trades were OTC, and that market makers now accounted
for more than 80 percent of the OTC trade volume. CFETS FX
derivative markets had continued to develop, but swaps were now
more popular than forwards since they allowed investors to
manage both exchange rate and interest rate risk. The forwards
market, introduced in August of 2005, had diminished in
importance and now averaged only about USD 100 million per day.
The swap market, introduced in April 2006, had taken off and now
accounted for about USD 1 billion per day (Ref A).

--------------------------------------------- --
Market Makers Increase in Number and Importance
--------------------------------------------- --

4. (SBU) There were now 22 market makers in the OTC spot market
(up from the original 15), with seven more banks added in
December 2006. Of these, four were Chinese banks -- China
Minsheng Banking Corp., Hua Xia Bank Co., China Everbright Bank,
and China Development Bank -- and three were foreign banks --
Deutsche Bank, Tokyo-Mitsubishi and Sumitomo Mitsui Banking
Corp. (Note: These banks began acting as market markers on
December 18. Of the 22 market makers, 13 were Chinese and nine

SHANGHAI 00000247 002 OF 004


were foreign. See Ref B for market makers' views on FX
developments. In addition to the three listed above, the other
foreign market makers are: HSBC, British Standard Chartered,
Citibank, ABN-AMRO, Credit Agricole, the Bank of Montreal. In
addition to above-listed four new members, the original Chinese
market makers were: Industrial and Commercial Bank of China,
Bank of China, Agricultural Bank of China, China Construction
Bank, CITIC, Bank of Communications, Shanghai Pudong Development
Bank, China Industrial Bank, and China Merchants Bank. End
note.) Xie explained that the market maker banks engaged in
trading of renminbi debt (interbank repo and bond) instruments
differed from those involved in FX trading although there was
some overlap. He noted that a few foreign banks were active in
this trade as well. For example Citibank Nanjing branch was
active in the renminbi debt market, although not in the FX
market.

5. (SBU) The trading volume of foreign bank market makers,
particularly HSBC, Citi, ABN AMRO and Bank of Montreal, had
increased because they generally offered the best prices. Xie
attributed this success to foreign banks having better trained
staff, and more skilled and highly compensated traders than at
Chinese banks.

6. (SBU) Xie said that CFETS methodology for calculating the
daily central parity price had not undergone any changes, but
that the weights assigned to each of the market makers (Ref C)
in calculating the opening trading price had changed based on
their respective trading volumes. He said that the Bank of
China now only accounted for about 15 percent of OTC FX trades
and that its weight had been adjusted downwards accordingly, but
did not disclose any additional specifics on the "black box" in
which the calculation was made.

--------------------------------------------- -----
"No Idea" How Central Bank Intervenes in FX Market
--------------------------------------------- -----

7. (SBU) Xie said PBOC did intervene indirectly in the FX market
in order to achieve its policy objectives, but he "had no idea"
of the mechanism that the PBOC used to accomplish this
intervention. There was, he said, "no direct link between PBOC
and the Bank of China." Though PBOC was not a CFETS member, Xie
acknowledged that it had relationships with what he deemed
"premium dealers" and that it made its trades through these
dealers. In addition, Xie said PBOC was still concerned with
excess liquidity, inflation and overheating and "was clearly
determined to control inflation through market measures rather
than administrative measures" whenever possible.

-----------------------------
New Trading Platform Launched
-----------------------------

8. (SBU) CFETS launched its new trading platform (ref A) in
March 2007 to adhere more closely to international norms and to
create a platform for more FX derivative products. Xie said
that its cooperation with Reuters in designing the software had
been very successful and that the software was "running on
American computers." Xie said that the new software system
played to the strengths of the foreign bank market makers who
"were very good at trading currency." The new platform allowed
for spot, forward and swaps to trade on the same platform, with
the screen listing only the best price offered.

9. (SBU) During a tour of CFETS' operations center, Luke
observed CFETS employees monitoring spot and swap trading of the
RMB as well as the Shanghai Interbank Borrowing Rate (SHIBOR)
and bond trading. Three large screens dominated the room. One
screen showed the RMB-USD trading price, one showed the SHIBOR
rate, and the third showed the status of CFETS' computer network
overlaid on a map of China. Song told Econoff that CFETS' staff
had grown by 60 in 2006.

SHANGHAI 00000247 003 OF 004

----------
Lower Fees
----------

10. (SBU) Xie noted that CFETS had implemented a new fee
structure on April 6. These fees were 30 times less than it had
charged previously. For example, where fees had been USD 3 for
every USD 10,000 exchanged, it now only cost USD 10 for every
USD 1 million exchanged. Xie also said that the fees declined
on a sliding scale based on the maturity or size of the trade.
(Note: More information on the fees can be found in Chinese on
CFETS' webpage:
http://download.chinamoney.com.cn/content/onl ine2002/URLCon
tent/gonggao/2007_80.doc End note.) According to Xie, CFETS also
charged prices consistent with international practice for
hard-currency to hard-currency trades. Volume for this type of
trade was only about USD 15 billion per year and represented a
fraction of CFETS workload. Only small banks lacking
international relationships of their own needed this kind of
service, he said.

--------------------------------------------- ---------
Agreement "in Principle" for Additional Liberalization
--------------------------------------------- ---------

11. (SBU) Xie said that PBOC and the State Administration of
Foreign Exchange (SAFE) had agreed "in principle" to: 1) allow
banks to hold net open positions shorting the dollar (or longing
the RMB); and 2) widen the daily USD/RMB trading band from its
current .3 percent limit. This would be in alignment with its
stated goal of "adding more market principles." Initially, Xie
said he expected this to occur in the next six months, then he
qualified his remarks by saying, "I don't know when or whether."
He added that, given the "oversupply of USD" in the market,
widening the band now would "have no effect."

---------------------------------------------
Experimenting with Two-Way Net Open Positions
---------------------------------------------

12. (SBU) One bank, located in Tianjin, had been designated by
CFETS to experiment with two-way net open positions; i.e.
holding positions that either longed or shorted the dollar, to
allow CFETS to "gain experience and understanding" on how to
manage such a policy change. Luke speculated out loud that the
bank selected was Bohai Bank. Xie refused to comment. (Note:
Bohai Bank is not one of CFETS market makers, but is a CFETS FX
trading bank. Aside from the bank in Tianjin, all other banks
in China are still prohibited from holding net open positions
that short the dollar (or long the RMB), a policy that traders
says operates as a one-way constraint on China's development of
its FX system (Ref B). End note.)

------
SHIBOR
------

13. (SBU) Xie said PBOC had encouraged the development of
financial tools and products, such as SHIBOR and the domestic
bond market to help develop China's banking and FX markets.
SHIBOR's January 2007 launch had created a domestic benchmark
and yield curve that would allow PBOC more ability to use
interest rates in carrying out macroeconomic policies and would
provide the necessary conditions to develop China's FX and
derivatives markets. (Note: During the tour of the operations
center, the screen displaying SHIBOR rates showed a yield curve
for different maturities with short-term rates exceeding
longer-term rates. End note) At an April 13 PBOC conference
Xie had attended in Beijing, PBOC stated its intent to gradually
deregulate China's lending and deposit interest rates as its
confidence with SHIBOR developed. Xie said there were currently
16 commercial banks acting as SHIBOR market makers. (Note: Four

SHANGHAI 00000247 004 OF 004


of the SHIBOR market maker banks are Chinese: Industrial and
Commercial Bank of China, Bank of China, China Construction
Bank, and CITIC Bank. The other 12 are foreign banks: Credit
Agricole, HSBC, Citibank, Deutsche Bank, ABN AMRO Bank, ING
Bank, Bank of Montreal, Royal Bank of Scotland, Standard
Chartered Bank, ANZ Bank, UBS Bank, and Mitsubishi Bank of
Tokyo. End note.)

14. (SBU) Xie said that, in March, the interbank bond/repo
market turnover was RMB 9 trillion (USD 1.2 trillion), "very
large for a developing market." The longest bond offered was a
30-year Treasury bill. The interbank bond market had no
maturity restrictions and bonds were sold by public auction.
Other bonds included policy bank bonds, commercial bank bonds
and OTC bonds. The corporate bond market, however, was very
small, with trading volume in March of only about RMB 100
million (USD 12 million.)

-----------------
Problems with CME
-----------------

15. (SBU) CFETS' goal of becoming a super clearing member of
CME, eligible to sell CME products in China, continued to await
CFTC approval. As Xie understood the problem, because of its
structure, CFETS was unable to meet CFTC's capital requirements.
While CFETS generated "lots of money" every year, this all went
to PBOC. CFETS was an institutional organization (shiye danwei)
of PBOC and had no independent capital. Xie expressed concern
that CFTC did not understand the Chinese organizational
structure and said, "If I make a mistake, I can be arrested or
even killed -- but as an institution, CFETS could never go
bankrupt." Xie said that CFETS had even tried to get permission
from PBOC to be established as an independent company in order
to meet the capital requirements, but the Ministry of Finance
had refused. Xie said it was unlikely that CFETS would meet its
previously announced deadline of June 2007 to begin offering CME
products.

16. (SBU) Note: Consulate has subsequently conveyed Xie's
remarks to CFTC. CFTC understands CFETS' organizational
structure and the Chinese concerns and is currently considering
its application.
JARRETT

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