Cablegate: China's Foreign Exchange Trading System Update

VZCZCXRO0092
RR RUEHCN RUEHGH
DE RUEHGH #7091/01 3321201
ZNR UUUUU ZZH
R 281201Z NOV 06
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 5305
INFO RUCPDOC/USDOC WASHINGTON DC
RUEHBJ/AMEMBASSY BEIJING 0649
RUEHCN/AMCONSUL CHENGDU 0338
RUEHGZ/AMCONSUL GUANGZHOU 0320
RUEHHK/AMCONSUL HONG KONG 0428
RUEHSH/AMCONSUL SHENYANG 0341
RUEHIN/AIT TAIPEI 0307
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RHEHNSC/WHITE HOUSE NATIONAL SECURITY COUNCIL WASHINGTON DC
RUEHGH/AMCONSUL SHANGHAI 5627

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

© Scoop Media