China urgently needs to develop an onshore derivatives market in preparation for the demise of the decade-old peg of its currency to the US dollar, state media said yesterday, quoting a top official.
Derivatives will help hedge against currency risk as the controls on the yuan exchange rate are gradually loosened, the China Securities Journal reported, citing Chang Qing, vice president of the China Futures Association.
"Increasingly liberalized global capital flows and China's intended shift from the de facto dollar-yuan peg to a more flexible forex rate [system] means that the risks of fluctuations in the exchange rate are rising," he said.
"The market now desperately needs some financial derivatives to hedge against forex risk and the development of a forex futures market, including forex futures and options trading, is becoming a task of the first priority," Chang said.
Foreign critics have long argued that the yuan is now seriously undervalued, giving Chinese exporters an unfair advantage in global markets. China currently has a small, tightly-controlled onshore yuan futures market, under the watchful eye of the People's Bank of China, with daily turnover estimated only in the tens of millions of dollars.
While hedging activities are currently face heavy restrictions, the authorities are keen to expand the market as part of their goals to develop the capital markets.
This issue runs right through the heart of the current revaluation speculation about the yuan.
A memorandum of understanding was signed in June between the Chicago Mercantile Exchange and China's central bank to develop the Chinese foreign exchange derivatives market.
The move drew applause from US Treasury Secretary John Snow, who said it illustrated "the seriousness of China's effort to reform and strengthen its financial system as it moves toward a more flexible exchange rate system."
Others have argued that, despite the talk among speculators, China cannot de-peg the yuan until there are suitable products available onshore to allow for the hedging of exposure to exchange rate risk.
"The nascent on-shore yuan derivative market is not yet ready to meet the huge hedging demand arising from 1.2 trillion [dollars] in international trade per year," said Deutsche Bank economist Jun Ma.
"At this moment, the market infrastructure can only handle a tiny fraction of that potential demand," Jun said.
However, Andrew Fung, head of sales for Greater China treasury and markets, said that a change in the currency regime will have to precede any significant expansion of the foreign exchange derivatives market unless heavy restrictions are enforced to limit trading activities.
"If they still have a fixed rate and everyone's expecting an appreciation, there would only be selling on the US dollar contract and who's going to buy it?" he said.
Speculation about a revaluation was boosted when the central bank raised one-year deposit and lending rates by 27 basis points last month.
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