Potential Risk Surges in Foreign Exchange Loans

The foreign exchange administration department in China warned the financial institutions in China to handle the potential risk in foreign exchange loans carefully.

On April 13, the State Administration of Foreign Exchange (SAFE) warned the commercial banks and dealers to be cautious about the potential risk in the increase of foreign exchange loans. But the SAFE didn’t give out the specified keynote of the foreign exchange regulations.

According to a source, the commercial banks in China began to borrow more and more US dollars when the RMB appreciation expectation climbed up. Wang Xiaoyi, deputy director of the SAFE said that the banks, as well as the dealers, should try their best to maintain the stability of market and must not set foot in the speculations.

Also on April 13, the Chinese president Hu Jintao reiterated China’s attitude toward the issue of RMB exchange rate when meeting the US president Barack Obama – the exchange rate reform to RMB will be influenced by the outside stress and will go on according to the fixed schedule.

The words from President Hu Jintao cooled the expectation for the RMB appreciation which went overheated in these days.

On April 13, the exchange rate between RMB and the US dollar was 6.8260 yuan against one dollar, with tiny changes from a day before.

Risk of Overseas Borrowing

In the first quarter of 2010, China saw a drastic increase of foreign exchange loans.

In March, the amount of foreign exchange loans in China increased by 10.1 billion US dollars, with the same increasing amount as in February. The foreign exchange deposits, however, only saw an increase of 1.5 billion US dollars, 1 billion US dollars smaller than February’s increase. Many bank customers which need the bucks will borrow US currencies through borrowing instead of purchasing.

This resulted in the drastic increase of the RMB counterpart of foreign exchange reserve. In the first three months of 2010, the RMB counterpart of foreign exchange reserve increased by 747.8 billion yuan (USD 109.7 billion), with the increasing amount 78% higher than the same period of last year.

The crazy increase of foreign exchange loans and RMB counterpart of foreign exchange reserve vexed the Chinese commercial banks a lot. Above all, the commercial banks are haunted by the limited foreign currency cash.

As introduced by an expert, the increasing demand for foreign exchange loans raised the local interest rate to the USD counterparts – equivalent to an increase of 300 points in the LIBOR index in the last six months (October 2009 to March 2010).

The shortage of US currencies forces the commercial banks to borrow a large amount of US dollars from the overseas, which stirred up the caution of the SAFE.

In comparison, there are enough or even too many US currencies in the international monetary market, making it possible for the Chinese commercial banks to borrow US dollars from the overseas market. However, the SAFE worried that backflow will happen to the US dollars if the international financial situation gets worse, which will cause the flow risk for the US dollars borrowed into the banks in China.

Meanwhile, some commercial banks, driven by the expectation for RMB appreciation, may conduct some speculations. There are two main speculation activities. The first one is the illegal investment in the NDF market; the second one is to lower the exchange rate of the US dollar against the RMB through SBOT and SWAP operation, casting bigger stress over the RMB appreciation.

Another matter worrying the SAFR is that some big enterprises may adjust and operate their businesses as instructed by the commercial banks. By then, a large amount of exchange settlement will come out, raising the fear in the market.

No Obvious Hints for Hot Money Inflow

In the first three months of 2010, the RMB counterpart of the foreign exchange reserve increased by 747.8 billion yuan (USD 109.7 billion), up 78% from last year. Correspondingly, the foreign exchange reserve in the first quarter increased by 47.9 billion US dollars, which was much smaller than the increase of 37.8 billion US dollars in the first quarter of last year.

According to an analyst from a big state-owned bank, the gap between the foreign exchange reserve and the RMB counterpart of foreign exchange reserve is on the one hand due to the increasing foreign currency cash in the commercial banks; on the other hand, the People’s Bank of China, or the central bank, may have injected some foreign exchange reserve into China Investment Corporation, which is another explanation to the gap.

The drastic increase of RMB counterpart of foreign exchange reserve also triggered the guess about the inflow of hot money.

The Agriculture Bank of China told the way of calculating the hot money inflow in China – the RMB counterparts of foreign exchange reserve minus FDI minus trade surplus equals the amount of hot money. Based on this, the amount of hot money flowing in China was 72.6 billion US dollars, which was the highest from the second quarter of 2008.

But there is another way of calculating, which is that the increase in foreign exchange reserve minus FDI minus trade surplus equals amount of hot money. In that way the amount of hot money flowing in China was only 11 billion US dollars in the first quarter.

The experts said that there are no obvious hints for the inflow of hot money. “The HK dollar acts as a prophet in telling whether the hot money has flowed in China or not. When a large amount of capital is ready to get into Mainland China, it will stay in Hong Kong for a while, which will influence the exchange rate of HK dollar.”

“Right now, the HK dollar is appreciating, which shows that the international hot money is less and less interested in the Chinese capital,” said one of the experts.

The expectation for the 5% of RMB appreciation didn’t mean a lot of attraction for the hot money. The interest rate in some emerging market, like Brazil and India, is very high.

Improvement of Market Maker System

Nowadays, one of the primary tasks for China’s financial and monetary policies is to improve the market maker system.

One of the greatest achievements made by the foreign exchange reform, which was started in 2005, is the introduction of market maker system in the domestic foreign exchange market. The number of market makers also increased from 22 at the beginning to today’s 26.

Now, the SAFE wants improvement. The previous pattern of single on-demand market maker should be changed and the forward market maker and the comprehensive market maker should be introduced. Meanwhile, some objectives or requirements should be set up for the existing market makers, like the requirements for principal and trade settlement. The banks and financial institutions must possess better and more varied qualities to become a market maker. The theory of “the survival of the fittest” should also be introduced.

According to a source, the 26 existing market makers had different levels of performance last year. Some of them didn’t carry out their obligations at all.

Nevertheless, the requirement for the principal to be a market maker was boycotted by some banks. The SAFE set the rate of capital sufficiency as a level higher than the 8% rate stipulated in the New Basel Accord, which is also known as Capital Accord. Though the SAFE wants to make sure that all the market makers have adequate capital to deal with any kinds of risks, some foreign banks without qualified rate of capital sufficiency still think the requirement is too rigorous and unfair.