VZCZCXRO2312
RR RUEHCN RUEHGH
DE RUEHGH #7096/01 3340904
ZNY CCCCC ZZH
R 300904Z NOV 06
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 5310
INFO RUEHGH/AMCONSUL SHANGHAI 5635
RUEHBJ/AMEMBASSY BEIJING 0656
RUEHHK/AMCONSUL HONG KONG 0432
RUEHSH/AMCONSUL SHENYANG 0344
RUEHGZ/AMCONSUL GUANGZHOU 0323
RUEHMT/AMCONSUL MONTREAL 0001
RUEHOT/AMEMBASSY OTTAWA 0008
RUEHGP/AMEMBASSY SINGAPORE 0024
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/USDOC WASHINGTON DC
RHEHNSC/WHITE HOUSE NATIONAL SECURITY COUNCIL WASHINGTON DC
RUEHCN/AMCONSUL CHENGDU 0341

C O N F I D E N T I A L SECTION 01 OF 05 SHANGHAI 007096 
 
SIPDIS 
 
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: DECL:  11/30/2031 
TAGS: EFIN ECON PREL CH
SUBJECT: CHINA FOREX: AFTER NEW HIGHS, NEXT STEPS NEEDED 
 
REF: A. SHANGHAI 7091 
 
     ¶B. SHANGHAI 5846 
     ¶C. SHANGHAI 1356 
     ¶D. SHANGHAI 1355 
 
CLASSIFIED BY: Mary Tarnowka, Political/Economic Chief, U.S. 
Consulate Shanghai, State Department. 
REASON: 1.4 (b), (d) 
 
 
 
¶1. (SBU) Summary: As the RMB continued to set record highs, 
closing at RMB 7.84 per USD on November 27, Shanghai forex 
traders expressed appreciation for the greater volatility in the 
forex market and predicted continued gradual appreciation of the 
RMB.  In a series of meetings in late October and November, 
representatives of foreign banks trading foreign exchange in 
Shanghai discussed market trends and identified future necessary 
reforms as including: allowing banks to hold net open positions 
shorting the dollar; expanding the 0.3 percent intra-day trading 
band; reducing the paperwork required for forex trading; and 
liberalizing interest rates to develop more effective market 
pricing of forex derivative products.  In a November 28 AmCham 
Shanghai address, Standard Chartered Senior Economist Stephen 
Green shared his analysis of China's foreign exchange policy. 
End summary. 
 
¶2. (SBU) In late October and November, P/E Chief and Econoff met 
with representatives from five banks engaged in forex trading in 
Shanghai to discuss recent trends and identify necessary 
reforms.  Those interviewed included: Citigroup Head of Sales 
and Trading Paulus Mok, Citigroup Global (Citi) Capital Market 
Vice President Alan Chan, and Citigroup Chief FX Dealer You 
Jiong; JP Morgan Treasurer and Head of Marketing and Trading 
Andrew Zhang; HSBC Deputy Treasurer Ryan Song, Bank of Montreal 
(BMO) Managing Director and Head of Asia Robert T. Martin and 
(via telephone) Guangzhou-based currency trader David Mu; and 
Standard Chartered (SC) Senior Economist Stephen Green. 
 
--------------------------------- 
CITIGROUP: THE MARKET IS RATIONAL 
--------------------------------- 
 
¶3. (C) According to Citigroup's (Citi) Mok, Secretary Paulson's 
visit to China was "well-received" in a market that had been 
increasingly volatile.  He noted that at the beginning of 2006, 
daily volume of RMB traded was approximately $500 million.  By 
the end of October 2006, however, volume was $40-50 billion per 
day.  He claimed that Citi ranked among the top of foreign banks 
trading RMB.  Mok said that the market was acting "more 
rationally," but that it was clear that the Bank of China (BOC) 
had the overriding influence in setting the morning reference 
price.  Mok believed that in terms of overall trade volume, Citi 
usually ranked second or third behind the BOC, vying with HSBC. 
When pressed, Mok said that Citi "sometimes sees that it has 
some influence" on the morning reference price quoted by CFETS 
at 9:15 AM on every trading day, based on a (secret) weighted 
average of market maker bids.  That being said, Mok added, it 
would be impossible to know for sure. 
 
¶4. (C) Mok said that of the 15 Market Makers, he surmised that 
BOC represented 15-20 percent of the total volume traded on the 
CFETS system.  Citi handled between 5-10 percent (sometimes up 
to 15 percent) of daily volume.  Mok added that the six foreign 
Market Makers accounted for roughly 30 percent of all trade with 
the nine Chinese banks accounting for most of the rest.  Foreign 
banks also had demonstrated a higher tolerance for risk than the 
Chinese Market Makers. 
 
¶5. (SBU) Mok said that the market volume had been increasing due 
to two factors.  He pointed out that (1) there had been an 
increase in the numbers of trades made close to the end of the 
trading day (5:30 PM) as traders were increasingly willing to 
stake out a position.  He noted that the extension of trading 
hours on the matching system was helpful in that regard because 
it provided a market of last resort for traders needing to clear 
their positions.  Mok added that (2) Chinese traders were 
 
SHANGHAI 00007096  002 OF 005 
 
 
getting more experienced and more confident trading. 
 
¶6. (C) Mok said he expected the PBOC to maintain its long-term 
control over the value of the RMB, but to allow greater 
intra-day and inter-day volatility.  His perception was that the 
Chinese authorities and regulators were pleased with the 
increased volatility as it gave their banks and corporations a 
chance to learn how to react to currency fluctuations. 
 
¶7. (C) According to Mok's contacts at the PBOC, the increasingly 
large foreign currency reserves were beginning to be seen as a 
"big burden."  Mok, and Citi's head trader You both commented 
that PBOC's involvement in forex trading was noticeable 
behind-the-scenes, from the time that the rate was set every 
morning to the close of trading.  Mok stated that PBOC 
sterilized its purchases two times a week.  Mok surmised that 
for some "big deals, like when Sinopec needs $1 billion in 
cash," it appeared PBOC worked directly with BoC without going 
through the CFETS platform.  However, he believed all sales of 
U.S. dollars went through CFETS in order to maintain the value 
of the RMB. 
 
¶8. (SBU) According to Mok, Citi's wish list of forex reforms 
was: (1) Change the exposure limit calculation to two-way 
(allowing traders to both long and short the dollar; currently 
traders are only allowed to hold net open positions longing the 
dollar); (2) Raise or eliminate the "arbitrarily-set" short- and 
long-term foreign debt limits that restrict Citi's ability to 
function efficiently as an international bank; (3) Allow 
corporations to "net settle" the end result of multiple daily 
trades (as banks are now); (4) Standardize and reduce the 
amounts of documentation needed for contracts to allow the 
ability to do cash flow and budget hedging; and (5) Increase the 
intra-day trading band beyond 0.3 percent of the daily reference 
price. 
 
------------------------------- 
HSBC: NO NEED TO WIDEN THE BAND 
------------------------------- 
 
¶9. (C) According to HSBC's Ryan Song, China's forex market was 
"stable and liquid."  HSBC had two to three forex traders in 
China, compared to the more than 20 forex traders at BOC.  Song 
said that HSBC perhaps had "some small impact on the value of 
the reference price at 9:15 AM," adding that HSBC's influence on 
setting the price appeared to be in line with what his traders 
understood to be their weighting and size within the CFETS 
system. 
 
¶10. (C) Song also noted the increased market volatility by 
pointing out that while a normal trading day might see the 
market move between 100 and 200 pips away from that morning's 
reference price, it had not been unusual to see 100 pip swings 
in price "in a few minutes."  In response to a question about 
the affect of the Chinese government purchasing large quantities 
of dollars, Song said that he and his traders could tell when 
huge trades took place since the market sometimes moved 
dramatically "from the time when they decided to make a trade 
and the two seconds it took for them to manually enter that 
trade."  Their only explanation for these changes was that PBOC 
had been making a large dollar purchase.  Song noted that his 
traders often squared USD 10-20 million without moving the 
market and so speculated that the rapid "drying up of liquidity" 
was related to massive purchases of dollars. 
 
¶11. (C) The forex reform that HSBC would most like to see 
implemented, according to Song, was the ability to short the 
dollar.  In contrast to Citi, however, Song indicated that there 
was no need to adjust the 0.3 percent trading band (equivalent 
he said to about 2,000 pips) since at its most volatile, the 
trading swings had only been 100-200 pips. 
 
¶12. (C) Song told P/E Chief and Econoff that HSBC had been 
attempting to educate Chinese policy makers and regulators on 
the importance of continued reforms of the forex market.  He 
said that HSBC sent representatives to Beijing to educate them 
 
SHANGHAI 00007096  003 OF 005 
 
 
on the benefits of having a more volatile market-based foreign 
exchange market.  HSBC also informed Beijing that the next step 
should be to allow forex options since banks were ready in terms 
of the technical infrastructure and system.  Song also said that 
HSBC had argued for the creation of a strong inter-bank 
borrowing curve -- the vital next step in permitting banks to 
accurately price the forwards market. 
 
------------------------------------------- 
BANK OF MONTREAL: PUNCHING ABOVE ITS WEIGHT 
------------------------------------------- 
 
¶13. (C) Econoff's meeting on October 25 with BMO's head Robert 
Martin was, according to Martin, the first contact he had had 
with the USG since coming to China four years previously.  He 
added that his headquarters had initially viewed the meeting 
request with suspicion, convinced that the underlying goal of 
the meeting was to figure out its market-share in order to help 
a U.S.-bank replace BMO as a CFETS Market Maker.  Martin told 
econoff that he had persuaded his headquarters to permit the 
meeting by reminding them that BMO owned Chicago-based Harris 
Bank and so ought to be considered a "U.S.-institution as well." 
 
¶14. (C) Martin said that part of his institution's defensiveness 
was based on its own understanding that its position as one of 
six foreign Market Makers in China's forex system was a bit of 
an anomaly given its relative size compared to banks like Citi 
and HSBC.  Martin was very proud of the fact that BMO "punched 
above its weight" in China.  Martin informed Econoff that BMO 
moved into China in the mid-1990s, at a time when few other 
banks were interested in China's forex market, in anticipation 
of the day when China's forex market would liberalize.  It 
established good relations with SAFE and other regulatory bodies 
and helped to educate Chinese policy and regulation makers on 
forex markets.  This investment paid off, according to Martin, 
with BMO becoming one of the Market Makers.  However, this 
status was now threatened by other foreign banks attempting to 
replace BMO.  He said that BMO believed that it ranked 13th or 
14th out of all Market Makers in terms of trade volume -- and so 
was vulnerable. 
 
¶15. (C) Martin, whose own status in Shanghai was unofficial 
since BMO's application to open a Shanghai branch continued to 
be refused, said that BMO had branches in Beijing and Guangzhou 
- with both of its branches holding RMB licenses.  Martin said 
that BMO was not interested in pursuing RMB retail banking. 
Martin referred all forex questions to the head trader at BMO's 
Guangzhou branch, David Mu. 
 
¶16. (C) Mu informed Econoff on October 26, via telecon and 
email, that intra and inter-day forex movements were based on 
four factors: (1) overnight customer positions, including those 
of the central bank; (2) speculative positions; (3) SAFE imposed 
position limits and the need to square any long position on the 
RMB before the end of the trading day; and, (4) SAFE's 
evaluation criteria for market makers.  Mu noted that SAFE 
encouraged participation in all currency pairs by giving higher 
scores to banks who quote not just USD/RMB, but also JPY/RMB, 
EUR/RMB, GBP/RMB and HKD/RMB -- something that Mu said worked 
better for local banks.  He also added that inter-day, overnight 
USD movement had significant influence on the next trading day's 
reference rate.  He said that his regression analysis showed a 
higher correlation in EUR/USD than in USD/JPY on the RMB. 
 
¶17. (C) Mu laughingly responded to Econoff's question about the 
increase in forex liquidity by stating that Econoff was after 
"state secrets which I don't know."  That being said, Mu 
estimated that liquidity had increased this year by 10 to 20 
fold. 
 
¶18. (C) According to Mu, BMO's number one desire for 
institutional reform was the same as other Market Makers -- 
allowing banks to short the USD onshore.  Mu said that not 
permitting the shorting of dollars in an attempt to control 
speculation on the RMB was completely ineffective.  He pointed 
out that banks were already among the most regulated 
 
SHANGHAI 00007096  004 OF 005 
 
 
institutions in the financial market and that not allowing them 
to short the USD actually increased their operating risk without 
providing tangible benefits for the central bank or other 
regulators. 
 
--------------------------------------------- ---- 
JP MORGAN: NOT A MARKET MAKER, BUT STILL A PLAYER 
--------------------------------------------- ---- 
 
¶19. (SBU) Providing the perspective of a non-Market Maker, but 
still very active CFETS currency trade, JP Morgan's Andrew Zhang 
said that there was a definite need to liberalize the 
one-directional nature of the market.  Zhang said that an 
initial step might be to provide a "limited" ability to short 
the USD.  JP Morgan had become a "Market Maker" in the forex 
swaps market due to its high level of swaps activity in order to 
meet its high demand for RMB, according to Zhang. 
 
¶20. (C) Zhang said that to improve its forex system, the Chinese 
government needed to address the foreign debt limit that was 
based on a bank's onshore loans without taking into 
consideration that bank's other needs for forex.  He agreed that 
traders needed to be able to hold net open positions both 
longing and shorting the dollar.  He also said that he did not 
think that the Chinese had any desire to liberalize the interest 
rate system since it was one of their key mechanisms to control 
the economy.  Zhang added that PBOC would also not want to widen 
the 0.3 percent trading band since "it would make clear how much 
it was manipulating the exchange rate." 
 
¶21. (C) Zhang informed P/E Chief in a separate telecom on 
October 26 that JP Morgan was very interested in becoming a 
Market Maker on the OTC market.  Its major obstacle to this was 
that JP Morgan did not meet the criteria set up by CFETS that 
Market Makers must be among the top 50 cross-international 
border settlement of forex traders.  When asked what advantages 
JP Morgan would have as a Market Maker that it currently did not 
have as a trader, Zhang said that as a Market Maker it would "be 
one step closer to the black box" where the Chinese government 
made its forex decisions. 
 
¶22. (SBU) Zhang said that the CFETS forward market "died" in 
July 2006 when CFETS changed the rules that allowed it to both 
long and short the USD on the Forward Market.  This rule, which 
according to Stephen Green, did not apply to Market Makers who 
were restricted from such trading, meant that JP Morgan could 
either long or short on a forward, but did not need to square 
the position until the contract matured.  Since CFETS unified 
its rules for both Market Makers and non-Market Makers in July, 
all traders needed to include any forward contracts in 
determining their net open position when squaring at the end of 
the day.  (Note: According to Stephen Green, Market Makers had 
never been allowed to benefit from this loophole, but non-Market 
Markets had been able to "game the system" until July.  End 
note.) 
 
----------------------------------------- 
Standard Chartered: PBOC still in Control 
----------------------------------------- 
 
¶23. (C) Standard Chartered's (SC) Stephen Green said that 
China's economic growth continued to be strong despite the 
continued appreciation of the RMB.  He noted that PBOC, which he 
said favored more movement towards a market-based exchange rate, 
made a point of talking about the textile market's continued 
strong international performance.  However, Green said that the 
Ministry of Commerce was "still mostly conservative" on the 
issue of RMB appreciation and unconvinced that Chinese industry 
would not be hurt by a stronger yuan.  Green said that clearly 
it was the PBOC moving the inter-day RMB rate, and the BOC, as 
PBOC's proxy that controlled the intra-day trading rates as well. 
 
¶24. (SBU) Green listed several issues that SC had identified as 
important steps in the continued reform of China's forex market. 
 These were: debt quota allocation reform, the ability to hold 
net open positions shorting the USD, and restructuring CFETS 
 
SHANGHAI 00007096  005 OF 005 
 
 
fees. 
 
¶25. (SBU) Green said that SC would like to see CFETS foreign 
debt quota system reallocated based on a bank's actual needs and 
not based on the previous year's figures.  SC's 50 percent 
growth last year did not factor in the debt quota allocated this 
year.  Green identified CFETS fee restructuring in terms of 
international norms as an important structural reform. 
 
¶26. (C) The next change that CFETS must undertake, according to 
Green, was to allow banks to hold net open positions shorting 
the USD.  He said that traders were "sort of allowed to short 
the dollar overnight" already, on an informal basis for "small 
amounts."  He defined small amounts as $100-200 million and said 
that CFETS and SAFE "turned a blind eye" to these transactions 
because they seemed to understand that at the end of the trading 
day, a bank sometimes happens to end up short. 
 
¶27. (C) Green also identified the lack of a real U curve as a 
central factor in limiting the market for interest rate 
products.  According to Green, SC was one of three unnamed 
foreign banks part of the trial of the Shanghai Interbank 
Offered Rate (SHIBOR) that began on October 8.  Green said that 
the Chinese government knew that it needed to liberalize 
interest rates, but was not sure "what should come first."  He 
pointed out that there were seven loan rates and five deposit 
rates set by the PBOC, and that PBOC's next step was to reduce 
its involvement to just setting two rates. 
 
¶28. (C) On November 17, Green informed P/E Chief that the 
measures implemented by SAFE in early November to limit offshore 
non deliverable forward (NDF) had produced the, perhaps 
unintended, effect of increasing RMB appreciation.  He said that 
after SAFE restricted both foreign and domestic banks operating 
in China from trading NDFs, there had not been enough buyers on 
Hong Kong NDF market -- leading to the RMB appreciation.  Green 
also commented that another step taken by SAFE, after 
restricting NDF trades outside of China, was the liberalization 
of some of the documentation requirements.  He said that 
Standard and Chartered foreign exchange traders felt that this 
was a step in the right direction, but not as much as was 
needed. 
 
-------- 
COMMENT: 
-------- 
 
¶29. (C) Having started the process of piece-meal reform of its 
currency market, China is faced with increasing demands from its 
forex traders -- interested in maximizing their own profits -- 
to continue the process.  However, the more China liberalizes 
and reforms its forex market, the less it will be able to use 
politically-based macro-economic controls to limit inflation and 
to direct investment.  For now, while China's technical and 
regulatory framework for a free-market based floating currency 
is in place, forex rates still appear to be directed based on 
political calculations. 
JARRETT