China is taking concrete steps to construct a more mature foreign exchange market, as part of efforts to improve its exchange rate forming mechanism.

The China Foreign Exchange Trade System (CFETS) said it will soon select a further eight banks to act as market makers for the new products it plans to launch in May, after it signed up Bank of China as the first market maker earlier this week.

"And we are going to Beijing later this week to promote the new products," said an anonymous CFETS official.

The new products in the pipeline are eight types of transactions between foreign currencies, including trading between the euro and US dollar and between the euro and Japanese yen. Currently, only transactions between the Chinese currency, the renminbi, and four overseas currencies - US dollar, euro, the Hong Kong dollar and Japanese yen - are permitted in China's foreign exchange market.

The other eight would-be market makers reportedly include one Chinese bank and seven foreign banks, including HSBC and Deutsche Bank. Market makers are responsible for a continuation in trading, by offering buying and selling opportunities simultaneously to market participants.

While the new types of transactions and their market maker system will help activate trading in the domestic forex market and meet domestic companies' trading needs, analysts say what is also significant is that the moves will pave the way for the launch of a market maker system for trading between the renminbi and the US dollar, which the local currency is pegged to.

China's central bank, the People's Bank of China, has said it will launch a trial program for a US dollar market maker system this year, but did not elaborate.

"The market maker system for the foreign currencies will help China accumulate experience, and help the market makers improve their risk-management capacity, which will facilitate the launch of the US dollar market maker system," according to Chen Daofu, an analyst at the Institute of Finance and Banking under the State Council Development Research Centre.

And "the US dollar market maker system will create a market-oriented renminbi exchange rate forming mechanism," he said.

China has been under pressure from some trading partners to revalue its currency, but has insisted the renminbi is not undervalued, and has reiterated its stance as improving the exchange rate forming mechanism rather than a simple revaluation.

As part of the preparations, the State Administration of Foreign Exchange, the nation's forex regulator, said earlier it will speed up the construction of the nation's forex market this year, including running an experimental US dollar market maker system and launching derivatives.

A prerequisite to creating an optimized renminbi exchange rate forming mechanism is a forex market with healthy price discovery functions, according to analysts.

The renminbi is currently traded in a narrow floating range of around 8.27 yuan to the US dollar. The central bank, acting as the sole virtual market maker, enforces the range by trading with banks in the forex market, where banks are the only participants.

Under the current forex regime, Chinese banks buy forex from individuals and businesses and sell forex to them as the forex regulator requires.

"If they have to sell when their forex holdings exceed the regulatory ceiling, price discovery is impossible," said Chen. "The market maker system will enable them to base their (trading) behaviour on their judgments about exchange rates, and therefore help fulfill the price discovery function."

At a time of heavy inflows of forex, China's central bank has been forced to increase domestic money supply when trying to enforce the renminbi trading band, somewhat offsetting efforts to curb the rapid loan increases and prevent excess investment.

(China Daily March 18, 2005)