Forex Regulator Decodes Forward Hedging Rules

* Measures outlined in the document mark a key step toward market reform for China’s foreign exchange regime

* New policy’s impact would be no less than the exchange reform in 2005, analyst says

China’s foreign exchange regulator recently fleshed out details of its policy on foreign exchange forward hedging, providing greater leeway and convenience to companies trying to limit foreign exchange risks.

The State Administration of Foreign Exchange (SAFE) published a document Tuesday on its website outlining relaxed requirements on forex forward transactions. For instance, companies that have foreign exchange exposure but no actual forex transactions can use forward hedging to manage their risk, according to the document.

Market analysts said measures outlined in the document mark a key step toward market reform for China’s foreign exchange regime as they clarified previous policy and further relaxed control on the forex derivative market to encourage participation.

“The market has yet to understand the importance of this new policy,” said a senior forex industry analyst. “Its impact would be no less than the exchange reform in 2005.” He was referring to the China central bank’s decision to end a decade of strictly pegging the yuan to the U.S. dollar and incorporate a “reference basket” of currencies when setting the exchange rate for the yuan.

The new document “addressed many long-existing issues for which forex market players are longing for explanation,” said the analyst, who asked not to be identified. “It will further expand access to the forex market and promote reform of the foreign exchange regime,” he said.

The document, in question-and-answer format, explains in detail an earlier policy on forex forward contracts published by SAFE in February that allows both physical and cash settlements of foreign exchange forwards to make such transactions fully market-oriented and encourage market participation.

China allowed cash settlement in buying foreign exchange forwards in 2016. But before the February policy, forex forwards in the yuan were settled on a physical basis, meaning there was an actual delivery of the underlying currencies upon maturity of the contract. The new policy granted market players the flexibility to pay the net basis and roll over the forwards.

The new settlement method is similar to non-deliverable forwards (NDF), which are commonly used offshore. But the market has remained lukewarm to the new policy because of a lack of detailed rules to guide the implementation, analysts said.

A manager at a foreign bank in China told Caixin that the bank has executed only two “in-shore NDFs” for its clients since the policy was issued in February.

In the latest explainer, SAFE reiterated the February policy that all foreign exchange forward contracts should be conducted under the premise of the principle of real needs. But it added that such hedging activities can cover not only current account but also capital account transactions, expanding the access of market players.

China has never clearly regulated whether companies can use forex forwards to hedge risks for capital account transactions. In practice, banks have hesitated to facilitate such deals as the country’s capital account hasn’t yet been made fully convertible.

Han Huishi, a forex market commentator, said the clarification would attract more investors to the derivative market, such as offshore investors who invest in China’s onshore bond market. “It is very important to make it clear as more and more foreign investors are entering China’s capital market,” Han said.

The Tuesday document also made clear that companies are not required to provide documents to prove they have had actual forex transactions to hedge against as long as banks can confirm they have real underlying need, SAFE said.

For instance, a Chinese company that acquires an offshore business may have forex exposure in combining the foreign unit’s financials, so it can use the forward exchange to hedge against such risks.

Analysts said this could put more compliance pressure on banks. SAFE said in the document that banks should understand their clients and their business and conduct the forward transaction based on due diligence.

Contact reporter Han Wei (weihan@caixin.com)