In step with the news China has widened its currency trading band, the State Administration of Foreign Exchange (Safe) also announced changes to the net open position (NOP) limit for onshore banks in China.
Safe’s announcement on April 16 is designed to allow banks greater flexibility to work to the new daily renminbi trading limit of 1% against the dollar. It should also make onshore FX forwards more attractive in terms of pricing, experts agree
A net open position is the difference between a total open long (receivable) and an open short (payable) positions in any given assets, be it a securities, foreign exchange, or commodities.
Safe made two key policy changes:
The lower limit on FX NOP was further lowered from zero to a negative level, allowing banks to maintain net short FX positions against the renminbi. For market-making banks the new limits are decided by the People’s Bank of China. For non-market making banks the limits are calculated based the volume of FX deals they individually conducted in 2011.
It abolished a regulation that limited banks ability to be short foreign currency versus renminbi flows in FX derivatives from clients. The regulation was colloquially known as NOP2.
Before the changes, onshore banks struggled to cover their spot risk, limited in their ability to sell dollars against renminbi in the onshore market. Now they can hold a short overnight position, that restraint has lessened.
“Overall, the regulation change increases the capacity for onshore banks to sell dollar/renminbi spot to cover their FX risk, which arises whenever an onshore corporate sells a dollar forward to the bank,” Deutsche Bank said in a April 17 research note.
Evidence to this was the convergence of the FX forward and swap curve immediately after the announcement (see graph). The two diverged after the NOP2 came into place in November 2010.
The reason is because of the structure of the two products.
A swap consists of two legs executed at the same time: a spot FX transaction and a forward FX transaction. As such the exchange offsets each other and does not impact the NOP2 limit. A forward transaction, on the contrary, is a one-way directional bet, leaving a company and the bank on opposing sides of it.
As a result onshore banks were effectively quoting two FX forward curves. One was geared for the interbank market—dominated by FX swaps deals—while the other was tuned for corporations, who typically buy forwards.
“In the latter, banks were quoting lower dollar versus renminbi forward prices than in the interbank market, so as to reduce the attractiveness for corporations to sell dollar forwards to the banks, given their limited ability to hedge the resultant spot risk,” Deutsche Bank notes.
This means that for approximately 16 months, banks were pricing onshore forwards at levels nearer that of the non-deliverable forward and offshore renminbi markets .
The hope is now that the onshore dollar/renminbi forward market will be more driven by a corporations risk profile than regulation.