Open forex market in country’s best interest

Govt encouraged to temper yuan's global rise with risk control measures

The future direction of the Chinese yuan was a hot topic at a forum on currency market investment held by hexun.com Sunday. In fact, Jim Rogers, one of the co-founders of the Quantum Fund, used the forum to once again describe China and the renminbi in bullish tones. Furthermore, he urged China to open its foreign exchange market as soon as possible.

Rogers has certainly been right about many things in the past, but does his latest exhortation represent sound advice for China?

China's position in the global foreign exchange market has swelled substantially over recent years thanks to the internationalization and unilateral appreciation of the yuan. The country's forex trading volume has expanded by an average annual rate of 33.1 percent between 2005 and 2013, an official from the State Administration of Foreign Exchange (SAFE) reportedly said last month in a speech. Total trading volume amounted to $11.2 trillion last year, up ten fold from 2004.

This sum, however, represents just a small corner of the global forex market, where daily trading amounted to an average of $5.3 trillion in April 2013, according to data from the Bank for International Settlements, an organization of central banks. To many this might seem surprising, considering that China now boasts the world's second-largest economy and is one of the most active trading nations on Earth.

At this point in its development, China needs to further promote the global use of the yuan in trade and investment to gain more sway in the world market. To accomplish this goal, authorities must, as Rogers suggested, further open the country's currency market to outside forces.

The Chinese government's quest to promote yuan trading began some two decades ago, when a national integrated inter-bank forex market was established in 1994. The market has improved over subsequent years with the introduction of new instruments and diversified trading models. Plans are also in the works to open the market to more institutional participants, including insurance companies, brokerages as well as trust and fund companies. At present, banks are the only institutions allowed to use the market.

But despite these developments and the clear need for China to expand the yuan's global footprint, there are several stumbling blocks that will have to be overcome as authorities work to reach their goals.

For starters, despite stringent controls over cross-border capital movements, there is still a great deal of speculative pressure in China's forex market. Amid efforts to open this market, steps should be taken to counter the potential impact of international hot money flows.

At the same time, authorities should also widen the yuan's daily trading band, which was expanded in March to 2 percent above or below a central parity point. This represents a substantial increase from an earlier limit of 1 percent imposed in 2012. By allowing for a more elastic yuan, authorities can break expectations of the currency's continued appreciation. Such expectations, as many know, have led to major inflows of foreign capital from traders looking to profit from currency arbitrage.

Additional work is also needed on the development of more instruments with lower leverage rates. The market is still filled with such instruments at the moment, which only amplify risks for investors. With more products to choose from, trading activity stands to increase, thereby injecting new life into the market.

Once the needed technological, regulatory and risk response measures have been taken, China can further open its forex market and accelerate the international usage of its currency.