From Cover, issue no. 357 Mar 3rd 2008
Translated by Ren Jie
Original special: [Chinese] 

The deposit account has been recording negative growth while the loan account growing strong, this has been the trend in the Chinese foreign currency market for some time. 

What are the funding sources for banks to support such high credit growth? The State Administration of Foreign Exchange (SAFE) too is puzzled, and it has launched an investigation into the matter. 

One SAFE official said: "We are also looking for the source of the problem." 

The Imbalance Saving-Credit Flows
The enormous growth for loans in foreign currency last year was the main concern for SAFE. New loans issued last year reached 51.1 billion dollars, nearly equivalent to the total sum of previous three years' credits in foreign currency. In January this year alone, new credits issued stood at 15.7 billion dollars, close to that for the whole year of 2006.

The demand that fueled the staggering growth was linked to valuation of the Chinese currency. Last year, the yuan appreciated by 6,9%, thus encouraging the corporate sector to apply for credits in foreign currency. The move was to cut cost, as the average annual interest rate for loans in dollars was 5.5% last year, as compared to 7.93% of weighted average interest for credits in yuan. Moreover, credits in dollars would actually depreciate over time under such circumstances.

As for the banks, by providing credits in foreign currency, they could manage exchange rates related risks through swap or forward transactions. Thus, earning not only processing fees and interest rate spread gains, but also preserving their client base.

In terms of supply, the ability to fund high credits with low saving was puzzling. Last year, the balance of savings in foreign currency stood at 152.2 billion dollars, dropped by 10 billion dollars as compared to 2006. The negative growth rate was the highest in five years.

Zhong Wei, director of the Finance Research Centre under the Beijing Normal University, said foreign currency credits involved large quantity of trade financing with high liquidity, thus, the real credits value incurred last year could have been much higher than on the book. 

He added that commercial banks were also required to pay for reserves in foreign currency, and this would further reduced funds available for loans. 

To increase foreign currency savings, some commercial banks had last year introduced higher interest rate around 7% instead of 5% to attract depositors. Despite that, a source from the banking industry said: "failed to improve savings."  

If that was the case, where did the funds come from to support the ballooning credits demand for foreign currency?

Piecing the Puzzles Together
According to a spokesman from a state-owned bank's capital planning department, funding for foreign currency came from four major sources – registered capital, savings, call loans and swap transactions.

Another banker said the market in general expected between 6% and 10% of losses from exchange rates fluctuation, thus, the motivation to hold on to foreign currency was relatively low.

Since August last year, the Chinese central bank had directed all commercial banks to fulfill their reserves quote using foreign currency. In addition, the reserves rate had gone four times since then, freezing at least 100 billion dollar from circulation.

A foreign currency trader from the China Construction Bank confirmed the above by saying: "In reality, the banks do not have much foreign currency in hand; I too wonder about the mystery behind such strong credits growth." 

Since last year, foreign-capital banks have become incorporated banks, and their registered capital turned into a new source of funding for China's foreign currency market. Based on statistics from the China Banking Regulatory Commission (CBRC), the paid-up capital of the 21 foreign banks amounted to 14.657 billion yuan. The amount was only barely enough to off-set the negative growth in foreign currency savings.

Therefore, the only logical explanation for low savings to support high credits would be through swap transactions. According to a source from the Bank of China, such method could only be a short-term measure and would be unsustainable in the long run. 

Swap transactions are highly complex and come in many variations. In the foreign exchange market, one of the ways is to bet on the direction of interest rates in different countries, and make forward swap to bring in profits through interest spread. 

One famous barometer for short-term interest rates in the world is the London Inter Bank Offered Rate (LIBOR). This global inter-bank market provides a means for financial institutions with excess capital to earn higher rates of return by loaning liquid assets to those in need of the funds. 

At present, the cost of swap transactions in domestic and international markets is high and still rising. In general, the cost involved is calculated based on the LIBOR benchmark with extra points added depending on demand.

Finance academic Zhong Wei believed the swap transactions in domestic market would only alter the structure of funding distributions among banks, but would not change the amount of currency supply. 

As such, according to commercial banking industry sources, the additional capital to fund credits originated from global foreign exchange market, including swap transactions between commercial banks and various countries' central banks.  

Statistics from the Chinese central bank might offer some clues. Its fourth quarter currency policy implementation report revealed active swap transactions for the Chinese currency, with a growth rate of 5.2 times in transactions volume, mainly between yuan and the dollar. 

This led market watchers to believe that through swap transactions, commercial banks obtained the much needed foreign currency while the central bank retained yuan.

Could this be the missing puzzle in the mystery? 

Consequences of the Imbalance
No matter how the capital was obtained, usually when the credit account experienced high growth rate, the saving account too would expand – if not correspondingly, at least registering positive growth; as those taking credits would maintain deposits in foreign currency for future usage and payment. Not this time, though.

Song Fengming, professor of finance studies from Tsinghua University, believed the scenario was partly due to yuan appreciation. He said under high expectation for yuan to appreciate in future, companies and individuals alike would rather not hold foreign currencies, and that was reflected in savings.

Zhang Bing from the Institute of World Economics and Politics under the Chinese Academy of Social Sciences suggested that soon after obtaining credits, the companies concerned had immediately changed the currency into yuan instead to keep foreign currency deposits at the minimal.

According to SAFE regulations, companies operating within certain zones, such as special industrial parks for export quality processing industry, logistic hub and duty free zone, are allowed to do transactions in foreign currency. 

An industry insider told the EO that companies located within the special zones prefer to trade in foreign currency with companies outside of the zone. This would allow them to dispose off foreign currency, gained in exchange rates differences and interest rate spread.

A spokesman from the capital operation department of Agricultural Bank of China pointed out that yuan appreciation, along with higher interest spread of the yuan compared to the dollar, had provided opportunities for the corporate sector to gain from currency arbitrage. 

That led to the banks facing currency mismatch and higher risks in managing unnatural credits boom in foreign currency under increasing pressure from exchange rate fluctuations.