Q: Why is the risk reserve requirement on FX forward sales adjusted from 0 to 20 percent?

A: FX forward sales is an exchange rate risk management instrument provided by banks to enterprises. Through FX forward purchase, enterprises can hedge the future FX risks to a certain extent. However, since enterprises do not make spot FX purchase whereas banks need to purchase FX in the spot market, the trading will influence the spot exchange rate and then forward purchase behavior of enterprises. This pro-cyclical behavior may easily have herding effect. After August 11, 2015, in order to curb excessive movements in the FX market, the PBC has decided to include banks’ FX forward sales into the macro-prudential policy framework and set a risk reserve requirement ratio of 20 percent for financial institutions that conduct agency FX forward sales.

With the deepening of the supply-side structural reform and the reform of streamlining administration and delegating power, and the implementation of innovation-driven development initiative, China’s economy is growing in a more balanced manner. The cross-border flow of capital and the supply and demand in the FX market have restored balance, and market expectations have become  more rational. In September 2017, the PBC adjusted the counter-cyclical macro-prudential management measure previously  adopted to contain pro-cyclical fluctuations in the FX market by lowering the FX risk reserve requirement ratio to 0.

The FX market has been stable since the beginning of 2018. Based on market supply and demand, the RMB exchange rate has moved in both directions with greater flexibility. Market expectations have remained basically stable, and the cross-border capital flow and FX supply and demand broadly balanced. Recently, due to trade frictions and changes in the international currency market, there are signs of  pro-cyclical fluctuations in the FX market. In order to prevent macro financial risks, promote sound operation of financial institutions, and strengthen macro-prudential management, the People’s Bank of China (PBC) has decided to adjust the risk reserve requirement on FX forward sales from 0 back to 20 percent again.

Q: Is the risk reserve requirement on FX forward sales a capital control measure? How will it affect FX forward sales by enterprises?

The reserve requirement on FX forward sales does not impose limits on the volume of enterprises’ FX forward, option, or swap trading, nor require approval before each transaction. It is not a transaction ban on enterprises. Apparently, it is neither a measure of capital control, nor an administrative measure; instead, it is a component in the macro-prudential policy framework. Specifically, the PBC requires financial institutions to deposit reserves equivalent to 20 percent of their contracted volume of FX forward sales (including options and swaps), as a risk reserve for potential loss, which, after being transmitted through pricing, will curb enterprises’ pro-cyclical FX forward sales behavior. Therefore, the measure is a transparent, non-discriminatory, and price-based counter-cyclical macro-prudential policy tool.

The FX risk reserves are deposited by financial institutions and not by enterprises. Enterprises can conduct FX forward sales in accordance with existing regulations.  The FX forward sales remains a risk management tool for enterprises. In order to satisfy the requirement for FX risk reserves, banks will adjust their asset-liability management, and contain enterprises’ pro-cyclical behavior in FX forward sale through price transmission. It will have little impact on enterprises with actual hedging demand.