January 24,2008

Shanghai to Set Yuan Asset Pricing Benchmark

By Ma Wenluo
On worries that the US economy is slipping due to the sub-prime crisis, the Federal Reserve, on January 22th, cut its benchmark interest rate by 75 basis points, to 3.25%. The next day the LIBOR, (London Interbank Offered Rate, the international benchmark rate for borrowing between top quality banks) for one-year USD fell to about 3.08%, while the same day China’s one-year Shibor (Shanghai Interbank Offered Rate) was 4.65%. With the difference in market interest rates between China and the US reaching 140 basis points and drawing dollars into China, the RMB is bound for more rapid appreciation. On January 23 the central parity rate for RMB (yuan) to USD rose as much as 206 bps, breaking the barrier of 7.24 to 7.2350. Recently it reached another historical high at 7.2293.

Besides expectations of appreciation, yuan assets are becoming more popular among global investors because the pricing for yuan assets is also being marketized, relieving worries of currency price controls. China launched Shibor in January 2007. This is an arithmetic average interest rate based on the bids of 16 high quality commercial banks, i.e. primary dealers in the open market and market makers in the foreign exchange market. The formation mechanism of Shibor is very close to that of LIBOR, and hence is called China’s LIBOR.

China requires a reliable market benchmark rate as it promotes interest marketization. After a year of operation, Shibor now functions as LIBOR at a preliminary level and will become a true benchmark of China’s monetary market and a guide to the allocation of financial resources.

Financial asset prices usually consist of a benchmark interest rate and a spread. The spread includes product credit ratings, long and short-term factors caused by inflation and a liquidity factor decided by the convenience of transaction. Since Shibor was launched, yuan assets such as fixed income bonds have gradually moved from a price based on the central bank RMB interest rate to a sum of Shibor-based benchmark rate and spread. Shibor has also successfully affected the price of floating rate bonds. As China’s interest rate is now climbing, it will be less risky for investors to buy financial products based on a floating rather than a fixed rate.

Financial derivatives also require a benchmark rate. Libor, the Fed Funds Rate and Euribor are widely used in derivative pricing and contract clearing. Shibor was first used in financial derivatives. Interest rate swaps based on Shibor and forward rate agreement have been signed between commercial banks.

The central bank also hopes a variety of market capital can also be priced on Shibor. "Later products, ranging from internal reserve funds, public welfare funds, internal trust, to financing, housing funds and security dealer deposits should all be pegged to Shibor," said Yi Gang, the newly appointed vice governor of the People’s Bank of China, the country’s central bank.

There has been a strong call from international financial markets that China set a marketized benchmark rate, and the US complains of its lack in China. The US Department of Commerce announced in 2007 the preliminary decision to impose anti-subsidy penalties on Chinese coated free sheet paper as they claim China provided funds and loans not in accordance with market interest rates. But Li Yang, head of the financial research center of the Chinese Academy of Scientists, says that "China has not only short-term monetary market instruments, but also thirty-year-long bonds and emerging financial derivatives. Almost all Chinese financial institutes and many foreign financial institutes and non-financial enterprises are involved in these markets." Therefore, China’s interest rate system has basically been marketized.

Shibor as a benchmark and worldwide recognition and application are marking the foundation of a RMB market. The central bank will pay increasing attention to Shibor and recently held a first anniversary conference on the benchmark. Yi Gang said that Shibor will certainly become gradually established.


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