Major Chinese banks are asking for more hedging instruments allowing them to juggle foreign exchange losses as the yuan appreciates.

"As the yuan increases in value, Chinese banks are becoming more exposed to potential exchange losses when they convert overseas profits into yuan and conduct foreign exchange transactions with their own assets," said Wen Bin, a senior strategic analyst with the Bank of China (BOC).

"Chinese commercial banks need more derivative instruments to hedge against exchange losses," said Wen, adding that the country's foreign currency exposures of US$80 billion were mainly concentrated in the Industrial and Commercial Bank of China (ICBC), the China Construction Bank (CCB), Bank of China and Bank of Communications.

The current instruments used for exchange rate hedging are insufficient as the common consensus among overseas investors views the yuan as continuing to appreciate, ruling out option transactions, he said.

An option transaction is one of the hedging instruments available to Chinese banks. It gives the buyer the right, without obliging them, to buy or sell at a set price on or before an agreed date.

At present, the role of the option transaction as a hedging tool for Chinese banks has been almost nullified because the transaction usually involves high premiums signifying difficulty in predicting the growth margin of the yuan's value. The buyer is thus able to cancel the option transaction by which time the premium may have already exceeded the exchange losses.

"With option transactions incapable of guarding against exchange losses, at the moment Chinese banks can only rely on swap and forward transactions," said CCB president Guo Shuqing.

A swap transaction involves the exchange of two currencies on a fixed date assuming that the two currencies will be of equal value on that date. A forward transaction is an obligation to fulfill a pledge made for a future date, without requiring the payment of a premium. It can not be broken even if the buyer is set to incur a loss.

As the Chinese government controls capital account foreign exchange flows, Guo called on banking regulators and the central bank to relax their hedging restrictions, freeing up Chinese banks to hedge their foreign currency exposures.

There are a number of regulations currently in place which hinder the efficiency of conducting swap and forward transactions and, unlike overseas banks, Chinese banks are not allowed to combine hedging tools freely.

China's three largest state-owned commercial banks - ICBC, CCB and BOC - have faced exchange losses of billions of yuan since the currency has risen 3.88 percent in value since July 2005 through exchange reforms.

The three banks have large amounts of US dollars and other foreign currencies principally since completing substantial initial public offerings overseas.

BOC, the country's largest foreign exchange bank, suffered exchange losses of 3.5 billion yuan (US$438 million) in the first half of last year while CCB suffered losses of 2.4 billion yuan.

Goldman Sachs, the world's biggest investment banking firm, has predicted BOC's profits will shrink 3.3 percent and net profits 0.6 percent for every one percent rise in the yuan's value.

Many bank executives have said their banks will suffer from a depreciation in foreign currency assets if the yuan continues to appreciate.

Foreign currencies account for 0.52 percent of the total assets of China's five major listed banks - the three listed state-owned banks, the Bank of Communications and China Merchants Bank, the China Securities Journal reported on Monday.

However, the five banks' earnings per share (EPS) will decrease an average 0.014 yuan for every five percent rise in the yuan's value, the report quoted an anonymous analyst as saying.

EPS stood at 0.09 yuan for the ICBC and 0.07 yuan for the BOC on June 30 last year, according to the two banks' half-year reports in 2006.

However, BOC vice president Zhu Min maintained an optimistic outlook, calling the foreign currency assets yielded higher than the domestic currency assets, which could offset the exchange losses caused by the yuan appreciation.

Zhu said BOC's net foreign currency exposure remained too minimal to pose a substantial threat to the bank.

The bank rose to number six in the world in terms of assets at the end of last year, with total assets of 4.7 trillion yuan and a capitalization of US$120.8 billion.

(Xinhua News Agency January 16, 2007)