China ‘closer to flexible exchange rate’

The move will improve the capitalisation of Bank of China and China Construction Bank prior to the opening up of the Chinese banking market to foreign competitors at the start of 2006. China is committed to this as part of World Trade Organisation commitments.

"The strengthening of the banking system is a key requirement for the freeing up of the capital account," said David Mann, economist at Standard Chartered in London. "This is another small step on the way to opening up the exchange rate. As a result we expect to see a widening of the trading band against the dollar in the second half of this year."

The move was necessary for the two banks, which have been plagued by bad debts, because: "Only a stronger bank can withstand exchange rate volatility," said Irene Cheung, FX strategist at ABN Amro in Singapore.

The move also helps to reduce the massive Chinese foreign exchange reserves, which currently total over $400 billion and are increasing at around $20 billion a month, said Qu Hongbin, China economist at HSBC in Hong Kong. "Reserves have gone through the roof and now they have too much," he said. The government had been under pressure over the need to have such a high level of reserves.

Separately, the Safe also confirmed last week that an investigation into foreign exchange conversion had found some banks and corporates have breached strict FX rules. The breaches were committed on the basis of expectation regarding the yuan exchange rate, it said.

An inspection of over 1,000 bank branches found that some banks had breached restrictions by providing renminbi-denominated loans with foreign currency used as collateral. Other breaches included the conversion of capital inflows wrongly described as personal transfers. HSBC’s Hongbin said the presence of illegal speculative flows has been "an open secret" for some time. "Foreign exchange reserves have been growing much quicker than the trade surplus suggests they should," he said, as people capitalise on interest rate differentials and speculate on a revaluation, he said.