Derivatives Dawn in China
By Leo Melamed

China Derivatives Conference
Beijing, China
October 24, 2006

"What you do not want done to yourself, do not do to others," so said the great Confucius.

We embrace that advice. We would not encourage the Chinese government to embrace financial derivatives, if we ourselves did not embrace them. We would not encourage the financial community of China to develop financial derivatives instruments, if the financial
community in the U.S. and other industrialized nations did not benefit from their development. What was true for the Chicago Mercantile Exchange (CME ) is true for the exchanges in China today. In other words, it is our unalterable opinion that development of financial derivatives on futures exchanges should be the next step in China's progression to develop strong, liquid, and efficient capital markets. That accomplishment will benefit the people of China.

Confucius' advice is fitting because we stand at the dawn of financial derivatives markets in China. It is a momentous milestone, one that did not occur by accident. It represents a link in a continuous chain which transformed China from an agriculturally based, centrally-planned, economy to one that is industrial and market-driven. The results have been nothing short of astounding.

China is today the world's fastest-growing large economy. The country has grown around 9 percent a year for more than 25 years, the fastest growth rate for a major economy in recorded history. In that time span, China has moved from less than 2% world economic output to nearly 7% of global output today. Since 1980 Chinese exports have surged more than seven times, while global international trade has merely doubled. China has achieved this export success by attracting a large volume of foreign direct investment and promoting total integration with the global economy. China is now the world's third largest exporting nation after the U.S. and Germany. At the current growth rates, China could become the world's largest exporter in just three years.

Two questions come to mind: First, how was this made possible, and second, what should be done to preserve the benefits to the Chinese people, while diminishing the inherent risk that comes with such fast growth? The answer to both questions is not difficult.

Clearly, the transformation was built on the economic reforms that began in 1978 with Deng Xiaoping and continued under the leadership that followed through President Hu Jintao today. But China's success is also the consequential result of information technology which created a world economy—in a word, globalization. A world of instant mass informational flows in total disregard of internal prohibitions or national boundaries. A world where nearly every country on the planet has a market-oriented economic system and is a competitor to everyone else. A world with technology so sophisticated that every idea can be swiftly tested and implemented. A world where whatever can be done will soon be brought to the marketplace by someone.

Governor Zhou Xiaochuan of the People's Bank of China recently stated Chinese growing trade surplus was primarily the result of cross-border outsourcing and supply chain readjustment under the globalization trend of recent years. The so-called cross-border outsourcing refers to multinational companies moving part of service or production abroad where labor cost, tax burdens and other burdens are lower. As the trend of globalization gained ground, more and more multinational companies have relocated production or services abroad, and included the products as part of their global supply system to readjust their supply chain. Quoting U.S. writer and columnist Thomas Friedman, Governor Zhou stated cross-border outsourcing and supply chain adjustment was the inevitable result of world economy moving to adapt to globalization.
The Governor is exactly right. The more China opened up to the global market, the more attractive it was in outsourcing. Thus, China has attracted over $650 billion of foreign direct investment (FDI) which now account for 51% of the country's trade surplus compared to only 3% in 2000.

This rapid growth has strengthened China's economic power and begun the process of raising the standard of living for its people. Make it in China and export it back to the rest of the world is now a predominant business strategy. Foreign-affiliated companies now account for half of China's exports of manufactured goods. Indeed, direct foreign investment into China has become the world's major trend, putting America in second place for the first time. That is a dramatic metamorphosis. These are the unalterable trends of the Twenty First Century, ones that cannot and will not stop. More globalization, greater interdependence, greater cross-border outsourcing, continuing supply chain adjustments, instantaneous informational flows, immediate recognition of financial risks and opportunities, continuous access to markets of choice, more sophisticated techniques, new innovations, and intensified competition.

There are those who would criticize this trend. They are in error. It cannot be stopped nor should it. There are those who point out the negatives of globalization. They are mistaken. Whatever negatives are inherent in globalization, they are vastly overwhelmed by the benefits it brings. Those benefits include lower-priced imports for U.S. and other world consumers and businesses; they include expanding export opportunities to China; they include advantages of Chinese capital flowing to the U.S. and other industrial nations. Indeed, most of what we import from China fits in the category of consumer goods that improve the lives of millions of Americans every day at home and in the office. Of the $243 billion worth of goods we imported from China last year, more than 80 percent were computers and computer accessories, cell phones and other telecommunications equipment, furniture, appliances and other household good, clothing and shoes, toys and sporting good, TVs, radios and other consumer electronics. The remaining 20 percent of imports from China last year were industrial supplies, industrial machinery, transportation equipment, food, and energy.

In other words, globalization is here to stay and China has dramatized its values.

But the answer to the second question is no less significant. China's unprecedented growth is not without risk. Clearly, government officials here are increasingly concerned about the potential of overheating in the economy. It recognizes the need to restrain its record trade surplus, fast-rising foreign exchange reserves, and ballooning current account surplus. It is aware that it should slow export growth and encourage imports, lower its savings rate, and boost domestic demand. Indeed, the government has already taken steps to help alleviate some of these concerns. The main policy measures are intended to boost domestic demand by reducing tax, increasing household income, speeding up infrastructure building in rural areas, encouraging financial institutions to extend consumer credit targeted at individuals. It has also moved to raise
minimum bank reserve requirements and allowed the yuan to strengthen twice as fast in the second half of 2006 as it did in the 12 months since revaluation in July of 2005.

Those are important measures. But there is more to be done. One paramount step toward this goal is develop strong, liquid and efficient capital markets. To achieve this result, most world economies have turned to financial derivatives.

As everyone here knows, financial derivatives allow the transfer of inherent business risks, such as in foreign exchange, interest rates or equities to those most able and willing to assume and manage the risk involved. Thus, they act as a gigantic insurance mechanism that allows financial market risks to be adjusted quickly, more precisely, and at lower cost than is possible with any other financial procedure. In doing so they allow capital to be used in a more productive fashion to the benefit of the overall economy, a process that will improve national productivity, growth and standards of living. Allow me to quote Alan Greenspan, the past Chairman of the U.S. Federal Reserve Board:

"By allowing for a more efficient management of risk derivatives have resulted in a more efficient allocation of capital. An efficient allocation of our resources, including capital, allows for more rapid global economic growth. It is through economic growth that each generation has the ability to live better than past generations. Thus, an expanded efficient use of derivatives is an important component for future economic growth."

As most financial people are aware, the era of financial derivatives was inaugurated in a series of revolutionary financial innovations originating at the futures exchanges in Chicago in the 1970s and early 1980s. It accelerated the movement toward financial engineering, the development of OTC products, and spawned financial futures exchanges in every corner of the globe—from Argentina to Australia, from Italy to India, from London to Kuala Lumpur. Virtually every currently successful exchange-traded derivative is a simple translation of one of the Chicago
initiated products to a geographically different underlying market.

It ultimately catapulted Chicago Mercantile Exchange as the foremost futures market in the world. Alan Greenspan, the former Chairman of the US Federal Reserve stated that "The financial derivatives markets, which the IMM has played a critical role in developing, have significantly lowered the costs and expanded the opportunities for hedging risks that previously were not readily deflected. As a consequence, the financial system is more flexible and efficient than it was 30 years ago, and the economy itself may be more resilient to the real and financial shocks." Nobel economist, Merton Miller named financial futures as "the most significant financial innovation of the last twenty years."

Last week's historic agreement merging the CME and the CBOT is another major step in the evolution of our markets. The combined company to be known as, CME Group, will bring together two proven industry-leading innovators to create a single company, strengthening its ability to grow in an increasingly competitive environment. The combined company will provide one of the most liquid marketplaces, with average daily trading volume approaching 9 million contracts per day, representing approximately $4. trillion in notional value. The combined company will provide customers worldwide efficient, global access to a wide array of benchmark exchange-traded derivatives base on U.S. interest rate yield curve, equity indexes, foreign exchange, agricultural and industrial commodities, energy and alternative investment products such as weather and real-estate.

Today, there is little controversy about the subject. The vast majority of the global economic establishment agree that financial derivatives markets have significantly lowered the cost of doing business across the entire circumference of the economic landscape. As a consequence, capital markets are strengthened, the allocation of capital is more efficient, and national productively is improved. Ultimately, the standard of living is enhanced and social order is greatly benefited. Indeed, the government of China is cognizant of this reality as well. During the last few years it has taken significant steps in the direction of financial derivatives. It has also encouraged the creation of new domestic financial instruments, such as a swap market to give local companies more opportunities for hedging risk. Indeed, the CSRC is presently taking the giant step of authorizing the creation of China's first financial derivatives exchange. Proudly, we believe that the Chicago Mercantile Exchange has provided assistance in many of these endeavors.

As I said before, all of the above are links in a continuous chain of advancing the maturing of Chinese capital markets. One of the major and historic moves in this direction again occurred with the CME. Last year as a consequence of extensive discussions with the Chinese government, the CME forged a unique and unprecedented agreement with the Chinese Foreign Exchange Trading System (CFETS). This multi-year strategic partnership will provide Chinese financial institutions and investors access to electronic trading of CME foreign exchange and interest products. As part of the agreement, CFETS will become a CME super-clearing member, providing services for investors based in mainland China who will be able to trade CME interest and FX products. In addition, CME and CFETS will jointly provide consulting, training, and technical services to CFETS members and staff.

As a further sign that the government of China has changed its attitude toward its exchange rate policy is the fact that the Chicago Mercantile Exchange has introduced futures and options contracts on China's renminbi against the U.S. dollar, euro and Japanese yen. Before it did so, the CME had extensive discussions with Chinese government officials about these plans and ultimately received Beijing's acceptance. Clearly the introduction of the futures FX contracts will create more opportunities for price discovery in the renminbi and further the goal of liquefying Chinese capital markets.

Of course these are sophisticated instruments which require expertise and experience. In this respect, the Chicago Mercantile Exchange stands ready to continue its advice and assistance to the government of China as well as its financial community in helping develop financial derivatives markets in China. Congratulations at this juncture in your history, the dawn of derivatives markets in China. Thank you.

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