China’s Exchange rate system reform Explained

In the past 40 years, China has undergone a remarkable economic transformation, positioning itself as a potential global hegemon. A key factor behind this extraordinary growth has been the reform of China's exchange rate system, which enabled the nation to emerge as the world's factory while effectively fending off speculative attacks on its currency. In this blog, I will provide a simplified explanation of this pivotal process that has reshaped the global economic landscape.

Introduction

On the 21st of July 2005, the reform was announced, and the immediate market response was even more moderate than government bodies originally anticipated. The reform had three major aspects. Firstly, the renminbi was revalued against the US dollar by 2.1%. Secondly, the renminbi-US dollar rate would only be allowed to fluctuate within a very narrow band of ±0.3% around the closing rate of the previous working day. Lastly, the renminbi would be monitored against an undisclosed basket of currencies instead of solely against the US dollar. The renminbi was revalued very moderately by 2.1% instead of a medium 5%.

This approach was taken to protect the economy from speculative inflows. If the realized revaluation of the renminbi were greater than the transaction costs and risk premium for the speculators, it would imply that speculation could appear potentially profitable and attract more illegal inflows of speculative funds. Furthermore, a major revision was not implemented as it could lead to an increase in unemployment and potentially hinder the economic growth of the Chinese economy at that time.

The 2.1% revaluation was a compromise that the government could afford to maintain a balance between external pressure for renminbi appreciation and internal political pressure. The narrow exchange rate band helped protect the economy from further speculation and other complications during the early stages of the transition.

The fact that the market response was more moderate than expected was also attributed to the professional performance of the People’s Bank of China on the administrative side and, more importantly, to the sufficient debate and discussion that led to such a moderate appreciation, which safeguarded the economy from illegal speculation at this stage of the reform.

Although there were some cases of speculative inflows through illegal channels or the abuse of legal channels, their amounts did not seem significant enough to exceed the sterilization capacity of the central bank. At this stage, it was essential to uphold the implicit promise to the members of the economy that the appreciation would, at most, be very gradual; otherwise, the number of speculators could reach a critical volume with disastrous outcomes. Maintaining the promise of gradual appreciation would also convince speculators to believe in the very moderate trend of appreciation, effectively transforming them into ‘believers’ in the gradual nature of the reform, thus further reducing the initial inflow of speculative funds.

Two Main Characteristics:

Although some academics believed that the ‘go-slow approach’ would create a ‘one-way bet’ for speculators, thereby increasing speculation on renminbi appreciation, the reform capitalized on the fact that any speculative inflows into China—whether explicitly illegal or through the abuse of legal channels—are illegal by nature. This reality significantly raises the transaction costs for speculation and the risk premium, further discouraging potential speculators. Additionally, China had the capability to enhance inspection efforts and impose heavier penalties on speculators when deemed necessary. This contributed to the overall perception of the reform as having its own logic, credibility, and viability.

The second characteristic that contributed to the success of the reform's first year was effective expectation management, which—unlike in 2007—succeeded in aligning market expectations with the government’s targeted path for the reform. This further convinced potential investors that speculation on the appreciating renminbi would not be profitable.

Two main types of measures were taken to cope with speculative inflows :

1)  Measures to Discourage Speculators

a)  Increase the transaction costs and risk premiums associated with speculative inflows (through enhanced inspections and penalties for speculators).

b)  Control the Investment Returns of Speculative Inflows (maintaining and further strengthening curbing measures in the domestic markets to avoid sharp and sustained asset inflation during the transitional period).

c)  Manage market expectations (this could be achieved by publicly communicating the reform’s intentions and informally through comments from market analysts who have strong connections with the government to disseminate information within the market).

2)  Measures to Mitigate the Effects of Speculative Inflows on Chinese Monetary Growth

A)  Promote Outward Foreign Investment and Acquisition of Productive Assets (encouraging domestic entrepreneurs to initially secure funds from domestic markets and then convert them into foreign currencies through foreign exchange markets to prevent excess money supply).

B)  Implement Sterilization (by issuing a sufficient number of central bank notes or government bonds to ensure that monetary growth aligns with targeted growth rates).

C)  Maintain capital control (as a last-resort tool for managing potential financial crises and as a crucial element of the medium-term exchange rate strategy).

Potential Negative Aftermaths of US-recommended once-and-for-all Revaluation

There are several outcomes that could follow if China would use the “once-and-for-all revaluation scheme:

Firstly it is likely Chinese economy would experience a sudden economic shock that would have a negative impact on exporters. Chinese goods would become more expensive in foreign markets leading to reduced competitiveness in the global economy and decrease in export sales. This might cause a major recession throughout export oriented sectors and subsequentially the economy as a whole.

Secondly large scale capital outflow might occur as a result of the abrupt change. Investors might panic among, resulting in capital flight as they adjusted to new economic realities, leading to increased volatility in the financial markets.

An internal balance disruption would probably follow immediately after the large revaluation. Domestic consumption, investment, and production might have become misaligned, causing inflationary pressures within China itself (see swan diagram below).

Initial Position: Let's assume China starts at point A, with internal and external balances being satisfied (a stable economy with an appropriate level of exports and imports).
Impact of Major Revaluation: After a severe revaluation renminbi (anywhere between 15 to 30 percent), the external balance would shift drastically due to the decrease in exports and increase in imports as explained above. This external disequilibrium could lead to a new

position at point B(blue), where China may experience a trade deficit. The internal balance may also be affected as overly priced goods begin to cause inflation within the country, moving away from its stable equilibrium.

Reaction of the Market: Economic mechanisms (such as labor market adjustments, business strategies, etc.) would be forced to react to the shock. Initially, the economy would be forced to readjust back towards equilibrium, but the dynamics would involve risks of recession in the export sector and inflationary pressures internally, with potentially delayed recovery and adjustment.

This would shift China's economy closer to the EB curve, from a trade surplus toward a balanced or even deficit position, insofar as the revaluation substantially decreased export competitiveness. Imports would get cheaper for Chinese consumers, further depressing the trade surplus. This movement toward external balance would come at the expense of the economy’s internal balance, leading not only to above mention problems with production but also increasing risk of unemployment.

The most direct effect of the decrease in demand for Chinese products a gradual production reduction would be job losses among export-based industries. This type of shift would relegate China to that quadrant of the Swan Diagram where unemployment, with a potential trade deficit, and a definite destabilization of the economy, takes place. An internal disequilibrium of this nature would now be hard to deal with, since the economy was now in need of stimulation to counteract rising unemployment and slackened demand(positive feedback loop losing the economy into a vicious cycle).

By contrast, the gradual revaluation of renminbi at 2.1% rate avoided the shock which

would have resulted from a single large revaluation. This gradual approach followed by the measures outlined above, allowed the gradual adjustment of the economy without major disruptions, allowing changes in the economy to be monitored and managed with appropriate demand. This gradual revaluation in the Swan Diagram meant that controlled, smaller changes in the position of China were achieved by not making large deviations from the IB and EB curves(staying at A), which would better keep both internal and external balances more stable.

If China chooses to monitor its nominal effective exchange it could automatically deal with large nominal swings of any major currency. If for example a major currency such as the USD surges by 15% against all other currencies within a certain short period of time, and the weight of that currency in China’s NEER is 30% then to maintain China’s competitiveness from being

affected by the nominal swing of the major currency is to just keep her NEER unchanged. China could let its currency depreciate 7% vis-à-vis the major currency and appreciate 3% vsis- à-vis all other currencies. This approach allows China to gain a relative price competitiveness from the former (= 7% × 30% = 2.1%) would be able to offset the loss in China’s relative price competitive- ness from the latter (= −3% × 70% = −2.1%).

Furthermore, the role of the central bank’s in exchange rate monitoring would require much less effort and therefore recourses. By monitors its currency vis-à-vis the trade weighted basket of currencies, Chinese Central Bank only needs to change the NEER if it identifies that there is a change in the inflation differential or for example a major permanent change in the real economy. It doesn’t have to concern itself with nominal swings in the USD as mentioned earlier.

China can now take the opportunity that the market’s attention is not yet on China’s NEER, and to complete the remaining necessary reform related to the NEER. Once this is properly done, China can then start to shift the market attention from the renminbi-US dollar rate to the NEER.

Nevertheless, the renminbi-USD rate is also important to monitor. While reiterating that the NEER would be the monitoring target and waiting for the reiteration to take effect overtime, the PBoC should also continue to monitor the renminbi-US dollar rate. It would be the best to keep the renminbi-US dollar appreciation rate within 2% per annum for another one to two years because realizing this would strengthen the market’s trust on the PBoC’s future announcements (see expectation management above) on her exchange rate system reform, which would be an extremely valuable intangible asset to the central bank
It is essential to complete the necessary reform on the NEER and then shift market attention as quickly as possible. This is it is only a matter of time before the US dollar undergoes a significant nominal swing. This nominal swing of the USD, it would be unfeasible for China to maintain an appreciation rate of less than 2% for both the NEER and the renminbi-US dollar rate. This situation could negatively impact the planned gradual appreciation of the renminbi and potentially expose the market to speculators.

Misinterpretation problem

The focus on the renminbi-US dollar rate in 2015 led to significant market reactions, causing capital flight and increased volatility(mentioned above). Investors were anxious about the implications of the devaluation for China’s economic health. The misinterpretation stems from a narrow understanding of the currency's value through the lens of one bilateral exchange rate, rather than considering broader trade relationships and overall economic indicators. For imagination it can be metaphorically explained as a scenario when someone would measure a depth of a river with sinking a stick to the bottom of it. One day this person would take a shorter stick than usually and alarm everyone that the amount of water in the river is increasing and floods are coming. NEER provides a more universal and diversified measuring tool and is therefore similar to making sure the measuring stick is always of the same length.

The incident of a misinterpretation problem in China in 2015 illustrates the importance of a broader approach when measuring exchange rate. By using NEER, China could mitigate the misinterpretation risk, as a more comprehensive indicator could provide a less distorted view of currency health and reduce market volatility. Monitoring NEER could promote a more stable economic environment by conveying that the government is focusing on maintaining overall trade competitiveness, rather than managing a specific bilateral relationship.

The Reform of the Chinese Banking Sector During the Early 2000s

The banking reform was motivated by the fact that the outbreak of the Asian Financial Crisis in 1997–1998 was very much related to the non-performing loans in Thailand and other Asian economies.

The banking sector plays a critical role, as the associated flows of funds are comparable to blood circulation in the human body. If an event (e.g., a bank run) leads to a malfunction in the heart (banking sector) and prevents blood (funds) from flowing to different parts of the body (industries), it can result in the person collapsing or even dying. Conversely, the loss of another industry is similar to losing an arm or a leg; while the person (economy) can still survive, it would be in a more painful and challenging manner. Therefore, the reform is essential. Firstly, it was suggested to permit foreign banks to hold a significant stake in domestic banks to enhance internal control and mitigate moral hazard activities within the banking industry. Secondly it was advocated for the hiring of chief and senior bank executives from foreign countries who are less inclined toward corruption, in order to support the establishment of effective internal control within domestic banks.
At that time, it was believed that this approach could only partially address the issue, primarily because the volume of non-performing bank loans in the four major state-owned commercial banks was too large for major banks in the international market to absorb. However, subsequent developments exceeded initial expectations, largely due to the potential for Initial Public Offerings (IPOs) of the “reformed” domestic banks, which presented foreign investors with opportunities for profit and exit. In fact, the three-step injections by the government, the involvement of strategic partners, and the IPOs significantly improved the capital adequacy ratio of Chinese banks. Since the government's injection was executed through the sale of the banks’ non-performing loans to the asset management corporation established by the government, the overall amount of non-performing loans was also substantially reduced by a considerable figure (i.e., at least nine hundred billion renminbi).
There were 2 factors that played even more major role that the ones mentioned above: Thriving economy with rapid loan growth in 2006–2007 significantly diminished the relative size of the remaining non-performing loans. There were fewer issues with the large volume of new loans following the injections from strategic partners and the IPOs, as improved loan management, lending criteria, and internal controls were implemented. This meant that bank executives needed to consider the interests of strategic partners and shareholders to avoid potential job losses in the future.

How the process took place:

Firstly, the non-performing loan ratio in China’s banking industry was at a precariously high level prior to the banking reform in 2005–2006. However, following the injections from the Chinese government, then from the new foreign strategic partners, and subsequently from the new shareholders through IPOs, the capital adequacy ratio in the Chinese banking industry has improved to a much healthier level.

Secondly, despite the elevated non-performing loan ratio of Chinese banks in the early stages, foreign strategic partners have shown interest in investing. They perceive the injection as a fee paid to acquire the “right” to engage in the banking business within the rapidly growing Chinese economy.

Thirdly, with the involvement of foreign strategic partners, there is a greater likelihood of establishing effective internal control in the future. This, combined with the anticipated

profits from the IPO allotments, has encouraged numerous individual and institutional investors to contribute funds to Chinese banks through IPO subscriptions.

Thus, China’s experience with banking reform has presented a theoretically viable strategy for enhancing banks’ capital adequacy ratios in other developing economies.

At that time China still had to prove to the international society that foreign strategic partners can establish effective internal controls and a business-oriented lending mentality within Chinese banks. In this context, the role of foreign strategic partners is crucial as their stake in the Chinese banks is significantly larger than the associated monitoring costs.

Conversely, the interests of shareholders are so widely dispersed that their stake is minimal compared to the monitoring costs. Therefore, one cannot rely on shareholders to effectively supervise the banks’ behavior in the desired direction.

While Chinese media and shareholders were focusing their attention on whether the IPOs represented a cheap sale of state assets to foreign strategic partners and whether they would be a “feast or trap,”. The most important objective of the banking reform was to establish adequate internal control within Chinese banks, thereby helping to prevent economically and politically destructive financial crises in China in the future.

Furthermore the banking system is integral to the flow of funds throughout the entire economy, and these flows are quite analogous to the circulation of blood within a human body. If there are events that impede the flow of blood (funds) throughout the body (economy), the entire system will fail to function. Therefore, ensuring that the banking system operates effectively is crucial for maintaining the flow of funds across various industries within the economic framework. Additionally, the substantial non-performing loans in banks and instances of bank runs are actually triggering factors (and one of the underlying causes) of the Asian Financial Crisis. Consequently, finding solutions to eliminate non-performing loans and to enhance the internal control of new bank loans is a vital step in preventing future financial crises.

Potential Aftermaths:

Based on the book and what we learned in class I would predict many possible aftermaths of China had not inviting foreign banks as strategic investors during its banking reforms:

Firstly, the economy might turn to have a slower overall capitalization and inefficiency. Without foreign investment, Chinese banks would probably have faced challenges in achieving the necessary capital levels to comply with international banking standards, leading to potential weaknesses in financial stability. Domestic capital might not have been adequate to address the systemic issues at that time.

Secondly it could lead to a lack of technological and management expertise. Foreign banks brought in technology, advanced risk management practices, and operational expertise(this happens in almost any such scenario and wasn’t only specific to China) . Without this influx of knowledge, I find it likely Chinese banks may have continued to operate inefficiently, hampering their ability to compete both domestically and internationally.

Thirdly the risk of financial instability would be likely. Because of the lack of foreign participation this might have resulted in continued problems related to non-performing loans and poor asset quality. This could have led to a higher likelihood of bank failures and a financial crisis, similar to those experienced by several Asian economies in the late 1990s(explained above).

Furthermore, other absence of foreign banks could have other possible implications such as:

Slow and ineffective NPL resolution which would essentially mean the government alone would likely struggle to manage the massive volume of NPLs. The process would likely be slower and less efficient. Furthermore continued weak governance I s another concerning potential aftermath because without foreign expertise and the infusion of best practices, the banks might have continued operating with weak governance structures, vulnerable to corruption and moral hazard. Next, reduced capital adequacy could appear as the banks' financial positions would be weaker, potentially making them more vulnerable to financial shocks. This could have hindered their ability to adequately support economic growth. I also hypothesize that Chinese international integration would be limited as the lack of foreign investment would have hindered the integration of China's banking system into the global financial environment. Lastly all these factors would lead to an increased risk of a financial Crisis. The combination of high NPL levels, weak internal controls and a slower pace of reform could have increased the likelihood of a significant financial crisis, potentially with severe consequences for the Chinese economy and possibly wider geopolitical implications.

Overall, the involvement of foreign strategic partners played a crucial role in the success of the Chinese banking reform. Their investment provided much-needed capital, expertise and corporate governance standards, significantly enhancing the chances for a stable and sustainable outcome. Without them, the risk of a much slower, less efficient, and potentially disastrous reform process was high.

Roles of Speculators and Arbitragers

• Speculators: predict currency depreciation and short-sell futures or spot market

positions, increasing pressure on the currency's value through aggressive selling

• Arbitragers: exploit price differences between spot and futures markets, increasing

market supply of the currency, which pressures the currency's value downward.

Transmission to Spot Market

• Market Expectations: futures market sell-offs signal devaluation, prompting investors

to sell in the spot market, increasing supply and lowering the currency's value

• Central Bank Pressure: central banks (in China’s case the PBoC) buy currency to defend its value, depleting reserves, but large sell-offs make maintaining the peg

increasingly challenging

Transmission to Domestic Money Market

• Money Supply Impact: next to the impact on the interest rate that I focus on here the

other effect is the reserve depletion from currency defense reduces the domestic money

supply, tightening liquidity and pushing up interest rates to attract foreign capital.

• Interest Rates: higher rates support currency value but increase borrowing costs

domestically, potentially leading to an economic slowdown due to costly credit.

The Specific Roles of Speculators and Arbitragers in a Currency Attack

For both types it is basically a bet on the currency's future value based on their expectations. If speculators believe a currency (let's say renminbi) is overvalued due to poor economic indicators, such as high debt or low reserves, they may expect the currency to depreciate. Alternatively, they might expect the currency to appreciate which is what the PBoC feared in the case of the Chinese exchange rate reform.

The behaviors of these two groups in the case of currency not holding its value are:

Short Selling in the Futures Market: In this approach, they short-sell futures contracts on country’s currency, which allows them to lock in a sale price now with the intent to buy back at a lower price if the currency depreciates. This strategy is profitable if their predictions are correct.

Direct Selling in the Spot Market: In this case speculators might sell directly in the spot market. The combined selling activity in both markets creates a powerful signal of potential currency trouble, which other market participants notice, amplifying the trend.

Arbitragers: These traders capitalize on price differences between markets. During a currency attack, arbitragers act on the price gap between the futures (where the currency's expected future value is set) and the spot market (where the current rate is determined). Their strategy often involves:

• Sell in the Spot Market and Buy Futures: If the futures price suggests a lower value than the spot price, arbitragers sell currency in the spot market and buy in the futures market, which increases spot supply and adds pressure on the currency.

• Equalize Prices Across Markets: Arbitragers narrow the gap between markets by their actions, which leads to a convergence of the spot and futures prices—often to the detriment of the currency's value in the spot market.

In the other example where the currency appreciation is expected as it was in Chinas case discussed earlier their behaviors might involve:

Expectation of Revaluation: If speculators believe that a currency is undervalued and anticipate that an imminent exchange rate reform will lead to its appreciation, they might begin accumulating large positions in the currency. This speculative demand can lead to a sharp increase in its value as more investors pile in, expecting gains from the predicted change.

Arbitrage Opportunities: Arbitragers might exploit price discrepancies between different currency markets or between the spot and futures markets, betting on the expected appreciation. Their activities can amplify the market impact as they move to align with the expected future value of the currency, contributing to increased upward pressure.

Market Signals: As speculators and arbitragers act on their expectations, their transactions send signals to the broader market. Other market participants observing these moves might interpret them as confirmations of impending appreciation, further driving up demand for the currency.

Central Bank Intervention: Anticipation of a currency appreciation might prompt the central bank to intervene, especially if the speculative buying affects economic stability or disrupts monetary policy goals. The bank might sell its currency to maintain control over the exchange rate.

Shift in Capital Flows: Speculative activities create shifts in capital flows as investors and traders seek to capitalize on future currency gains. These movements can affect the balance of payments and foreign exchange reserves, influencing domestic economic conditions.

Impact on Domestic Markets: An appreciating currency, driven by speculative attacks, can impact the domestic economy. It might affect export competitiveness, alter investment dynamics, and necessitate adjustments in fiscal or monetary policies.

To avoid these kinds of behaviors the central bank needs to take measures that for example in the case of China in 2005 are discuss above. Nevertheless, this kind of attack where currency appreciation is expected is less typical and the more likely scenario of speculative attack is the first one where the expectation is that the currency is overvalued.

Now I will outline how the mechanism through which the effects of a speculative attack in the currency futures market are transmitted to the currency spot market and the domestic money market.

1) Futures Market to Spot Market Transmission:

Increased Selling Pressure: Speculative selling of the currency in the futures market creates a substantial supply of the currency. This supply, even if it does not immediately affect the spot rate, signals a negative outlook to market participants (especially when considering the combined effects of speculator and arbitrage actions).

Contagion Effect: The growing anticipation of devaluation among market participants based on futures market signals leads to increasing selling pressure on the currency's spot market. This creates a self-fulfilling prophecy, where the expectation of devaluation itself contributes to the actual devaluation.

Arbitrage: The difference between the spot and forward exchange rates (created by speculator actions) incentivizes arbitragers to engage in covered interest rate arbitrage. They borrow in a low-interest-rate currency, exchange it for the target currency at the spot rate, invest in high- interest-bearing assets denominated in the target currency, and simultaneously sell the target currency forward to offset currency risk. This process amplifies downward pressure on the spot market.

2) Futures Market to Domestic Money Market Transmission:

Increased Money Supply (Indirect): A substantial amount of the target currency (or equivalent assets) is borrowed (often using leverage, which magnifies the effect) to short sell the currency in the futures market. This generates a significant amount of the target currency in circulation. While not directly injecting additional money into the money market, this increased liquidity leads to a substantial increase in money supply in the domestic market. Central Bank Intervention: To maintain the exchange rate, the central bank may attempt to offset the speculative selling pressure by buying the currency. This intervention, however, requires the injection of domestic currency into the money market, further increasing the money supply, potentially fueling inflation.

Inflationary Pressures: As more domestic currency enters circulation, both through central bank intervention and increased liquidity indirectly generated by futures speculation, it puts upward pressure on prices, exacerbating inflationary pressures.

Reduced Confidence: Speculative attacks erode confidence in the domestic financial system and the currency's value, potentially leading to capital flight. This capital flight reduces the money supply (in terms of currency within the domestic economy), but the initial influx of currency through increased speculative activities in the futures market and central bank intervention dominates this effect in the short term, leading to overall expansionary pressure within the money market.

The overall effect is basically a vicious cycle and a round of positive feedback where speculative selling in the futures market creates downward pressure on the spot market, driving arbitragers to participate, which further accelerates the decline in the spot rate and inflation in the domestic economy. The initial high-volume speculative actions in the futures market have a domino effect across multiple markets, magnifying the impact of the attack far beyond the initial trigger. The central bank's interventions, intended to stabilize the exchange rate, frequently exacerbate the problem by contributing further to money supply expansion.

An Example:

An example of this dynamic was seen in the 1997 Japanese currency situation. I give this specific example because China avoided these attacks by not listening to the US-recommenced once-and-for-all solution as Japan did in 1997 and so avoided these attacks while doing their exchange rate reform. During this period, the yen came under speculative attack as financial uncertainties arose from the Asian Financial Crisis. Speculators shorted the yen, expecting further depreciation. Arbitragers, meanwhile, helped facilitate shifts between related markets by exploiting price differences, contributing to the yen's volatility. This activity necessitated intervention from the Bank of Japan to stabilize the currency, illustrating the interconnected roles of these market participants in such scenarios. The aftermaths of these attacks are still visible in Japan’s economy and remain on of the causes of the so called lost decades in Japan.

There are other microstructures that aew be worth discussing:

Order Books: The futures market operates with an order book system that records buy and sell orders, showing the quantity and price at which participants are willing to trade. This transparency allows investors to gauge market sentiment and depth, influencing their trading strategies based on visible supply and demand.

Trading Algorithms: Traders in the futures market increasingly use sophisticated algorithms to execute trades rapidly and efficiently. These algorithms can analyze market conditions and execute orders based on predefined criteria, often exploiting minute market movements to gain a competitive edge.

Liquidity: Liquidity in the futures market refers to the ease with which contracts can be bought or sold without significantly affecting their price. High liquidity is facilitated by the presence of numerous market participants, including speculators and hedgers, providing tighter bid-ask spreads and reducing transaction costs.

Price Discovery: The futures market plays a critical role in price discovery, reflecting collective expectations about future price movements. The traded prices provide signals to other market participants, impacting decisions in related markets like spot markets.
Margin and Leverage: Traders in futures markets are required to maintain a margin, a percentage of the contract value, allowing for leveraged positions. This leverage can amplify gains or losses, influencing trading behavior and risk management practices among participants.

Settlement: The finalization of futures contracts can occur through physical delivery or cash settlement. Most often, contracts are closed before expiration, but the method of settlement can influence trading strategies and market volatility, especially towards expiry dates.

When it comes to the spot market microstructure these are:

Order Books: In the spot market, the order book lists buy and sell orders with corresponding prices, providing a snapshot of current market supply and demand conditions. This mechanism allows traders to execute at market prices or set limit orders based on their strategic objectives.

Liquidity: Liquidity in the spot market is characterized by how easily assets can be bought and sold with minimal price impact. Market makers often provide liquidity by continuously quoting buy and sell prices, ensuring smoother price adjustments and lower volatility.

Trading Algorithms: The spot market, similar to futures, is increasingly dominated by automated trading algorithms. These algorithms process large volumes of data, executing trades within milliseconds, thereby enhancing market efficiency and often stabilizing prices through rapid corrections.

Price Discovery: The spot market contributes to immediate price discovery, reflecting the current value of an asset based on real-time transactions. This process involves the aggregation of individual trades, which influences short-term price movements and provides a base for future expectations.

Transaction Costs: Spot market transactions typically involve costs such as broker fees, bid- ask spreads, and sometimes taxes. These costs can influence trading frequency and volume, as market participants weigh the potential profitability against these expenses.

Settlement: Settlement in the spot market usually occurs within a few business days of the trade. This immediate settlement requirement necessitates efficient processing systems and strong liquidity provision, influencing cash flow management and risk assessment for participants.

In a speculative currency attack, speculators and arbitragers amplify market pressure by betting on devaluation and exploiting price differences. Actions in the futures market lead to expectations of currency weakness, which drive selling in the spot market and force the central bank to intervene(such as in the case of PBoC in 2005), affecting reserves and interest rates or exchange rates in the case of exchange rate reform. These pressures can spread through the money market, tightening liquidity, raising borrowing costs, and potentially forcing the central bank to abandon any peg or fixed rate. The result is a self-reinforcing cycle that often confirms initial expectations of currency instability, destabilizing both the currency and the broader economy.