Nov. 4 (Bloomberg) -- China needs derivatives products, including a deepening forwards market, to help companies hedge against risks as the yuan appreciates against the dollar, Vice Finance Minister Lou Jiwei said.

``We need products to hedge against risks,'' Lou told a conference in Beijing today. ``Yuan gains will have a certain risk for companies. We should have a yuan forwards market.''

The yuan rose for a second week on speculation the central bank will let the currency strengthen further to prevent exports from increasing China's record trade surplus and foreign-exchange reserves.

The yuan this week rose 0.23 percent to 7.8716 against the U.S. currency as of 5:30 p.m. in Shanghai, according to the China Foreign Exchange Trade System.

Chinese officials have repeatedly said the yuan's exchange rate will be loosened only gradually because the nation's banks and companies aren't ready to cope with a free-floating currency. The central bank on July 21, 2005, ended a decade-old link to the dollar and let its currency move by up to 0.3 percent around a daily fixing rate.

China's State Administration of Foreign Exchange banned banks operating in the country from trading yuan derivatives in the offshore markets, according to a document dated Oct. 25 issued to lenders.

Financial Tools

Foreign banks have been using offshore forwards to make bets on the yuan and avoid restrictions placed on onshore trades by the central bank. Domestic lenders have also been using the contracts, which are standardized and traded between global banks outside of an exchange. The document doesn't specifically refer to forwards trades or give a reason for the limits.

Forwards are agreements in which assets are bought and sold at current prices for future delivery. Yuan forward contracts are non-deliverable as they are settled in dollars and not local currency.

Derivatives are financial instruments used to hedge risks or for speculation. They're derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates. Options and futures are the most common types of derivatives.

Lou's comments reiterated remarks from Su Ning, the central bank's deputy governor, who said on Oct. 21 that China will loosen foreign-exchange controls gradually and it should step up the development of financial tools to help banks and companies adapt to a more flexible currency system.

Interest Rates

China also needs to increase the fluctuation of interest rates to better allow the market to assess risks, Lou said. The excessive liquidity in the market has led to the distortion of prices, he said.

``Increasing the flexibility of interest rates can help to price risks,'' Lou said. ``Higher interest rates should accompany riskier products.''

The People's Bank of China yesterday ordered lenders to set aside more money as reserves for the third time this year to curtail a credit-fueled investment boom that could lead to more bad loans.

Banks must set aside 9 percent of deposits as reserves starting Nov. 15, up from 8.5 percent. The move will cut the amount of money they have available for lending.

To improve the management of the cash in the Treasury, Lou said China can diversify its investments by buying assets such as financial debt.

Fiscal Deficit

The direction of China's fiscal outlook is ``stable, healthy and cautious,'' Lou said. The country needs to reduce its fiscal deficit, he said.

``We need to narrow our fiscal deficit, but it's unlikely to be a lot because China needs to spend money on education, sanitation and rural development,'' Lou said.

China's budget deficit was at 55 billion yuan ($7 billion) in September, according to the National Bureau of Statistics.

To contact the reporter on this story: Christina Soon in Beijing at csksoon@bloomberg.net

Last Updated: November 3, 2006 23:46 EST