The Currency Regime and Exchange
Market Pressure in China
Student Name: Xu Li
Student Number: 11377488
E-mail:
lx522878484@gmail.com
MSc Economics: International Economics and Globalization
Supervisor: Dr. Franc Klaassen
2
ndReader: Dr. Naomi Leefmans
Number of words: 12306
Statement of Originality
This document is written by Student Xu Li who declares
to take full responsibility for the contents of this
document.
I declare that the text and the work presented in this
document is original and that no sources other than those
mentioned in the text and its references have been used
in creating it.
The Faculty of Economics and Business is responsible
solely for the supervision of completion of the work, not
for the contents.
Table of Content
1.Introduction ... 4
2.Literature review ... 6
2.1 Approaches to measurement of EMP ... 6
2.2 Measuring EMP under capital control in China ... 7
3.The Currency Regime in China ... 8
3.1 Brief history of currency regime revolution ... 8
3.2 The appreciation pressure and depreciation pressure ... 10
4.The situation of capital control ... 12
4.1 The capital control policies in China ... 12
4.2 The effects of capital control policies ... 14
5.The Modeling of Exchange Market Pressure ... 1617
5.1 Constructing four components ... 17
5.1.1 Nominal depreciation of Renminbi... 17
5.1.2 Official intervention of foreign exchange reserve ... 17
5.1.3 Interest rate component ... 18
5.1.4 Capital control component ... 19
5.2 Constructing aggregated EMP index ... 20
6.Empirical Study of EMP ... 21
6.1 Data description of components ... 21
6.1.1 Data description of nominal depreciation ... 21
6.1.2 Data description of Official intervention of foreign exchange reserve ... 24
6.1.3 Data description of interest rate component ... 26
6.1.4 Data description of capital control component ... 28
6.2 EMP index aggregation ... 31
7.Conclusion ... 33
1.Introduction
China’s exchange rate regime has experienced a series of reforms in previous decades. From 21st of July in 2005, China’s currency policy moved to a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies, not only the US dollar. However, the weights are not announced until 2016 and practically the dollar still represents the main share of the weights, so the monetary policy in the US could trigger influential shocks through forex markets against Renminbi. The most recent news is that on March 16, 2017, Janet Yellen, chairwoman of the Federal Reserve, announced the Fed’s decision to raise its key interest rates, signaling an intention to continue to slowly increase rates. Thus, investment outflows start to happen and this aggravates the depreciation pressure of Renminbi again, further stimulates the speculation, and raises great volatility and external imbalances in the foreign of China markets, which violates the stable exchange rate target of the economy. Therefore, stabilizing Renminbi is really an important issue towards China’s economy since the internal imbalances also exist for several years as a result of the overheated economy and underdeveloped financial system (See Elliott, D. J., & Yan, K. 2013; Ito, H., & Volz, U. 2013). Thus, the economic condition becomes more and more complicated and whether PBoC could manage the exchange rate target well and curb the foreign exchange risk relates the stable growth of China in the following years to a large extent.
One of the best approaches to examining this kind of stress is to use the exchange market pressure (EMP), an important financial stress index1. This concept was introduced by Girton
and Roper (1977) by using a monetary model of exchange rate determination, and Weymark (1997) further formalized it later. Precisely account for it, the GR model indicates that under a complete fixed exchange rate regime, the central bank has to defend the committed parity with sales of foreign exchange in case of excess supply of domestic currency. When it comes to a pure floating exchange rate regime, the central bank has no such commitment and the exchange rate is totally free to absorb any change in demand and supply of the home currency, so the actual depreciation is the degree of EMP. However, neither completely fixed nor pure floating regimes exist in the world. Therefore, we need to consider a condition about an intermediate regime that the excess supply pressure, which the home currency faces, is usually relieved by a combination of factors such as official reserve, exchange rate, interest rates, and capital controls, etc. Weymark (1977) addressed this issue in her paper. Besides, the pressure to depreciate is not observed for the reason that the counterfactual case2 is not
observed, but we could measure it from an indirect way by capturing the policy variables to offset it. To be concrete, if pressure comes out, we could observe the policy variables
1World Economic Outlook: Crisis and Recovery, April 2009 - IMF
2 Taking away policy actions changes market expectations. As we want pressure in actual regime, we keep expectations at actual level when changing policy
adjusting. Then the EMP index could be constructed by the actual depreciation of the currency and a weighted sum of components that capture policy such as interest rate, forex intervention. As for China, it becomes more different due to the strict capital control in the country (See Kimball, D., & Xiao, F. 2006). Especially in the recent time, the devaluation pressure of currency gives rise to serious capital outflow and draining of foreign reserve3. The
capital control policies are examined use of funds overseas, restrictions on mainland companies’ purchases of offshore assets, and made it harder for residents to buy insurance in Hong Kong, etc. But we could apply special ways of measurement to capture the degree of the capital control in composing exchange market pressure. It is similar to studies about EMP measurement in India. The idea is motivated by Hutchison et al (2011), using covered interest rate parity (CIP) deviations to quantify the degree of the capital control. They applied this idea with non-deliverable forward (NDF) markets, which is also an ideal approach to the case of China, since this offshore renminbi market is an open market which is not influenced by the capital control policies in domestic4.
The main purpose of this paper is to measure the exchange market pressure in China under the condition of capital control. The paper will mainly focus on the modeling of EMP by the weighted components of several policy variables. The traditional views on this with the relating policy factors like the depreciation of currency, official foreign exchange intervention, and interest rate. As a result of a close relationship with the US dollar in the previous decades, the fluctuation of Renminbi could be witnessed by the exchange rate against US dollar. Though PBoC announced that the China’s currency is pegging a basket of so-called currencies, the US dollar is the most dominant reference which takes up 22.40% of the weights5. Besides, official intervention could be indicated by the change of China’s
foreign reserve6. Yet to the case of China, the capital control component should be added
through the measuring of CIP deviation within NDF markets. Then we could conclude that the EMP in China should be the combination of components relating actual depreciation, interest rate, foreign reserve, and capital control.
I firstly start the first chapter with the review of China’s different currency regime and the performance of its policies to absorb the pressure in recent years especially after the crisis in 2008. After that, the second chapter starts to include the content about the situation of capital control recent years in China, analyzing the reasons why capital control is applied, how it operates and the effects it contributes to. Moreover, in the third chapter this paper will mainly focus on the modeling of EMP. Empirical measurement as well as analysis of EMP index would be carefully undertaken in the fourth chapter with figures and plots. The sample period of this issue is from June 2006, when the currency regime just has finished first reform and the NDF market also started to work, to the most recent May 2017. The rest parts are the
3 See Bloomberg News, China’s yuan outflows plummet, showing capital controls payoff; January 20, 2017
4 China’s offshore RMB market, Daniel Joseph (2013), PNC’s International Treasury Management group
5https://www.dailyfx.com/forex/fundamental/daily_briefing/daily_pieces/china_news/2016/12/29/Chin as-Market-News-China-Expands-CFETS-Yuan-Basket-Cuts-Dollars-Weight.html
6 The valuation effects could be omitted since only large drop of foreign reserve from 2014 to 2016 may be highly related, see news: Decline in China’s FX reserves largely due to valuation effects, don’t point to a stable CNY, Econotimes, Tuesday, June 7, 2016
description of the data analyzed, then the empirical results would be showed later and a conclusion followed.
2.Literature review
2.1 Approaches to measurement of EMP
Exchange market pressure (EMP), one of the five important financial stress indexes7 (FSIs) to
examine the level of risk pressure in the financial system, is broadly applied in the measurement of external imbalances of the currency in a country. This idea was firstly introduced by Girton and Roper in 1977. They defined that EMP is depreciation of currency required to remove the excess supply of that currency on forex market in the absence of policy actions to offset excess supply. Since then, the study about this concept and application is extended and it also has developed as one of the most important indicators which indicates the stability of foreign market in a country. More importantly, it becomes frequently applied in practice as a result of the more closely integrated international markets and hence more shocks from outside incurred by the international transmission of pressure8, which makes
EMP measurement more relevant to the policy implementation.
Another representative contribution is given by Weymark (1995 and 1998), who enriched this basic concept and overcame some flaws. As she argues, the previous GR definition is unrealistic and model-dependent. It is so restricted when the intermediate regimes become more complex with more determining factors (China’s exchange regime is a good example) that the model. In order to provide a basis for deriving model-consistent measures of exchange market pressure for any model, Weymark proposed a model-independent definition of EMP. Under her new definition, any specific factors that make the exchange rate deviates from the actual value, the value comes from the equilibrium of foreign market without restrictions and interventions, could be the factors to examine the EMP.
Eichengreen, Rose, and Wyplosz (1996) explored a different way to derive the EMP index with a model-independent approach, which addressed the weakness of the former that structural models of exchange rate determination are difficult to explain and fail to predict the exchange rate movements in the short run. The research of Krugman and Obstfeld (2003) also has confirmed that the random-walk model outperforms the model-dependent approach in
7 FSI consists of five sub-indices about the pressure of different spheres in financial system, they are EMP for forex market, Sovereign spread for government bonds market, CAPM beta for banking-sector, Minus stock price return and Stock return volatility in portfolio market.
practical measurements. The ERW approach is actually the weighted linear combination of the percentage change in the bilateral exchange rate, the percentage change in the interest rate differential between the two countries, and the percentage change in foreign reserves relative to that of the central country.
Further improvement of ERW was accomplished by Klaassen and Jager (2011). They held the view that the use of change in domestic interest rate is inconsistent with the definition of exchange market pressure and took into consideration of a counterfactual case in former interest rate component. By using Taylor rule, they applied the difference of real interest rate in equilibrium, inflation rate and relevant gaps between the country and its target country in the construction of EMP index. Then the advanced approach consists the components of the weighted average change of exchange rate, the changes foreign reserves, and the difference between current interest rate and counterfactual level interest rate. According to their results, new EMP index for ERM crises is well improved for France, Italy and the United Kingdom in 1992-1993. Besides, the result of Asian crisis in 1997-1998 also confirms for the case in Hong Kong, Korea and Thailand.
2.2 Measuring EMP under capital control in China
Nevertheless, the measurement of exchange market pressure in China should be considered more carefully due to the condition that tight capital controls are undertaken. The Renminbi has been witnessing a depreciation in recent years as the Fed announced the growing interest rate of US dollar. To defend the Renminbi and curb the outbound investment, strict restrictions on capital could mitigate the pressure of outflows and help the currency avoid volatility. Since China applied such capital control regulations which absorb some degree of the pressure, the factor about capital control should be taken into account in modeling the EMP index under the China’s situation.
Aliber, R. Z. (1973) suggested that covered interest rate parity (CIP) could reflect the degree of capital control in a country. He distinguished the exchange rate risk and political risk9 as
the determinants of deviation of interest rate parity. Forward contracts enable investors hedge their portfolios against exchange rate risk, yet the part of interest agio not explained by exchange risks reflects the political risks. It is the truth that not only in China exists this issue of capital control, but also in some other developing countries like India. Hutchison et al (2011) successfully measured the capital control through the deviations from covered interest rate parity, from which capital controls could be more easily measured10. They found the
evidence from the offshore NDF market11 in India and concluded that this method is effective
9 In his paper, the political risk is defined as the probability that the authority controls the capital flows, which further implies that the part of differential in interest rate not reflected by forward premium could witness the level of capital control.
10 Alternative approaches are Capital control Effectiveness(CCE) index and Weighted Capital Control Effectiveness(WCCE) index.
to examine. They also applied it to China’s NDF market to test the robustness of this method. The graph and summary statistics clearly indicated that Chinese capital controls were very effective in creating a wedge between onshore and offshore yield differentials.
Jie Li (2012) also used a similar idea of uncovered interest rate12 (UIP) to incorporate the
capital control into the simple monetary from Weymark (1995). In the paper, the new EMP index is derived and compared with the former definition through data analysis. The result shows that the conventional EMP index overestimates the EMP measurement by 91% on average. Though interesting access to the issue of capital control in China, the paper did not avoid the weaknesses mentioned previously in the model from Weymark. So the ideas by Hutchison et al (2011) is preferred and would be combined with the progress made by Klaassen and Jager (2011) in the following analysis in this paper.
3.
The Currency Regime in China
3.1 Brief history of currency regime revolution
The China’s exchange rate regime evolves through several stages for many decades, which also reflects part of the development of the financial system in China as it grows a powerful economic entity in the world. The first period is from 1949 to 1972, during which the economy is planned totally due to the condition of recovery from the wars, the new government commanded the economy in all respects to meet the development need and accomplish political purposes. Therefore, the central bank determined the exchange rates to encourage foreign trades and the regime is actually the Single pegged exchange rate towards US dollar. However, this kind of exchange rate is actually seriously overvalued since the exchange rate is not determined by the market but by PBoC and the exchange rate is for the purpose of meeting the greater import demands against low export capability in China at that time.
The second stage is from 1973 to 1985. The collapse of Bretton Woods system caused great shocks to the world economy and many currencies started to float to each other for coping
available for CIP measurement, thus for capital control.
12 By using a coefficient to capture UIP in the equations from Weymark. When the coefficient is lower than 1, the UIP does not hold any more, which implies the capital control in the country.
with the following turbulences. Compliant to such situation, Renminbi also tried to peg on a basket of currencies at first, in which the selection of currencies depends on the importance and their values of international trade with China. The weights of those currencies changed many times to influence the trade with other countries. A historical time in this period is 1978 when the famous Reform and Open policy came into the world. It is also the time that China began to develop quickly and became a surprising developing country in later years until now. Inevitably, a fresh exchange rate policy Dual exchange rate is enacted to better develop China as a widely opened economic entity. This rate is constructed by an official rate plus an additional equilibrium price (determined by the market). In this variety of currency regime, the new exchange rate is applied in the forex market, whereas the original official rate is only used for an intervention to the current account, which is so-called "Dual exchange rates" means.
To adapt to the trends of international trade, the dual exchange rates regime was abandoned in 1985 and from 1986 to 1993 a new time for currency regime was welcomed, which is so called Managed Floating Rate. This is practically the first step that China’s exchange regime moved to become floating, the final purpose for a long time even nowadays. Moreover, as a vital progress for the development of the financial system, managed floating rate played an influential role in accelerating the China’s economy (See Laurenceson, J., & Qin, F. 2005). A true sense of the foreign market for Renminbi was set up with 80 new trading centers in October of 1988. Yet the foreign exchange control was still so tight and the central bank signaled to the public that this measure was applied to stabilize the price of Renminbi in foreign market occasionally. But the market power was so big that pushed the devaluation of Renminbi, which aggregated the effects of already existing expansionary monetary policy, the high-speed development of the economy, and inflation through enormous export. While China was trying to get into WTO on the one hand, PBoC had to curb this trend and announced to promote the globalization process with a more stable exchange rate on the other hand.
In the period between 1994 and 2004, the exchange regime greatly reformed again, Renminbi was totally fixed towards US dollar around 8.27 CNY/ USD. In July 2005, Beijing announced it would revalue the Renminbi and peg it to a basket of currencies, which includes the US dollar, the Euro, the Japanese yen, and the Korean won. The number of reference currencies was increasing gradually with the trading strategy to some new partners and the weights for them was never open to the public until December of 2016. The recent news about the weights is that China Foreign Exchange Trade System (CFETS) announced that it will adjust
the way to calculate the CFETS Yuan Index, a key measure of the Renminbi against a basket of currencies, from January 1st, 2017. The weight of the U.S. Dollar in the CFETS Yuan Index will be reduced to 22.40% from 26.40% and the Euro’s will be cut to 16.34% from 21.39%; 11 new currencies will be added into the index. We could also find that dollar still represents the main share of the weights.
3.2 The appreciation pressure and depreciation pressure
For a long time that the Renminbi is undervalued (See Chang, G. H., & Qin, S. 2004). Since 1994 Renminbi underwent a large and persistent depreciation towards US dollar. Goldstein and Lardy (2003) suggest that the RMB was undervalued by 15–25%, while Zhang and Pan (2004) suggest the undervaluation ranges from 15% to 22%. In most of the period from 1994 until now, the United States has experienced substantial trade imbalance with China (See Wang, Y., Hui, X., & Soofi. 2007). Chinese policy makers depreciated the currency with the purpose to boost the economy. The typical policy is such foreign intervention by accumulating the foreign exchange reserve, mainly US Treasury Bonds and Institutional bonds guaranteed by US government. See the figure followed, we could find that the foreign reserves have increased rapidly in last decades, reaching an all time high of 3.993 USD trillion in June of 2014. After that, the foreign reserves started to drop really fast to around the mark 3 trillion USD, yet it is still a large amount.
Figure 1: The Foreign Exchange Reserves of China (100 million USD)
Data source: National Bureau of Statistics of China
An undervalued currency makes the export goods cheaper and more competitive which contributes a great share of the GDP. The truth is that China’s economy depends a lot on the export department (Akyüz, Y. 2011) and the cheap labor also makes this strategy possible with less valued currency. The result is actually so positive and China gradually becomes the
second biggest economy entity in the world. The people’s living standard and level are improved greatly in only 30 years after the Reform and Open policy in 1978 if roughly considering GDP. Nevertheless, the appreciation pressure still exists as a result of the high expectation in public13 and the political pressure from other countries. The US has been
asking for the appreciation of Renminbi for many years due to the unemployment in some export sectors when competing with China directly in the global market. For instance, In September of 2010, the US House of Representatives overwhelmingly passed a bill approving retaliatory import duties on Chinese goods due to China’s alleged manipulation of its exchange rate. The House claimed that China unfairly holds down the value of its currency in order to boost its exports to the US market. They also argued that the continuing increase in Chinese exports to the US (which has fueled a growing US bilateral trade deficit) has been taking jobs away from the US workers. The following figure 2 shows four lines about the value of imports, exports, and the amount of balance of trade towards the United States since 2000. As we see, the value of im- and exports have been growing all along relating the US except the period between 2008-2009, during which the trade was obviously affected by the financial crisis and jumped down very much degree. However, the external trade with the US is still growing in 2 decades roughly. The export to the US improves steadily though the speed is slower in 2015. But the import amount reduced a lot from 2014, so the balance of trade became much larger and the economy boosted extremely in consequence. Through all of these figures we have reasons to conclude that China possibly manipulated a low exchange rate to accomplish the economic purpose, as some of the authors stated in their papers even though the motivations are not known to the public actually.
Figure 2: Balance of Trade in China (million USD)
Data source: National Bureau of Statistics of China
However, on 26th of May 2015, officials at the IMF concluded that “[w]hile undervaluation of the renminbi was a major factor causing the large imbalances in the past, our assessment now is that the substantial real effective appreciation over the past year has brought the
13 The high expectation caused by the reason that Renminbi for a long time has been too undervalued in the market, which also attracts a lot foreign investment and speculators.
exchange rate to a level that is no longer undervalued” after a consultation mission to China. Therefore, the time of facing appreciation pressure has passed away.
Yet another thorny issue comes out as we could find in Figure 1, which is an extensive shrink of foreign exchange reserves from 2015. The newest data shows that the foreign reserves are stable at $3.030 trillion in April 2017. What makes this shrink interesting is that December 2015 is also the date Fed raised its key interest rate the first time. In the subsequent years, the interest rate is set higher another two times in December 2016 and March 2017. This measure signals that the key interest rate in the US would increase in the later years. Consequently, the exchange rate of Renminbi to US dollar devalues so much and would continue to depreciating as is expected in public. The first thing PBoC did is selling the reserves in a large amount to curb the devalued Renminbi. Besides, the CB of China announced that selling reserves is not enough to address the problem, though the foreign reserves is still sustainable. To avoid the appearance of the similar situation of Asian Crisis14 in 1998, special policies need to be
applied, such as capital control policies to deal with the catastrophic capital outflow. Data show that capital outflows from China surged in 2016 to a record $725 billion. Furthermore, outflows could accelerate further if US firms face political pressure to repatriate profits according to the recent relating report15.
4.The situation of capital control
Now we have already known the basic frame of the exchange regime background in China. However, to better understand it, one has to be informed of the situation of capital control in this country, which makes the country more different. That is also the reason we need to treat China as a special case, applying a slightly different model to study the EMP issue later.
4.1 The capital control policies in China
China's capital control measures are mainly a kind named “direct control”, that is, according to China's laws and regulations on cross-border capital flows, the regulators examine and approve through some specific operational process restrictions. China has promulgated a number of laws and regulations as the basis for control. For instance, the People's Republic of China Foreign Exchange Management Regulations: Chapter III the Capital Account for Foreign exchange stipulates some provisions of the capital in- and outflow, the relating examination and approval system, as well as foreign debt management. In Administration of the Settlement, Sale and Payment of Foreign Exchange Provisions: Chapter III the Settlement, Foreign exchange and Payment of foreign exchange under Capital Account
14 The great devaluation of currency even the foreign reserves is of large amount, since it depleted quickly when fast outflow of foreign investment. e.g. Thailand.
regulates the capital accounts that are not allowed for settlement and sale. The applications and submitted valid certificates for those process are also stipulated. Domestic Institutions External Guarantee Management Approach defines the external security behavior, administration institutions and vouchers, etc.
Under the guidance of these laws and regulations, capital control is divided into the management of capital transactions and exchange control. The six most heavily controlled items in China are China's foreign direct investment (outflow), residents of foreign equity securities investment (outflow), residents of foreign bonds (inflow), residents in the purchase of bonds outside, Residents borrow foreign debt (inflow), non-residents in the domestic securities market (except B shares) issued securities and securities transactions. In a nutshell, restrictions on trade link are mainly achieved by the examination and approval procedures, only those people who are authorized and acquire the qualifications could engage in the activities about capital in- and outflows.
Since 2017, the strength of capital control in China is enforced with several new regulations due to the diminishing foreign reserve and public expectation of future currency devaluation. It is called now the tightest capital control ever. After Fed raised its key interest rate from 2015, the State of Administration of Foreign Exchange (SAFE) has enacted a series of policies to react the shocks to Renminbi. For example, on 9th of September 2015, SAFE started to limit the purchase of currencies which take the form as “Ants moving house” action. This metaphor states the individual behavior that one buys large foreign currencies in very short time by several times or separately transfers purchased currencies to some relative foreign accounts. This action would be monitored and put in a special blacklist if necessary. Then from the first day of 2016, another measure to avoid the risk of money laundering activities abroad was applied. For one thing, daily withdrawal of foreign currencies in other countries by using UnionPay-Renminbi card should not amount to the money over equivalent 10000 yuan. For another thing, the accumulated amount withdrawn in a year should not also outnumber equivalent 100000 yuan.
However, the two policies above are just small parts of the policies from 2015 until now, the regulation becomes far more complicated with too many details relating all kinds of offshore business affairs. The process of purchasing foreign currencies is under strict screening and takes a longer period to assess for approval after the report of every trade. Individuals need to apply with a carefully examined agreement, explain the purpose of buying currencies, and only small amount of money could be exchanged. This unfriendly controls discourage the outflow of capital especially from the potential speculators and mitigate the possible motive that people safeguard their assets by saving or investing abroad, i.e. capital flight.
The reasons for capital flight could be many types. Roughly they are the expected devaluation of domestic currency, the lower domestic interest rates compared with other countries, the unstable domestic macroeconomic condition, the external shocks from international financial markets (e.g. the panic transmitted from external imbalances), the inefficiency of resource allocation (stimulates the motive of external financing for firms to meet their business needs), and by-product effect caused by tightening controls on capital flows (the stricter policies, the more flights stimulated). These factors make the capital outflow so complicated and hard to measure the influence of the economy. As for China, the reasons are also persuasive and we
could realize how much degree the authority values the flight issue according to the extent in its announced documents.
4.2 The effects of capital control policies
So far, the measures taken by SAFE work obviously. By the end of first quarter of 2017, the official statement said that the capital outflow eased sharply and cross border flows were more balanced. The authority did not worry so much about the issue anymore16. The released
pressure from outflows has stabilized the Renminbi in this year and brought China's foreign currency reserves back over the closely watched $3 trillion mark. The detailed information is showed below.
Figure 3: China’s Foreign exchange reserve in 2017 (100 million USD)
Data source: National Bureau of Statistics of China
Through the Figure 3 we could witness that the foreign exchange reserve once situated below
3 trillion dollars at 2.998 trillion dollars, which was the lowest amount since June 2014, the time almost 4 trillion dollars foreign exchange reserve started to drop drastically until now. After the turning point, the reserve grew steadily by the end of July. The SAFE also implies that the expectation of Renminbi depreciation also cooled down as the public awareness of tightening controls and individuals’ actual practice in foreign exchange trading.
The observations about FDI changes in some typical days of periods could also indicate if the capital control policies work for absorbing depreciation pressure of the currency. Capital control policies could ease the depreciation pressure and the phenomena of capital outflows. The capital flights should have been more serious if no capital controls at all, in which case lower existing FDI in the country as a result. As what we see, the figure is monthly data from
January 2010 to April 2017. Since 2010 the FDI climbed so fast to the highest rate about 25 percent in 2011. But during 2012 the FDI slightly weakened as a result of the disappointing global economy growth17, typically the deteriorating European debt crisis, “zero economic
growth” in Japan, and modest growth in the US affected the world trade and investment a lot. Yet the China’s economy just fluctuated a little bit with high GDP growth still at 7.5 percent in 2012. Whereas a huge shock happened in 2017 finally, the FDI fell drastically 80 percent, which is totally different with the no worth concerning case in 2012. Although the recovery also followed, we are not sure about the future as the FDI continues cutting at a low speed.
Figure 4: Growth Rate (%) of the Value of Foreign Direct Investment Actually Utilized
Data source: National Bureau of Statistics of China
To investigate more underlying secrets, the Figure 5 would show more detailed information about FDI, that is wholly foreign-owned enterprise. The shape of the line is similar but more volatile. In addition to the depression in 2012, the earlier outflow of “pure FDI” actually began by the end of 2015. Until February of this year, the time capital control policies played an increasingly crucial role, the value of FDI recovered to rise again. Thus, we could conclude that the confidence of foreign entrepreneurs come back to the level before and foreign investors become optimistic for future growth. At least, the GDP in the first quarter of 2017 is also robust with the growth rate of 6.9 percent, informing a positive signal to those foreign investors.
Figure 5: Growth Rate (%) of the Value of Foreign Direct Investment Actually Utilized for Wholly Foreign-owned Enterprise
17 Review and Prospect of World Economic Situation in 2012, Yuechun Jiang (2013), China Institute of International Studies
Data source: National Bureau of Statistics of China
Actually, capital control is always a heated debate for developing countries because of the spillover effects it may cause (Pasricha, et al. 2015). That is, the distortion as well as inefficiency of global resource allocation is resulted. For China, its underdeveloped financial system has been the thorny problem for many years as stated in previous chapters. The PBoC has tried many years as well to build a better financial system as all of the developed countries did. However, external shocks would come out suddenly, the sign of capital control indicates that the revolution of the system until now is not finished yet, we are still not sure if China could defend the next big shock from outside world. In short time, capital control is a successful measure and the figures above are convincing for investors all over the world. While in long term, the flexible capital account should be the final aim in theory18, we will
see what kind of new reform would be taken after this special time with the special measure.
5.The Modeling of Exchange Market Pressure
As mentioned in previous chapters, EMP index measured in China contains four main components. They are nominal depreciation of Renminbi, Official intervention of foreign
18 See IMF publications, Finance and development, Capital Accounts: Liberalize or Not? byM. Ayhan Kose and Eswar Prasad, 2012
exchange reserve, Interest rate component, and Capital control component. Before deriving the aggregation equation for EMP, I will firstly account for every component in detail.
5.1 Constructing four components
5.1.1 Nominal depreciation of Renminbi
According to the initial concept for EMP (Girton and Roper, 1977), if the exchange rate regime is totally flexible, EMP equals to the depreciation of the currency. The devaluation implies the excess supply of the currency that should be removed, thus the EMP could be measured entirely by actual depreciation. If the exchange rate regime is fixed to its target currency, no depreciation exists, but that does not mean there is no pressure in the exchange market. What we are focusing here is intermediate exchange rate regime, which is common to see in the world. Because many countries have tried to manage their exchange rate for a series of purposes (Giddy, I. H., & Dufey, G. 1992). For example, stable exchange rate target, avoiding exchange rate risk, international balance of payment, international economic cooperation, etc. Actually, mainly developing countries and emerging markets in the world try to control their exchange rate (IMF, 2013). There is no doubt that changes in exchange rate could be one of the key factors since the fluctuation of exchange rate explains part of the EMP. Here in our issue, the bilateral exchange rate the number of renminbi per dollar is represented by 𝑆𝑡, the spot currency rate in time t. Thus ∆𝑆𝑡 indicates the depreciation of the Renminbi and the bigger ∆𝑆𝑡, the higher EMP in the country. Thus, the component in the
model is:
∆𝑆𝑡 5.1.2 Official intervention of foreign exchange reserve
The definition of GR model (1977) for EMP considers the “absence of policy actions”, official intervention of foreign exchange reserve is included. Foreign exchange reserves have reached a record-breaking level in many developing countries after the late 1990s, especially in Asia and the Middle East (Fukuda, 2008). Regulators in developing countries have learnt so much from the Asian Crisis, during which time underdeveloped countries or areas with less mature financial structure in Asia suffered greatly from controlling panics and capital outflows. They realized that raising foreign exchange reserves could be an effective self-protection measure and applied this strategy after serious consideration. Foreign exchange reserve could act as a buffer or backup to adjust to the exchange rate shocks. Once the depreciation pressure caused by a certain reason, the central bank could sell their foreign exchange assets to shorten the supply of domestic currency, then some extent pressure of devaluation is incorporated by this way. That is the reason many countries accumulate large
foreign exchange reserve, it could be treated as an effective approach at least in theoretical moves19.
China has an astonishing accumulation of foreign exchange reserve. The adequate foreign assets give PBoC the capability of reacting to exchange rate risk and offsetting EMP. Let 𝑅𝑡
represent the foreign exchange reserve in time t, 𝑀𝑡−1 to be the inherited money stock
(narrow money: M1) in time t-1, ℎ𝑡 is the money multiplier. According to the monetary model from Weymark (1997), the equation for official intervention of foreign exchange reserve is ℎ𝑡 𝑅𝑡−ℎ𝑀𝑡−1𝑅𝑡−1
𝑡−1
.
However, money multiplier is internal confidential data that are notallowed to public access. For the reason that China has a prudent monetary policy since 1998 (Goodfriend, M., & Prasad, E. 2007), we assume the money multipliers during the examined period (2006-2017) are constant, thus the money multipliers could be derived out and be omitted because they are not related in the assumed case anymore. Hence, we get 𝑟𝑡 = ∆𝑅𝑡
𝑀𝑡−1 to
represent the foreign exchange reserve component we would use in the model. The component finally made in the model becomes:
𝑟𝑡 = ∆𝑅𝑡 𝑀𝑡−1
5.1.3 Interest rate component
The most direct logic connecting EMP and interest rate fluctuations is that lower interest rate relative to its target country incurs currency depreciation for domestic currency. To earn a higher return, international capital flows to higher interest rate areas, which changes the equilibrium of the currencies in the global currency market. Less demand for currencies in lower yields countries, resulting reduced “price” in the market. In other words, depreciation relative to the target country is brought about. Because of this basic mechanism, central bank makes use of interest rate adjustments (one of the police actions) when facing EMP to attain the aim of removing excess supplied currency.
Klaassen and Jager (2011) disagreed with traditional EMP that lagged value of interest rate variable is not appropriate in constructing the model for EMP. They came up with a counterfactual value of interest rate component that no forex intervention and capital controls exist. The counterfactual interest rate reflects the divergence of real interest rate, the inflation gap, the output gap, and some other factors between two countries by the use of Taylor rule, hence it is the desired interest rate that contributes to the equilibrium level of monetary policy. The differences between short-term interest rates and counterfactual interest rate are the movements by the central bank to offset the pressure from forex market.
Let 𝑖𝑡 represent the short-term interest rate, the most commonly used base interest rate that implies monetary policies from PBoC, so we use overnight interbank rate announced to the public. Whereas, 𝑖𝑡𝑑 donates the desired counterfactual interest rate. To calculate it, we need
19 Practically, to avoid the exchange rate risk is more complicated that only adequate foreign exchange reserve is not enough, since the foreign assets could deplete really quickly. See the case for Thailand.
take into consideration of short-term interest rate in the US, inflation- as well as output gap, and other factors between China and the US. For simplicity, the output gap and other factors between US and China could be omitted due to the slight change in recent years, counterfactual interest rate can be calculated as 𝑖𝑡𝑑 = 𝑖𝑡∗+ (𝜋𝑡− 𝜋𝑡∗), in which 𝑖𝑡∗ is the
short-term interest rate in US, contributed by overnight dollar Libor rate, 𝜋𝑡 and 𝜋𝑡∗ are the inflation
rate in China and US given the Consumption Price Index (CPI) growth rates in two countries. Hence, the difference 𝑖𝑡− 𝑖𝑡𝑑 would be measured to explain the monetary intervention from
PBoC in the model of EMP. In the end, the component in the model is: 𝑖𝑡− 𝑖𝑡𝑑
5.1.4 Capital control component
The capital control component mainly uses the idea of Covered Interest rate Parity (CIP) in offshore Non-deliverable Forward (NDF) market. By definition, CIP refers to a theoretical condition that the domestic and foreign interest rates as well as the spot and forward currency values of two countries are in equilibrium. Moreover, the covered interest rate parity refers to the situation that no-arbitrage condition is satisfied by means of forward contracts. As a result, no interest rate arbitrage opportunities between those two currencies.
NDF market is an offshore forward market for freely traded currencies. The market develops as a result of the absence of or serious restricts on the onshore forward market (Hutchison et al, 2012). Products in NDF market can be a useful tool because these prices actually could reflect market expectations and the supply as well as demand factors that cannot be fully examined in onshore currency product prices in a country with capital controls (Lipscomb, L. 2005). Therefore, NDF market becomes the market to avoid the exchange rate risks in using the currencies with capital control policies applied. The core idea is that the trading of forward contracts is based on different beliefs on future spot exchange rate which offers a good channel to hedge and speculate. At present in the Asian region, Renminbi, South Korean Won, New Taiwan Dollar, and other currencies are very active in non-delivery forward transactions, their owner areas have experienced large amounts of foreign investment and industrialization in recent decades while lagging in financial liberalization. Banks behave as intermediaries, the supply and demand sides sign non-delivery forward contracts in regard to their own different views. The contract determines the forward exchange rate at first, when the contract expires, the settlements are made in US dollars, whereas the other currency, usually an emerging market currency with capital controls, is “non-deliverable”. If the future spot exchange rate is greater than the forward exchange rate in the contract (assuming all exchange rates are invoiced in US dollar), the long side of emerging country currencies must pay the other side for the difference between contract forward exchange rate and spot exchange rate. Conversely, if emerging country currencies appreciate (with smaller spot exchange rate), the long side gain from the exchange rate differences and the short side would lose money.
Early in 2006, SAFE in China actually regulated the offshore Renminbi foreign exchange derivatives. Any form of NDF trades is forbidden unless the SAFE permits, given the reason that the foreign exchange market in China is in infancy and should avoid any kinds of speculation activities. Hence, in line with the regulation, NDF transactions are limited. While
in practical operations, the procedures do not involve cross-border flows of Renminbi and foreign exchange, the earned profits could also be saved in the offshore banks, therefore the regulation is totally invisible, that is also one of the reasons Renminbi NDF transactions are prevailing in foreign exchange market in Asian area.
As far we have talked about NDF market, covered interest rate parity (CIP) would be studied when it comes to thinking about capital control issue (Hutchison, et al, 2012). The opportunity of carry trade would be eliminated instantly through cross-border forward transactions. The formula is (1 + 𝛾)/(1 + 𝛾∗) = 𝐹/ 𝑆, in which 𝛾∗and 𝛾 mean the foreign and
domestic interest rate separately, F is forward exchange rate and S is the current spot exchange rate20. The riskless profits earned from the disparity between 𝛾∗and 𝛾 are totally
offset when operating carry trade by the means of forward contracts, that is the repayment of (1 + 𝛾) for every unit of domestic currency borrowed equals to the received amount of domestic currency (𝐹/ 𝑆)×(1 + 𝛾∗).
Taking the formula above as logarithm, it approximates to 𝑓 − s = 𝛾 − 𝛾∗, the 𝑓and s are log
form for F and S. If CIP does not hold, we could derive the formula 𝛾= 𝑓 − 𝑠 + 𝛾∗+ c, and
let c reflect the degree of capital control. Then the component of capital control could be written as 𝑐 = (𝛾 − 𝛾∗) − (𝑓 − 𝑠). Here for the data that would be used, monthly average
spot exchange rate during in logarithm is applied to s and three-month NDF exchange rate in logarithm is to f. Besides, three-month China interbank offered rate (Chibor) and three-month dollar London interbank offered rate (Libor) would be used for 𝛾 and 𝛾∗ in the calculation. Hence, the component applied in the model is:
𝑐𝑡 = (𝛾 − 𝛾∗) − (𝑓 − 𝑠)
5.2 Constructing aggregated EMP index
Firstly, the detailed relationship between EMP and other variables need to be settled. The depreciation of the currency should have a positive correlation with EMP, the larger pressure, the more currency depreciates. While as central bank raises current interest rate in domestic to the level greater than the counterfactual interest rate, the fewer flights of capital to invest abroad, which curbs the depreciation of the domestic currency. The greater pressure of currency depreciation, the higher interest rate would be set to offset the pressure. As for official foreign reserve, it could offset the depreciation pressure by selling the foreign currency invoiced assets to lower the supply of money. Similarly, capital control policies are applied to incorporate the pressure as well. The larger pressure of depreciation, the tighter capital control policies. Therefore, in line with the new EMP measure by Klaassen, and Jager (2011), we get the model:
20Here 𝛾 and 𝛾∗ are applied for the purpose of differentiating the interest rates used in the interest rate component. The reason is that the interest rates applied in capital component would be 3-month Chibor and Dollar Libor but short-term interest rates in this section. See details in the following chapters.
𝐸𝑀𝑃𝑡=∆𝑆𝑡− 𝛽1𝑟𝑡+ 𝛽2( 𝑖𝑡− 𝑖𝑡𝑑) − 𝛽3𝑐𝑡 𝑟𝑡 = ∆𝑅𝑡 𝑀𝑡−1 𝑖𝑡𝑑 = 𝑖𝑡∗+ (𝜋𝑡− 𝜋𝑡∗) 𝑐𝑡 = (𝛾 − 𝛾∗) − (𝑓 − 𝑠) 𝛽1≥ 0, 𝛽2≥ 0, 𝛽3≥ 0
6.Empirical Study of EMP
6.1 Data description of components
6.1.1 Data description of nominal depreciation
The revolution of China’s exchange regime has made the exchange rate varies with different paths in different periods. The figure could also reflect the reform of China’s special exchange regime directly.
Figure 6: China’s exchange rate towards US dollar (CNY/USD)
As what we have talked before in the 3rd chapter, we could see that for a long period the exchange rate is fixed at 8.27 CNY/USD until the July of 2005. Ever since the reform in 2005, the long time undervalued exchange rate (Plasschaert, S. 2007) started to appreciate gradually to the level closer to its equilibrium value. Actually, from the last season of 2008 to the mid time of 2010, the exchange rate roughly stabilized at 6.83 CNY/USD. While many economists still believe that PBoC manipulates the currency rate to support the crucial export sectors of China. The true purpose behind is unknown. But the Renminbi depreciated again to the lowest level to around 6.06 CNY/USD on 21st of January in 2014. This level has been confirmed by IMF announcing to the world that Renminbi is not undervalued anymore from May 26, 201521.
After the historically low level of the exchange rate in the beginning of 2014, the exchange rate floated around 6.2 CNY/USD until the end of third quarter in 2015, then a sudden jump to a higher rate happened in August. This abrupt devaluation is attributed to the step taken by PBoC on 10th of August22. The PBoC announced that it just has changed the approach to
calculating the daily midpoint of Renminbi to against the so-called “greenback”, taking the midpoint from market-makers quotes and the previous day's closing price. By examining the export data in 2015, we could find that the export amount dropped to a large degree about 8.3% in July, thus many analysts also agreed on the opinion that underlying reason behind of PBoC’s action is to reverse the bad situation and to boost the public confidence of exporting sectors at the same time.
Unexpected but reasonable strategies also taken by US side, the largest importer from China, to fight against the previous practice of PBoC. The first time Fed raised its key interest rate in nearly a decade on 6th of December in 201523. The post-meeting statement explained that this
measure was on the purpose of expanding economic activities at a moderate pace as well as strengthening the labor market by taking consideration of the given economic outlook after the financial crisis in 2008 to the end of 2015, during which a zero rate monetary policy enacted. Nevertheless, the historical issue actually signaled to the world that the Fed would recovery the exchange rate gradually as the economic conditions changed.
To deeply investigate EMP, the degree of fluctuations of the exchange rate would be examined. Therefore, the monthly data about exchange rate changes are applied for data exploration. Figure 7 shows that after a long-term silence of exchange rate changes, the Renminbi began to face an appreciation pressure in 2005, the year Renminbi gave up pegging US dollar resulting in a roughly 2% appreciation at first. Actually, in the following years, the Renminbi was mainly facing the appreciation pressure for almost a decade until 2015, the year Fed key interest rate was raised the first time. Large depreciation caused by the external shock from the US is also clearly exhibited on the figure. After the special measure of changing the calculation approach for midpoint by PBoC, the devaluation degree attained to more than 4%, which is also a rare phenomenon in history. Then the exchange rate fluctuated at 2% to depreciate in most following time as a result of the first time policy reaction by US
21 See https://www.worldfinance.com/markets/imf-renminbi-no-longer-undervalued
22 See http://www.cnbc.com/2015/08/10/rply-depreciate-to-yuan.html
Fed. More distinct changes are captured in Figure 8 with the beginning time from the day of historical reform in 2005. Figure 8 reflects the data used for exchange rate component in EMP model directly. We could also find that Renminbi started to appreciate in the recent May in 2017.
Figure 7: Monthly data about Fluctuations of exchange rate (CNY/USD) in percentage since 2005
Data source: Quandl Core financial data
Figure 8: Monthly exchange rate (CNY/USD) changes since 2005
6.1.2 Data description of Official intervention of foreign exchange reserve
To study the foreign exchange reserve component, the monthly data about official foreign reserve changes are collected from 2000 to 2017 showing the path of official operations in foreign exchange market. From the figures, we witness that China’s foreign exchange reserve has accumulated in almost all the time since 2000 to 2014. Then it dropped largely even reaching to 100000 million USD decreased once from Figure 9, which is so enormous compared with other time in history. However, if we think about the total amount that still exists, we would discover that the changes relative to its total amount in percentage were much larger before 2011, the first stage of accumulation of foreign exchange reserve through Figure 1, than the years after. For instance, the greatest decrease relative to the total amount is roughly 4% in the far past around 2004, whereas in recent years only about 2% in average of decrease24. Therefore, we could conclude that actually the influence of the “horrible drop” in
2014 to the whole foreign exchange market by official intervention is not that much terrible when considering the fact that still huge foreign exchange reserve exists and it is a normal size to satisfy the needs, which is in line with the official announcement by SAFE. But the issue was still so worried by the market that a debate of whether burning the reserve to defend Renminbi currency rate is really prevalent until now. Though we do not know the real answer, the fact observed by us is that the foreign exchange reserve in China is recovering.
Another part of the component we need is the Narrow Money (M1). The equation we derived in the last chapter is that official foreign intervention equals to the changes of foreign reserve. In Figure 9, we could see the movements of M1 in years with a green line, foreign exchange reserve is represented by the yellow line. Through the figure, we see that the M1 increases steadily in a long-term period. An apparent movement of M1 is that it grows much faster after 2015. While at the same time, foreign exchange reserve actually is reducing quickly. Thus, the currency rate in recent two years at least is the result of double operations applied. On the one hand, the SAFE sells foreign assets to safeguard the currency rate of Renminbi, on the other hand, additional monetary expansions pervade and offset part of the M1 contraction. Remember the Figure 8, the exchange rate fluctuates in two years and stabilizes finally. We cannot exclude one of the reasons is due to the double operations by authorities in China. Following the equation of the component, Figure 10 is generated after the necessary data calculation. The figure movements show that the changes of foreign exchange reserve relative to the inherited money stock grow largely before 2014. The highest level even reaches to 12% increase in 2007. Days after 2014, the data and the figure are consistent with former analysis that the path indicates the operations by the PBoC and Fed and their reaction policies. The tail of the line also indicates the trend that the foreign exchange reserve is recovering after continuing decreases in recent two years.
Figure 9: Foreign exchange reserve and M1 amount (100 USD)
Data source: Quandl Core financial data and National Bureau of Statistics of China Figure 10: The path of foreign reserve component
6.1.3 Data description of interest rate component
According to the equation we have derived in Chapter 5, the interest rate component actually is the difference between short-term interest rate 𝑖𝑡 in China and the desired counterfactual interest rate 𝑖𝑡𝑑. Here in Figure 11, the monthly average overnight China interbank rate
(Overnight China Interbank Rate) is applied to represent 𝑖𝑡. As what we could see, the short-term interest rate in China is much more volatile during the post financial crisis period from 2010 to 2015, attaining highest average rate at 6.710% in June 2013. This strange sign is because of the Chinese Banking Liquidity Crisis, the credit crunch happened in Shanghai interbank overnight leading rates to the abnormal 30 percent on 20 of June in 201325.
However, the interest rate stably varies within 3% in other periods. Also, we could find that from 2016, the interest rate climbs slowly to only 2.754% in May 2017. Whereas, the path of short-term interest rate in the US (Overnight US dollar Libor rate) shows that the recent trend of interest rate in China actually is consistent with the Fed’s decision of raising key interest rate since the end of 2015. Except that, the characteristic of the movements for Overnight US dollar Libor rate is different. The short-term interest rate in US was largely reduced from 2007 to a historical low level at that moment. However, it hiked soon in 2008 to around 6.875 percent at highest, which indicates the horrible depress. This extremely high interest rate is mainly resulted from the really risky subprime loans and other similar financial products in the market. Then after the big shock, the short-term interest has been really low for a long time to stimulate the economy until the Fed’s interest rate decision. Practically, the interest rate during the time between 2005 and 2007 is no less than 3%, which is much higher than the interest rate in China at the same time.
Figure 11: Overnight China Interbank Rate and US dollar Libor rate (Monthly Average)
Data source: Datastream
25 See essay: China’s banks: The Shibor Shock, The economist, Jun 22nd 2013.
0 1 2 3 4 5 6 7 8 2 00 6/ 6 /1 2 00 6/ 9 /1 2 00 6/ 1 2/ 1 2 00 7/ 3 /1 2 00 7/ 6 /1 2 00 7/ 9 /1 2 00 7/ 1 2/ 1 2 00 8/ 3 /1 2 00 8/ 6 /1 2 00 8/ 9 /1 2 00 8/ 1 2/ 1 2 00 9/ 3 /1 2 00 9/ 6 /1 2 00 9/ 9 /1 2 00 9/ 1 2/ 1 2 01 0/ 3 /1 2 01 0/ 6 /1 2 01 0/ 9 /1 2 01 0/ 1 2/ 1 2 01 1/ 3 /1 2 01 1/ 6 /1 2 01 1/ 9 /1 2 01 1/ 1 2/ 1 2 01 2/ 3 /1 2 01 2/ 6 /1 2 01 2/ 9 /1 2 01 2/ 1 2/ 1 2 01 3/ 3 /1 2 01 3/ 6 /1 2 01 3/ 9 /1 2 01 3/ 1 2/ 1 2 01 4/ 3 /1 2 01 4/ 6 /1 2 01 4/ 9 /1 2 01 4/ 1 2/ 1 2 01 5/ 3 /1 2 01 5/ 6 /1 2 01 5/ 9 /1 2 01 5/ 1 2/ 1 2 01 6/ 3 /1 2 01 6/ 6 /1 2 01 6/ 9 /1 2 01 6/ 1 2/ 1 2 01 7/ 3 /1
Moreover, to calculate the desired counterfactual interest rate 𝑖𝑡𝑑, the inflation gap between
China and US is applied in this component by using Taylor rule. Figure 12 clearly exhibits the gaps since 2005. In the figure, the movements of inflation rates in two countries are really similar that after 2006 the inflation rates in China are larger generally. In 2008 crisis, deflation happened in both countries greatly. Yet the inflation rates re-backed afterwards and they are at the same level from 2012 to now. If we calculate the changes of inflation gaps, the differences are smaller as the time goes by, from more than 4% to 2% average, even minus once in 2017.
Finally, the desired counterfactual interest rate 𝑖𝑡𝑑 could be obtained through the equation
𝑖𝑡𝑑= 𝑖
𝑡∗+ (𝜋𝑡− 𝜋𝑡∗). Then we calculate the difference ( 𝑖𝑡− 𝑖𝑡𝑑) to get the Figure 13. In
2007, the deviation from the counterfactual interest rate is quite huge that domestic interest rate in China is far below the counterfactual level reaching to minus 8.2% at most. Considering the Figure 6 about the bilateral exchange rate CNY/USD, during this period Renminbi was facing enormous appreciation pressure also. The result is from too high Fed fund rate in the US to a large extent, which is caused by the well-known high risk and overheated subprime mortgage lending market in the US. To save the economy, special remedy measures enacted in the US after 2008, the Fed signals to keep on lowering the interest rate that in 2009 the interest rate in China has already outnumbered its counterfactual level. Between 2011 and 2015, the deviation is always positive to highest 5.6% once upon a time. Though the Fed key interest rate is raised in recent two years, the deviation in practice is widened smoothly. Only in the beginning of 2017, the difference from counterfactual interest rate dropped sharply to zero almost.
Figure 12: The Inflation Rate of China and US (CPI change rates)
Data source: Datastream
-4 -2 0 2 4 6 8 10 2 00 6/ 6 /1 2 00 6/ 9 /1 2 00 6/ 1 2/ 1 2 00 7/ 3 /1 2 00 7/ 6 /1 2 00 7/ 9 /1 2 00 7/ 1 2/ 1 2 00 8/ 3 /1 2 00 8/ 6 /1 2 00 8/ 9 /1 2 00 8/ 1 2/ 1 2 00 9/ 3 /1 2 00 9/ 6 /1 2 00 9/ 9 /1 2 00 9/ 1 2/ 1 2 01 0/ 3 /1 2 01 0/ 6 /1 2 01 0/ 9 /1 2 01 0/ 1 2/ 1 2 01 1/ 3 /1 2 01 1/ 6 /1 2 01 1/ 9 /1 2 01 1/ 1 2/ 1 2 01 2/ 3 /1 2 01 2/ 6 /1 2 01 2/ 9 /1 2 01 2/ 1 2/ 1 2 01 3/ 3 /1 2 01 3/ 6 /1 2 01 3/ 9 /1 2 01 3/ 1 2/ 1 2 01 4/ 3 /1 2 01 4/ 6 /1 2 01 4/ 9 /1 2 01 4/ 1 2/ 1 2 01 5/ 3 /1 2 01 5/ 6 /1 2 01 5/ 9 /1 2 01 5/ 1 2/ 1 2 01 6/ 3 /1 2 01 6/ 6 /1 2 01 6/ 9 /1 2 01 6/ 1 2/ 1 2 01 7/ 3 /1 China US
Figure 13: Interest rate deviation from desired counterfactual level
Data source: Datastream
6.1.4 Data description of capital control component
The last component is capital control, which is composed through the idea of deviation from CIP. Here we use the 3-month data since the transactions in NDF market are always between 2 to 6 months, not in short term. Perhaps another reason maybe that capital control policies are better captured by average data in periods than instant changes of interest rates. In Figure 14, the 3-month dollar Libor rate was larger than Chibor rate before the beginning of 2008. Then they both fell in the 2008 crisis, though the changes of dollar Libor rates were astonishing and drastic. Nevertheless, the Chibor reverted from 2009 to the highest level and it has fluctuated smoothly afterwards with no rapid changes until now. Compared with Chibor, the dollar Libor rate has gone through a big shock after the crisis. In more than half decades it has stayed a low profile and just started to go up in recent years. When focusing on the differences between two rates in Figure 26, we see that the differences have enlarged since 2006 to the end of 2015, the special time Fed just raised its key interest rate. Soon after, the differences have shrunk and seem to be stable at a level from last year.
The results in the following figures are in line with the facts that economy stimulation by extremely low interest rates in the US after the crisis, whereas in China this situation seems mitigated. Actually, the financial crisis only had limited spillover impacts to China and China has kept its relatively high growth rate during the crisis period. In 2010, China’s economy rebounded, with GDP growth of around 10% outperforming all other major economies. While
-10 -8 -6 -4 -2 0 2 4 6 8 2 00 6/ 6 /1 2 00 6/ 9 /1 2 00 6/ 1 2/ 1 2 00 7/ 3 /1 2 00 7/ 6 /1 2 00 7/ 9 /1 2 00 7/ 1 2/ 1 2 00 8/ 3 /1 2 00 8/ 6 /1 2 00 8/ 9 /1 2 00 8/ 1 2/ 1 2 00 9/ 3 /1 2 00 9/ 6 /1 2 00 9/ 9 /1 2 00 9/ 1 2/ 1 2 01 0/ 3 /1 2 01 0/ 6 /1 2 01 0/ 9 /1 2 01 0/ 1 2/ 1 2 01 1/ 3 /1 2 01 1/ 6 /1 2 01 1/ 9 /1 2 01 1/ 1 2/ 1 2 01 2/ 3 /1 2 01 2/ 6 /1 2 01 2/ 9 /1 2 01 2/ 1 2/ 1 2 01 3/ 3 /1 2 01 3/ 6 /1 2 01 3/ 9 /1 2 01 3/ 1 2/ 1 2 01 4/ 3 /1 2 01 4/ 6 /1 2 01 4/ 9 /1 2 01 4/ 1 2/ 1 2 01 5/ 3 /1 2 01 5/ 6 /1 2 01 5/ 9 /1 2 01 5/ 1 2/ 1 2 01 6/ 3 /1 2 01 6/ 6 /1 2 01 6/ 9 /1 2 01 6/ 1 2/ 1 2 01 7/ 3 /1
the major reasons are that strong fiscal position, substantial foreign exchange reserve and limited international capital flows (Li, L., Willett, T. D., & Zhang, N. 2012). The crisis “epicenter” US suffered more and took more time of policy stimulation carefully.
Figure 14: The 3-month Chibor and Dollar Libor rates
Data source: Datastream
Figure 15: The difference between 3-month Chibor and Dollar Libor (percentage)
Data source: Datastream
0 1 2 3 4 5 6 7 2 00 6-06 -0 1 2 00 6-09 -0 1 2 00 6-12 -0 1 2 00 7-03 -0 1 2 00 7-06 -0 1 2 00 7-09 -0 1 2 00 7-12 -0 1 2 00 8-03 -0 1 2 00 8-06 -0 1 2 00 8-09 -0 1 2 00 8-12 -0 1 2 00 9-03 -0 1 2 00 9-06 -0 1 2 00 9-09 -0 1 2 00 9-12 -0 1 2 01 0-03 -0 1 2 01 0-06 -0 1 2 01 0-09 -0 1 2 01 0-12 -0 1 2 01 1-03 -0 1 2 01 1-06 -0 1 2 01 1-09 -0 1 2 01 1-12 -0 1 2 01 2-03 -0 1 2 01 2-06 -0 1 2 01 2-09 -0 1 2 01 2-12 -0 1 2 01 3-03 -0 1 2 01 3-06 -0 1 2 01 3-09 -0 1 2 01 3-12 -0 1 2 01 4-03 -0 1 2 01 4-06 -0 1 2 01 4-09 -0 1 2 01 4-12 -0 1 2 01 5-03 -0 1 2 01 5-06 -0 1 2 01 5-09 -0 1 2 01 5-12 -0 1 2 01 6-03 -0 1 2 01 6-06 -0 1 2 01 6-09 -0 1 2 01 6-12 -0 1 2 01 7-03 -0 1
Chibor-3 month monthly Dollar Libor-3month monthly
-4 -3 -2 -1 0 1 2 3 4 5 6 7 2 00 6-06 -0 1 2 00 6-09 -0 1 2 00 6-12 -0 1 2 00 7-03 -0 1 2 00 7-06 -0 1 2 00 7-09 -0 1 2 00 7-12 -0 1 2 00 8-03 -0 1 2 00 8-06 -0 1 2 00 8-09 -0 1 2 00 8-12 -0 1 2 00 9-03 -0 1 2 00 9-06 -0 1 2 00 9-09 -0 1 2 00 9-12 -0 1 2 01 0-03 -0 1 2 01 0-06 -0 1 2 01 0-09 -0 1 2 01 0-12 -0 1 2 01 1-03 -0 1 2 01 1-06 -0 1 2 01 1-09 -0 1 2 01 1-12 -0 1 2 01 2-03 -0 1 2 01 2-06 -0 1 2 01 2-09 -0 1 2 01 2-12 -0 1 2 01 3-03 -0 1 2 01 3-06 -0 1 2 01 3-09 -0 1 2 01 3-12 -0 1 2 01 4-03 -0 1 2 01 4-06 -0 1 2 01 4-09 -0 1 2 01 4-12 -0 1 2 01 5-03 -0 1 2 01 5-06 -0 1 2 01 5-09 -0 1 2 01 5-12 -0 1 2 01 6-03 -0 1 2 01 6-06 -0 1 2 01 6-09 -0 1 2 01 6-12 -0 1 2 01 7-03 -0 1
