Guobing Shen Associate Professor of World Economy & International Finance Institute of World Economy School of Economics Fudan.

Guobing Shen Associate Professor of World Economy & International Finance Guobingshen@yahoo.com.cn Institute of World Economy School of Economics Fudan University Monographic Study on Chinese Finance

Topic One  RMB ’ s Exchange Rate, Foreign Exchange Market and Foreign Exchange Exposure  Discussing the academic papers related to Topic One

3Copyright © Guobing Shen, Fudan University. 1: Exchange Rate and RMB Exchange Rate 2: Chinese RMB Issues in Dynamic and Global Perspective 3: Foreign Exchange Market and Market Intervention in China 4: Renminbi (RMB) Equilibrium Exchange Rate 5: Foreign Exchange Exposure and its Estimation Topic One: Chapter Organization

4Copyright © Guobing Shen, Fudan University. 1: Exchange Rate and RMB’s Exchange Rate  Exchange rates are important because they enable us to translate different counties’ prices into comparable terms.  An exchange rate is the price of one currency in terms of another, is a relative price, and also an asset price.  Foreign exchange rate is the price of some foreign currency expressed in terms of a home currency.  Exchange rates are determined in the same way as other asset prices.  We use the letter S to represent the home currency price of a unit of foreign exchange.

5Copyright © Guobing Shen, Fudan University. 1: Exchange Rate and RMB Exchange Rate ——Exchange Rate Quotations 1.1: Exchange Rate Quotations  An exchange rate can be quoted in two ways:  Direct quotation  The price of the foreign currency in terms of RMB  It is usually called the price quotation system, and this quotation defines the exchange rate as the number of units of domestic currency per unit of foreign currency. This amounts to defining the exchange rate as the price of foreign currency in terms of domestic currency. –eg. a direct quotation USD1= CNY 6.9472 in China  Indirect quotation  The price of RMB in terms of the foreign currency  It is usually called the volume quotation system, and this quotation defines the exchange rate as the number of units of foreign currency per unit of domestic currency. With this definition the exchange rate is the price of domestic currency in terms of foreign currency. –eg. GBP1=USD1.7452 in the United Kingdom

6Copyright © Guobing Shen, Fudan University. 1: Exchange Rate and RMB Exchange Rate ——Exchange Rate Quotations CurrencyIn US DollarPer US Dollar Argentine Peso0.262193.81400 Australian Dollar0.897831.11380 Brazilian Real0.563861.77350 British Pound1.637730.61060 Canadian Dollar0.926181.07970 Chinese Yuan0.146546.82400 Euro1.471020.67980 Hong Kong Dollar0.129047.74960 Indian Rupee0.0212647.03000 Japanese Yen0.0110490.56000 South Korean Won0.000831201.30007 Mexican Peso0.0750513.32400 Russian Ruble0.0341729.26920 Swedish Krona0.141517.06680 Swiss Franc0.973711.02700

7Copyright © Guobing Shen, Fudan University. 1: Exchange Rate and RMB Exchange Rate — Nominal and Real Exchange Rate, NEER and REER 1.2: Nominal and Real Exchange Rate, NEER and REER  Denote by S the nominal exchange rate between two currencies. In China, we normally talk about S so that a rise in the number represents a depreciation of the RMB, as domestic currency units per unit of foreign currency, i.e. RMB yuan per US dollar, and that is the system that will be used throughout these lectures.  Nominal Exchange Rate: Assuming the law of one price holds, the nominal spot exchange rate can be written as:  S=P/P* (1) Here, P is the domestic price level and P* the foreign price level.  Real Exchange Rate: When we come to real exchange rates, this makes a difference to the equation. The real exchange rate (Q) is:  Q =SP*/P (2)

8Copyright © Guobing Shen, Fudan University. 1: Exchange Rate and RMB Exchange Rate — Nominal and Real Exchange Rate, NEER and REER  Often these equations are written in logarithms, for which I shall use lower-case letters:  q = s + p*– p (3)  Since there are many countries in the world, we also want a measure of the average exchange rate against all countries. This is the effective exchange rate (usually constructed as a weighted average, using trade flows (exports + imports) as weights).  Nominal Effective Exchange Rate: The effective exchange rate is:  S = w 1 S 1 + w 2 S 2 + ……+ w n S n (4)  Where wi is the weight on currency i and Si is the bilateral exchange rate against currency i. Then S is the nominal effective exchange rate (NEER). For all countries this appears in IMF classifications so that a rise in the number represents an appreciation, and as an index with a particular year defined as 100.

9Copyright © Guobing Shen, Fudan University. 1: Exchange Rate and RMB Exchange Rate — Nominal and Real Exchange Rate, NEER and REER  Real Effective Exchange Rate:  The real effective exchange rate (REER) is defined in the same way, except using Q instead of S:  Q = w 1 Q 1 + w 2 Q 2 + ……+ w n Q n (5)  This is the best measure of the international competitiveness of a country’s products. A rise in Q represents a loss of competitiveness.  From (3), it can be seen that any change in the real exchange rate may be decomposed into a nominal exchange rate change and inflation at home and abroad:  ∆q = ∆s + ∆p* – ∆p (6)  The same holds for real effective exchange rates if we think of ∆p* as the trade-weighted average rate of inflation in other countries.

10Copyright © Guobing Shen, Fudan University. 1: Exchange Rate and RMB Exchange Rate — Nominal and Real Exchange Rate, NEER and REER  Real Exchange Rate expressed by tradables & nontradables  Sometimes the real exchange rate is expressed as the price of nontradables relative to the price of tradables. Tradables can be thought of as goods with negligible transport costs. Suppose the price index is a geometrically weighted average of these two:  P = P N b P T 1-b = (P N /P T ) b P T (7)  Then Q = [SP* T / P T ] [(P* N /P* T ) b /(P N /P T ) b ] (8)  This says the real exchange rate is equal to the real exchange rate for tradable goods times the ratio of the relative prices at home and abroad to the power b. If “the law of one price” prevails for tradable goods (i.e. they sell for the same price in all currencies), then their real exchange rate (SP* T / P T ) is just 1, in which case the first term disappears. Then, for given P* N /P* T, Q moves in the same direction as P T /P N.

11Copyright © Guobing Shen, Fudan University. 1.3: Changes in exchange rates  Two types of changes in exchange rates  Depreciation of domestic currency  A rise in the home currency prices of a foreign currency –It makes home goods cheaper for foreigners and foreign goods more expensive for domestic residents. P = SP*  Appreciation of domestic currency  A fall in the home price of a foreign currency –It makes home goods more expensive for foreigners and foreign goods cheaper for domestic residents. P = SP*  A general principle: All else equal  Appreciation of a country’s currency:  Raises the relative price of its exports P* = P/S  Lowers the relative price of its imports P = SP*  Depreciation of a country’s currency:  Lowers the relative price of its exports P* = P/S  Raises the relative price of its imports P = SP* 1: Exchange Rate and RMB Exchange Rate ——Changes in exchange rates

12Copyright © Guobing Shen, Fudan University. 1: Exchange Rate and RMB Exchange Rate — Covered Interest Parity  1.4: Covered Interest Parity  Yuan 1 invested at home at time 0 yields Yuan (1+i) at time 1. Yuan 1 invested abroad yields Yuan (1+i*)( S 1 / S 0 ) at time 1, because $(1/S 0 )yield an interest of i*/S 0, converted back to RMB at the rate S 1. To equalize returns at home and abroad requires that  i - i*= ∆s+ i*∆s ≈∆s (9)  Now suppose that the real exchange rate stays constant (∆q = 0). From (6), this implies that  ∆s = ∆p –∆p* (10)  And also those real interest rates are the same in both countries.  i - ∆p = i* - ∆p* (11)  Thus a country with high inflation can have high interest rates and a high rate of nominal exchange rate depreciation, together with a constant real exchange rate and the same real interest rate as other countries. Inflation need not make any difference to any real variables.

13Copyright © Guobing Shen, Fudan University. 1: Exchange Rate and RMB Exchange Rate ——Characteristics of RMB Exchange Rate Mechanism 1.5: Characteristics of RMB Exchange Rate Mechanism  The main focus of the reform to RMB exchange rate mechanism was that RMB exchange rate would no longer be pegged solely to the U.S. Dollar, but rather, a number of principal currencies that would be chosen and given an appropriate weighted value to form a package of currencies. In light of the domestic and foreign economic and financial situation, a mechanism based on market supply and demand that uses a package of currencies to calculate changes in multilateral exchange rate indices for the RMB, and exercises management and regulation of RMB exchange rate can better maintain stability.  Making reference to a package of currencies indicates that changes in the exchange rates of foreign currencies will have an effect on the RMB exchange rate. There is also the need to take the market relationship of supply and demand as another important basis by which to form a managed floating exchange rate.

14Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issues in Dynamic and Global Perspective——Is the RMB undervalued? 2.1: Is the RMB undervalued?  Since 1994, China has managed to maintain a steady nominal peg of its Renminbi (RMB) currency against the U.S. dollar, while China’s trade with the United States and other Western countries has grown dramatically.  Governments in the US, Japan, and several other countries contend that the rapid growth of China’s exports has been largely caused by an unfair undervaluation of the Chinese RMB, and thus call for either a revaluation or a shift towards a more flexible exchange rate regime.  However, many scholars disagree, and the subject is now under intense debate among economists, China specialists, and policymakers.

15Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issues in Dynamic and Global Perspective——Is the RMB undervalued?  McKinnon (2004) argues that complaints about the RMB exchange regime are largely misplaced, and that the policy of China and other economies in East Asia to peg against the dollar is, in effect, the best available policy for regional stability in an imperfect world.  Tung and Baker (2004) argue that a one-time revaluation of the RMB would serve China’s own interests by helping to slow down the continuing expansion of credit that leads to speculative bubbles, bad lending, and inflationary pressures.  Chang and Shao (2004) conducts a quantitative estimation for the equilibrium value of the Chinese currency, the RMB. After controlling for heteroskedasticity, we find that the RMB was undervalued by 22.5% in 2003, with a P value of.286. These findings confirm that the RMB was undervalued, although the results are not statistically significant. A revaluation may be inevitable in the coming future if the Chinese economy continues to expand at the current pace and inflation is kept in check.

16Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issues in Dynamic and Global Perspective——Is the RMB undervalued?  Haihong Gao (2006) indicates that the Balassa–Semuelson Hypothesis (BSH) is applicable to the economies that obtain high growth through changing industrial and export structures. In the case of China, historical data does not seem to lead us to conclude that China’s past high growth brings RMB real exchange rate appreciation.  We find that the determining factors underlying the BSH were not working as the BSH predicted. However, our forward-looking view about the real exchange rate of the RMB is no longer negative, because we see several positive signals indicating that the real exchange rate of the RMB will rise along with continuous industrial structure upgrading, steady growth of productivity and corresponding increase in wage levels.  Real exchange rate appreciation is not only likely, but also desirable, because we see that the relationship between economic structure upgrading and real exchange rate appreciation is in fact a two-way link: industrial structure upgrading results in real rate appreciation, and real appreciation in turn can be a stimulator to further industrial upgrading.  The focal point is the equilibrium value of the RMB exchange rate. Is the RMB undervalued? Some empirical studies on the equilibrium exchange rate, although each adopts a different technique and methodology, and they all suggest undervaluation, although to varying degrees.

17Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issues in Dynamic and Global Perspective——What is the RMB policy? 2.2: What is the RMB policy? Whether Float or Stable/Peg?  To limit future exchange rate misalignments and ‘‘hot’’ money flows, International Monetary Fund (IMF) argues that East Asian currencies should float more freely.  The G-7 financial ministers and central bankers are urging China to let the RMB float more freely, but the deputy chief of the People’s Bank of China has stated that a stable RMB exchange rate is crucial both for China’s development and for the maintenance of financial stability in the rest of Asia.  Regardless of the different views, there is a general agreement among all parties that the trend of globalization and integration is inevitable, and that the RMB value will eventually have to move towards its equilibrium value. Both Chinese and Western monetary authorities agree that the RMB policy should adjust to the changing macroeconomic situation in the coming years, although there is no consensus on the schedule.

18Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issues in Dynamic and Global Perspective——What is the RMB policy?  Argument for pegging to the U.S. dollar  McKinnon (2004) believed that the relatively high-saving East Asian countries are virtually forced to run export surpluses whatever the exchange rate regime, because of massive U.S. government fiscal deficits and very low saving by American households.  More important than direct trade with the United States is the currency of choice for invoicing East Asian trade and capital flows.  With the sharp rise of intra-east Asian trade and economic integration, mutual exchange rate stability among East Asian countries is devoutly to be wished. In the absence of an ‘‘Asian euro,’’ however, the only feasible way of achieving this mutual exchange stability is for East Asian governments individually to peg the region’s dominant key currency: the U.S. dollar.

19Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective——Why Peg to the U.S. Dollar? 2.3: Why do East Asia countries choose to peg to the U.S. dollar?  Most developing economies lack broad and deep bond markets in the domestic currency. Thus, they cannot borrow internationally in their own currencies—sometimes called the problem of original sin.  Forward markets in foreign exchange remain too expensive or poorly developed. Thus their exporters and importers have trouble hedging against exchange fluctuations.  In any debtor economy with original sin, the financial fragility from the currency mismatch is compounded by a maturity mismatch.  Dollar assets: In the new millennium, however, East Asian economies are becoming dollar creditors. Instead of building up claims on foreigners denominated in their domestic monies, most of the foreign claims—held either privately or as official exchange reserves—are highly liquid dollar assets.

20Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective ——Why Peg to the U.S. Dollar?  Any creditor country that cannot lend in its own currency cumulates a currency mismatch that I call the syndrome of conflicted virtue.  The government is ‘‘conflicted’’ because appreciation could induce deflation, but foreigners may threaten trade sanctions if the creditor country in question does not allow its currency to appreciate. Hence, the syndrome of conflicted virtue.  Soft dollar pegs (McKinnon, 2004)  The imperfect solution is for each East Asian government to keep its dollar exchange rate as stable as it can.  Short of adopting a full-fledged system of regional dollar parities, a difficult exercise in collective action for East Asia, soft pegging is the result.  McKinnon (2004): Using the dollar as the key currency for stabilizing relative exchange rates within East Asia is tenable as long as the U.S. keeps the international purchasing power of the dollar fairly constant.

21Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective ——Why Peg to the U.S. Dollar?  Because of the unusually low saving of U.S. households and massive dissaving by the federal government with its large and growing budget deficit, the relatively high-saving East Asian countries are virtually forced to run export surpluses in order to lend their ‘‘surplus’’ saving to the United States—whatever the exchange rate regime.  Without provoking a damaging credit crunch in the American economy, the only way the US trade deficit can be substantially reduced is to greatly increase net national saving in the United States(McKinnon,2004).

22Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective——Is Appreciation Effective?  2.4: Is China’s Exchange Rate Appreciation Effective for the U.S.?  Today’s US mercantile pressure on China to appreciate the renminbi against the dollar is eerily similar to the US pressure on Japan to appreciate the yen more than 30 years ago. The overvalued yen and the expectation of appreciation destabilized the Japanese financial system; the bubble economy of the late 1980s was followed by a deflationary slump and a zero-interest liquidity trap in the 1990s.  International savings imbalances, rather than misaligned exchange rates are the root cause of the US current-account deficit. However, suppose that the US trade deficit is misdiagnosed to result from a misaligned exchange rate, so that a surplus country on the dollar’s periphery is forced to appreciate against the dominant money. It will suffer a slowdown in economic growth including imports and eventually deflation (McKinnon, 2006).

23Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective——Is Appreciation Effective?  The erratically appreciating yen undermined the natural process of relative wage adjustment for balancing international competitiveness between Japan and the United States, and the resulting deflationary pressure severely depressed the Japanese economy in its ‘lost decade’ of the 1990s.  For creditor countries on the periphery of the dollar standard, such as China, that have current-account (saving) surpluses, foreign mercantile pressure to appreciate their currencies and become more flexible is misplaced. Exchange rate appreciation, or the threat of it, causes macroeconomic distress without having any predictable effect on the trade surpluses of creditor economies.  The main idea for China is to reduce forward exchange rate uncertainty.

24Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective——Chinese Yuan after the Reform 2.5: Chinese Yuan after Chinese Exchange Rate System Reform  The Chinese government announced its change in exchange rate system from the dollar peg system into a managed floating exchange rate system “with reference to” a currency basket on 21 July 2005.  Ogawa and Sakane (2006): It was not identified that Chinese monetary authority is adopting the currency basket system because the change is too small in the economic sense. It is indicated that the Chinese government should take account of the productivity growth of countries composing the currency basket in order to operate a currency basket regime. The Chinese government has shifted its exchange rate system into the managed floating exchange rate system with reference to a currency basket.  A nominal effective exchange rate (NEER) of the Chinese yuan is calculated based on its trade weights with nine trade partners that include the United States, European Union, Hong Kong, Japan, Korea, United Kingdom, Singapore, Russia, and Australia. A real effective exchange rate (REER) is a measure of effective exchange rate adjusted for inflation differentials between China and its trading partners.

25Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective ——Chinese Yuan after the Reform  In Figure 1 we find increases in NEER from 21 July to the end of 2005, which shows that a value of the Chinese yuan in terms of the NEER was appreciating after the reform. However, the value of the Chinese yuan in terms of NEER has been depreciating in 2006. In contrast, we find that values of the Chinese yuan in terms of the REER have been fluctuating around a constant level after 21 July 2005.  Therefore, the value of the Chinese yuan in terms of NEER is appreciating while its value in terms of REER is fluctuating around a constant level even after the reform. Ogawa and Sakane (2006, p.41)

26Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective ——Chinese Yuan after the Reform  Note: The terms ‘renminbi’ and ‘yuan’ are generally used interchangeably to refer to China’s currency. The renminbi is the currency, while the yuan is the unit of account.  Composition of Currency Basket for China: The Chinese economy has about 15 percent of its total trade volume with each of the United States, the EU, and Japan. It implies 70 percent: 15 percent: 15 percent for the US dollar, the euro, and the Japanese yen in the currency basket if currencies of the rest of the world are closely linked with the US dollar.  It is proved that the coefficient on the US dollar is nearly equal to unity even after the exchange rate system reform. The coefficient on the US dollar decreased a little immediately after the exchange rate system reform although it remained at a high level. However, it has increased to unity in recent months.

28Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective ——Chinese Yuan after the Reform  A simple model to explain the Balassa-Samuelson effect is described as follows. It is assumed that both domestic and foreign economies have a tradable good sector (T) and a non-tradable good sector (N). The domestic economy is assumed to be too small to have any effects on the foreign economy. It is assumed that workers can freely move between the tradable and the non-tradable good sectors in each of the economies while workers cannot move across the border between the two economies. Accordingly, a nominal wage rate (W) should be equalized between the tradable and the non-tradable good sectors.  Higher growth rate of productivity should appreciate home currency. Higher growth rate of productivity should lead to decrease in prices of traded goods. If the relative prices of domestic tradable goods against foreign tradable goods decrease, the currency of the country should appreciate. Accordingly, revaluation of the Chinese yuan accompanied with productivity growth will take place in the long run.

29Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective ——Undisclosed Renminbi Basket 2.6: The Undisclosed Renminbi Basket  Funke and Gronwald (2008): On 21 July 2005, the People’s Bank of China (PBoC) announced a revaluation of the currency, together with a reform of the exchange rate regime. In the new regime, the PBoC manages the RMB against an undisclosed basket of currencies of the main trading partners. Although critics were not impressed with the initial 2.1 per cent appreciation of the RMB to 8.11 per USD, much initial excitement surrounded the Chinese pledge to link the RMB to a group of major currencies.  According to the PBoC, the US dollar (USD), the Japanese yen (JPY), the euro (EUR) and the South Korean won (KRW) have the largest weights, but the basket also includes the currencies of Australia (AUD), Canada (CAD), Great Britain (GBP), Malaysia (MYR), Russia (RUB), Singapore (SQD) and Thailand (THB). Given the political problems this might pose, the Hong Kong and Taiwanese dollars are absent. The choice of currencies depends not only on the pattern of China’s trade but also on the sources of its foreign direct investment and the currency composition of its reserves.

30Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective ——Undisclosed Renminbi Basket  On 18 May 2007, the PBoC eventually widened the RMB’s daily trading band against the USD from 0.30 per cent to 0.50 per cent. In July 2008 China tightened its capital controls in an effort to curb speculative inflows betting on a rising RMB. Exporters will have to put their export revenues in temporary accounts and prove they come from genuine trade transactions rather than disguised hot money flows.  The parameter estimates indicate that the new regime has rather little flexibility. The coefficient for the USD is nearly one. Thus, the RMB is appreciating extremely slowly. The overall conclusion is that the RMB has remained pegged to the USD, with rather limited currency flexibility. The reason why Chinese policy usually takes place through a series of smaller steps is the fear that a sharp appreciation of the RMB could seriously hurt Chinese GDP growth.  Our working hypothesis is that the de facto RMB/USD exchange rate exhibits nonlinear features and that TV-AR-GARCH models can adequately characterize the smooth nonlinear evolution of the Chinese exchange rate regimes.

31Copyright © Guobing Shen, Fudan University. 2: Chinese RMB Issue in Dynamic and Global Perspective ——Undisclosed Renminbi Basket  Much economic literature has suggested that running intermediate exchange rate regimes, i.e. managed floats, basket pegs, crawling bands and the like, are too difficult to run for a country with open capital markets. Speculative pressures will sooner or later challenge the credibility of intermediate regimes and countries will thus be forced to move to the corners and adopt either full floats or hard pegs such as currency boards or dollarisation.  Without doubt, the new exchange rate regime depends in large measure on China’s ability to maintain capital controls – in the absence of deep, liquid foreign exchange markets, traders and investors cannot bring market forces to bear against Chinese monetary policy. In other words, once China can no longer maintain effective capital controls, a flexible exchange rate regime will become more likely (Funke and Gronwald, 2008, p.1596).

32Copyright © Guobing Shen, Fudan University. 3.1: Foreign Exchange Market——Structure  Exchange rates are determined in the foreign exchange market.  Foreign exchange market  The market in which international currency trades take place  The actors in the market ：  Commercial banks  Corporations  Nonbank financial institutions  Central banks  Individuals  The major participants in the foreign exchange market are:  Commercial banks  International corporations  Nonbank financial institutions  Central banks 3: Foreign Exchange Market and Market Intervention in China——Structure

33Copyright © Guobing Shen, Fudan University. 3: Foreign Exchange Market and Market Intervention in China——Structure  Inter-bank trading  Foreign currency trading among banks  It accounts for most of the activity in the foreign exchange market.  A vehicle currency  It is one that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency.  It has been suggested that the euro, which was introduced at the start of 1999, will evolve into a vehicle currency on a par with the dollar. By April 2001, however, only about 38 percent of foreign exchange trades involved euros.

34Copyright © Guobing Shen, Fudan University. 3.2: Foreign Exchange Market——Characteristics  Characteristics of the Market  The worldwide volume of foreign exchange trading is enormous, and it has ballooned in recent years.  New technologies, such as Internet links, are used among the major foreign exchange trading centers (London, New York, Tokyo, Frankfurt, and Singapore).  The integration of financial centers implies that there can be no significant arbitrage.  The process of buying a currency cheap and selling it dear.  Spot Rates and Forward Rates  Spot exchange rates  Apply to exchange currencies “on the spot”.  Forward exchange rates  Apply to exchange currencies on some future date at a pre- negotiated exchange rate.  Forward and spot exchange rates, while not necessarily equal, do move closely together. 3: Foreign Exchange Market and Market Intervention in China——Characteristics

36Copyright © Guobing Shen, Fudan University. 3.3: Foreign Exchange Markets in Transition Economies: China  Phylaktis and Girardin (2001): One striking feature of the Chinese economy since 1978 has been the co-existence of planned and market prices in many areas of the economy. In the foreign exchange market, three types of exchange rates have co-existed. The official rate, which was fixed and rarely changed; the swap rate, which was used by Chinese enterprises to swap their foreign exchange quotas and/ or foreign currencies at a state determined rate by the Bank of China in selected cities, and which was less managed since 1988; and the black or parallel market rate, which was market- determined. The black market emerged because of the government’s attempts to set the exchange rate and to monopolize access to and use of foreign currencies.  The swap rate was a more representative state rate for the period 1988 to 1993 than the official rate, since an increasing amount of transactions were channeled through that market. In China, black market transactions have been a keystone of economic activity and monetary life for over half a century. The fixing of the exchange rate and use of restrictions governing access to the foreign exchange market has resulted in a thriving black market. In 1994 the official rate and the swap rate were unified. 3: Foreign Exchange Market and Market Intervention in China—Foreign Exchange Markets in China

37Copyright © Guobing Shen, Fudan University.  In 1986, we see the establishment of Foreign Exchange Adjustment Centers (swap centers) where Chinese enterprises and foreign investment corporations were permitted to transact. The swap rate was determined by the government on the basis of the official rate, and from 1988 onwards it was set through a managed floating system where market forces played some role. In January 1994, the official and swap market rates were unified at the prevailing market swap exchange rate and the issuance of retention quotas was terminated. Quantitative restrictions on current account transactions have been abolished in 1994.  The changes in the exchange rate regime and the movement towards liberalization of international transactions have been reflected in the black market premium: the spread between the black and swap exchange rate see Fig. 1 (Phylaktis&Girardin, 2001, p.219). 3: Foreign Exchange Market and Market Intervention in China—Foreign Exchange Markets in China

38Copyright © Guobing Shen, Fudan University. 3.4: RMB Exchange Market Pressure and Market Intervention  Xiaohui Liu and Jing Zhang (2009): The renminbi (RMB) has been subject to great appreciation pressure over the past decade, thus the People’s Bank of China (PBOC) has frequently had to intervene in the foreign exchange market to stabilize the RMB/US$ exchange rate. The appreciation pressure still remains. Carrying out the research on the estimations of RMB exchange market pressure (EMP) is extremely important. The estimation of EMP can provide a predictive indicator of the central bank’s exchange market operations.  Exchange market pressure is usually connected with the changes in official holdings of foreign exchange reserves and the nominal exchange rate. Under a complete fixed exchange rate regime, the central bank has to defend the committed parity with, in principle, unlimited purchases or sales of foreign exchange in case of excess demand for or excess supply of domestic currency. Under 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. However, neither completely fixed nor pure floating regimes exist worldwide. Under an intermediate regime, the excess demand or supply pressure that the home currency faces is usually relieved by a combination of both official reserve changes and exchange rate changes. 3: Foreign Exchange Market and Market Intervention in China——RMB Market Pressure and Intervention

39Copyright © Guobing Shen, Fudan University.  Girton and Roper (1977) first put forward the EMP concept. They construct an EMP index that is the sum of international reserve changes and exchange rate changes. The most important work on the EMP index is undertaken by Weymark (1997). Weymark modifies the limitations of previous works and constructs an IS-LM-AS-type SOE model under the price stickiness assumption. She also introduces a parameter into the EMP index construction and estimates it. The parameter is a conversion factor that represents the relative weight of the exchange rate changes to the intervention changes (represented by international reserve changes). Eichengreen et al. (1995) put forward a model-independent EMP index that is a linear combination of the interest differential, the percentage changes of both bilateral exchange rates and foreign exchange reserves.  Where s is the exchange rate in natural logarithm, w1 and w2 are the weights of the interest rate changes and the reserve changes. If the index is below zero, the home currency is facing appreciation pressure; otherwise, the currency is facing depreciation pressure. 3: Foreign Exchange Market and Market Intervention in China——RMB Market Pressure and Intervention

40Copyright © Guobing Shen, Fudan University. Foreign Exchange Market Pressure and Central Bank Intervention:  The central bank should allow the exchange rate changes to relieve all the appreciation or depreciation pressures that the home currency is facing. In such a case, there are no changes in international reserves. This case implies that the economy adopts a pure floating exchange rate regime.  However, if the central bank relieves all pressure via exchange market intervention, then the central bank might fully intervene in the exchange market. This means that the country adopts a fixed exchange rate regime.  If the central bank absorbs the pressure partly through exchange rate changes and partly through exchange market intervention, then the central bank might actively intervene in the exchange market. This undoubtedly means that the country adopts an intermediate exchange rate regime. 3: Foreign Exchange Market and Market Intervention in China——RMB Market Pressure and Intervention

41Copyright © Guobing Shen, Fudan University.  Liu and Zhang (2009) obtain the modeldependent EMP index and the central bank intervention index (INTER) as follows:  Where s is the exchange rate in natural logarithm, and r is the international reserves adjusted by base money (B); namely, where Δ is the first difference operator and R denotes the level of international reserves.  If INTER index equals unity, it means that the central bank intervenes heavily in the exchange market, and that all the EMP could be relieved by the central bank’s interventions. In this case, the country is actually adopting a fixed exchange rate regime, although it may announce a different regime. The closer the index gets to unity, the heavier the intervention is, hence, the more rigid the de facto regime is. 3: Foreign Exchange Market and Market Intervention in China——RMB Market Pressure and Intervention

42Copyright © Guobing Shen, Fudan University.  It is showed that the EMP index has been well below zero since 1999, which indicates that the RMB has been facing appreciation pressure. In an attempt to stabilize the RMB exchange rate, the PBOC has had to intervene in the exchange market.  The trend of the intervention activity changed a little after the reform in July 2005 (see Figure 2). At this time, the PBOC reduced its exchange market interventions. However, since this time, the INTER index has been fluctuating between 0.84 and 1, which means that the RMB exchange rate regime is not much more flexible since the new reform. 3: Foreign Exchange Market and Market Intervention in China——RMB Market Pressure and Intervention

43Copyright © Guobing Shen, Fudan University.  RMB exchange market pressure has been relieved largely by the intervention activities rather than the RMB exchange rate changes. Therefore, RMB exchange rate regime is not as flexible as what the PBOC has announced.  The potential exchange rate pressures might lead to a currency crisis if the exchange rate does not react to the misalignment of the currency. In such a case, the EMP index is an indicator for identifying a potential currency crisis.  A currency crisis refers to a large exchange rate depreciation (over 25 percent). It usually leads to the exhaustion of official reserves and capital flight. However, an appreciation crisis is often neglected. An appreciation currency crisis is typically accompanied by economic shrinking and increasing growth of official reserves under a de facto fixed regime. The latter will further lead to monetary expansion and increases in the price level. However, research on appreciation crises are still far and few and between.  From July 2005 to June 2008, the RMB EMP is excessive after reform, which could lead to a currency crisis. Therefore, in response to the potential crisis, the PBOC should allow more flexibility in the RMB exchange rate regime, reduce interventions in the exchange market, and allow the RMB exchange rate to relieve or remove more appreciation pressure so as to avoid a crisis. 3: Foreign Exchange Market and Market Intervention in China——RMB Market Pressure and Intervention

44Copyright © Guobing Shen, Fudan University. 3.5: Foreign Exchange Transaction  Foreign exchange (FX) market is a highly decentralized market. Market participants seldom physically meet, but rather operate in separate offices of the major commercial banks. Trading typically takes place using telephone and electronic means. There is no central regulator governing these trading relationships, although private regulation exists to ensure a code of conduct in market transactions. Traditionally, individual dealers had only to disclose information to the trade’s counterparty and no mechanism existed to observe other market activity. However, with the introduction of electronic broker dealer trades, foreign exchange traders have access to information on other traders’ activity and can now assess ongoing market conditions in real-time. 3: Foreign Exchange Market and Market Intervention in China——Foreign Exchange Transaction

45Copyright © Guobing Shen, Fudan University.  Purpose: An FX transaction may be useful in managing the currency risk associated with importing or exporting goods and services denominated in foreign currency, investing or borrowing overseas, repatriating profits, converting foreign currency denominated dividends, or settling other foreign currency contractual arrangements.  History and Speculative transaction: Foreign exchange (FX) market is an inter-bank market that took shape in 1971 when global trade shifted from fixed exchange rates to floating ones. During exchange, the exchange rate is determined simply by supply and demand. The scope of transactions in the global currency market is constantly growing. Global daily conversion transactions came to $1,982 billion in mid-1998. Speculative transactions intended to derive profit from jobbing on the exchange rate differences make up nearly 80% of total transactions. Jobbing attracts numerous participants: both financial institutions and individual investors. 3: Foreign Exchange Market and Market Intervention in China——Foreign Exchange Transaction

46Copyright © Guobing Shen, Fudan University.  Information technology: FX transactions are now publicly accessible thanks to e-commerce systems. The foremost banks also often prefer trade in electronic systems over individual bilateral transactions. E-brokers now account for 11% of the FX market turnover. The daily scope of transactions of the biggest banks (Deutsche Bank, Barclays Bank, Standard Chartered Bank) reaches billions of dollars.  Features: FX market is not designed for attempts at catching a bluebird there. Another essential feature of FX market is its stability. Everybody knows that sudden falls are very typical of the financial market. However, unlike the stock market, the FX market never falls. FX market is a 24-hour market that does not depend on certain business hours of foreign exchanges; trade takes place among banks located in different corners of the globe. The starting costs of joining this business are very low now. The main thing the market will require for successful operations is not the quantity of money but the ability to constantly focus on studying the market, understanding its mechanisms and participants’ interests. 3: Foreign Exchange Market and Market Intervention in China——Foreign Exchange Transaction

47Copyright © Guobing Shen, Fudan University.  How to work: When you enter into an FX transaction, you nominate the amount and the two currencies to be exchanged. You also nominate the maturity date. Your FX provider will then determine the exchange rate, known as the contract rate, based on the date and currencies nominated by you. The contract rate is the rate at which the currencies will be exchanged.  Your FX provider determines the contract rate, taking several factors into account including:  the currency pair and the time zone you choose to trade in  the maturity date set by you  inter-bank spot foreign exchange rates  the contract amount, and your currency providers ability to trade small amounts on the inter-bank market  market volatility  Inter-bank interest rates of the countries of the currency pair. 3: Foreign Exchange Market and Market Intervention in China——Foreign Exchange Transaction

48Copyright © Guobing Shen, Fudan University.  Foreign Exchange Swaps  Spot sales of a currency combined with a forward repurchase of the currency.  They make up a significant proportion of all foreign exchange trading.  Foreign Exchange Futures and Options  Futures contract  The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future.  Foreign exchange option  The owner has the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date. 3: Foreign Exchange Market and Market Intervention in China——Foreign Exchange Transaction

49Copyright © Guobing Shen, Fudan University. 4: Equilibrium in the Foreign Exchange Market  Interest Parity: The Basic Equilibrium Condition  The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return.  Interest parity condition  The expected returns on deposits of any two currencies are equal when measured in the same currency.  It implies that potential holders of foreign currency deposits view them all as equally desirable assets.  If capital flow is free, the expected rates of return are equal when: R $ = R € + (E e $/€ - E $/€ )/E $/€

50Copyright © Guobing Shen, Fudan University.  How Changes in the Current Exchange Rate Affect Expected Returns  Depreciation of a country’s currency today lowers the expected domestic currency return on foreign currency deposits.  Appreciation of the domestic currency today raises the domestic currency return expected of foreign currency deposits. 4: Equilibrium in the Foreign Exchange Market

51Copyright © Guobing Shen, Fudan University. Table 1: Today’s Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When E e $/€ = $1.05 per Euro 4: Equilibrium in the Foreign Exchange Market

52Copyright © Guobing Shen, Fudan University.  The Equilibrium Exchange Rate  Exchange rates always adjust to maintain interest parity.  Assume that the dollar interest rate R $, the euro interest rate R €, and the expected future dollar/euro exchange rate E e $/€, are all given.  And then: E $/€ = E e $/€ - (R $ - R € )*E $/€  Equilibrium in the foreign exchange market requires interest parity.  For given interest rates and a given expectation of the future exchange rate, the interest parity condition tells us the current equilibrium exchange rate. 4: Equilibrium in the Foreign Exchange Market

53Copyright © Guobing Shen, Fudan University.  The Effect of Changing Expectations on the Current Exchange Rate  A rise in the expected future exchange rate causes a rise in the current exchange rate.  A fall in the expected future exchange rate causes a fall in the current exchange rate.  The Effect of Changing Interest Rates on Current Exchange Rate  An increase in the interest rate paid on deposits of a currency causes that currency to appreciate against foreign currencies.  A rise in dollar interest rates causes the dollar to appreciate against the euro.  A rise in euro interest rates causes the dollar to depreciate against the euro. 4: Equilibrium in the Foreign Exchange Market ——Interest Rates, Expectations, and Equilibrium

54Copyright © Guobing Shen, Fudan University. Dollar return R2$R2$ R1$R1$ Figure 1: Effect of a Rise in the Dollar Interest Rate Rates of return (in dollar terms) Exchange rate, E $/€ 2 E2$/€E2$/€ 1'1' 1 E1$/€E1$/€ Expected euro return 4: Equilibrium in the Foreign Exchange Market ——Interest Rates, Expectations, and Equilibrium

55Copyright © Guobing Shen, Fudan University. Dollar return R$R$ Figure 2: Effect of a Rise in the Euro Interest Rate Rates of return (in dollar terms) Exchange rate, E $/€ 1 E1$/€E1$/€ 2 E2$/€E2$/€ Rise in euro interest rate Expected euro return 4: Equilibrium in the Foreign Exchange Market ——Interest Rates, Expectations, and Equilibrium

56Copyright © Guobing Shen, Fudan University. 5: Renminbi (RMB) Equilibrium Exchange Rate——Evolution of RMB Exchange Rate 5.1: The Evolution of RMB Exchange Rate  Wang, Hui and Soofi (2007): Before 1978, China’s exchange rate policy was mostly determined by the nation’s strategic interests, and was formed in the context of the tense, inhospitable climate of the Cold War. With the beginning of economic reforms in China, functions of the market were increasingly valued by the policy makers, and from 1981, a dual exchange rate system emerged, whereby, the official fixed exchange rate was complemented with market- determined exchange rate in the swap centers. In 1988, the swap centers were established so that the transactions of the exporters, importers, and other currency dealing entities could be centralized.  In early 1990s, the swap market rate depreciated sharply, and the official rate became highly overvalued. In 1994, the official rate was devalued according to the swap market-determined rate, from 5.8RMB/USD to 8.7RMB/USD, and the exchange rate regime was officially defined as a managed floating system. The new rate remained more or less stable until July 21, 2005, when China revalued the RMB by 2.1% to RMB8.11 = USD1, and announced that it would switch from dollar-peg to a basket-peg, and allow for more flexible floating of the currency.

57Copyright © Guobing Shen, Fudan University. Chou and Shih (1998): Two approaches are used to estimate the equilibrium exchange rates of the Chinese currency, the renminbi (RMB): the purchasing power parity (PPP) model and the shadow price of foreign exchange (SPFE) model. The SPFEs are estimated including tariffs and import quotas. In comparison with the estimated equilibrium exchange rates, we find that the actual rates were in general overvalued. From 1990 to 1994, the official exchange rates are found to lie between the PPP rates and the SPFEs. This implies that the Chinese government has adopted an exchange rate policy that maintains official exchange rates close to equilibrium levels.  Dual exchange rates: The exchange rate of the Chinese currency, the renminbi (RMB), was overvalued persistently for decades through the late 1980s. As China opened its economy, policymakers began to realize that the exchange rate, which had been used heretofore as an accounting tool, could be a means of regulating the external sector of the economy. In August 1979, the State Council decided to adopt a dual exchange rate system that went into effect in 1981. From 1981 to 1984, an internal settlement rate of RMB 2.80 Yuan per US dollar was set for trade transactions, while official rates continued to be used for non-trade transactions. Dual exchange rates were used again in the latter part of the 1980s with the emergence of foreign exchange adjustment centers or swap centers in many cities. 5: Renminbi (RMB) Equilibrium Exchange Rate——Evolution of RMB Exchange Rate

58Copyright © Guobing Shen, Fudan University.  RMB Devaluation: Between 1985 and 1990, the official rate of the RMB was devalued significantly several times.  RMB 3.20 yuan per dollar in the fourth quarter of 1985  RMB 3.72 yuan in the fourth quarter of 1986  RMB 4.72 yuan per dollar in the fourth quarter of 1989  RMB 5.22 yuan in the fourth quarter of 1990  Since April 1991, the Chinese government has officially adopted a managed float system.  From 1991 to 1993, RMB 5.80 yuan per dollar.  In January 1994, the official rate was unified with the swap rate at RMB 8.7 yuan per dollar. The new rate was allowed to fluctuate within a range according to market forces.  Official exchange rate of the RMB had been overvalued. 5: Renminbi (RMB) Equilibrium Exchange Rate——Evolution of RMB Exchange Rate

59Copyright © Guobing Shen, Fudan University.  Exchange rate unification and RMB convertibility: The 1994 unification of the official and swap rates is a major step towards the establishment of currency convertibility. In the process of introducing currency convertibility, an appropriate exchange rate is needed to ensure macroeconomic stability. In fact, an appropriate exchange rate is one of the commonly recognized preconditions for the establishment of currency convertibility. The questions are how the appropriate or equilibrium exchange rate of the RMB is determined. 5: Renminbi (RMB) Equilibrium Exchange Rate——Evolution of RMB Exchange Rate

60Copyright © Guobing Shen, Fudan University. 5.2: Estimating RMB Equilibrium Exchange Rate  The difficulty with this method is that it is rarely possible to find an appropriate base period. One way to circumvent the problem is to use the long-run average of past relative prices as the benchmark for estimating current PPP exchange rates. The results show that the RMB experienced more than 50% overvaluation during the first three years of economic reforms. The overvaluation fell to 5% in 1989, followed by a period of undervaluation.  An alternative approach to calculating equilibrium exchange rates is based on the shadow price of foreign exchange (SPFE). In developing economies, the official exchange rate does not reflect the social value of foreign exchange because of the existence of widespread trade restrictions (Chao and Yu, 1995). 5: Renminbi (RMB) Equilibrium Exchange Rate ——Estimating RMB Equilibrium Exchange Rate

61Copyright © Guobing Shen, Fudan University.  Chao and Yu demonstrate that, in a developing dual economy with trade restrictions and labor market distortions, the SPFE is greater than the official exchange rate in the presence of tariffs. Furthermore, the SPFE under quotas and VERs can be greater or smaller than the official rate depending upon the degree of capital mobility.  A comparison of the actual official exchange rates and the estimates of SPFEs indicates that the official exchange rates were overvalued throughout the whole sample period. Compared with the estimated PPP rates, the RMB was in general overvalued between 1978 and 1989 and undervalued from 1990 to 1994, with the exception of 1993.  We find that the real exchange rate of the RMB is mean-reverting and the long- run PPP relationship holds. The estimated PPP exchange rates indicate that the RMB was in general overvalued between 1978 and 1989. Starting from 1990, the PPP exchange rates in general reflect a persistent undervaluation of the RMB. On the other hand, a comparison of the actual official exchange rates with the estimated SPFEs indicates that the official exchange rates were overvalued throughout the whole sample period. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Estimating RMB Equilibrium Exchange Rate

62Copyright © Guobing Shen, Fudan University.  A further look at the estimated equilibrium exchange rates and the actual rates reveals that from 1990 to 1994, the official exchange rates were found to lie between the PPP rates and the SPFEs. Since 1990, Chinese government has adopted a more realistic exchange rate policy that has maintained official rates closer to equilibrium levels.  The SPFE reflects the social value of foreign exchange for the economy of China, which has been characterized by extensive trade restrictions and factor price distortions. Moreover, PPP specifications have been criticized for simplifying and unrealistic assumptions. Furthermore, prices in China had been under long-term government control and have been liberalized only somewhat in recent years. Thus, on the basis of the SPFEs, we conclude that the RMB official exchange rates were overvalued throughout the whole sample period rather than undervalued from 1990 to 1994 as suggested by PPP rates (Chou and Shih, 1998, p.174). 5: Renminbi (RMB) Equilibrium Exchange Rate ——Estimating RMB Equilibrium Exchange Rate

63Copyright © Guobing Shen, Fudan University.  Wang, Hui and Soofi (2007): Based on estimation of the behavioral equilibrium exchange rate (BEER) and using Johansen co-integration technique, we conclude that RMB fluctuates around its long-run equilibrium rate within a narrow band. This implies that the currency has not been consistently undervalued. We identify the money supply, the foreign reserve holdings of China’s central bank, and a measure of China’s productivity as important explanatory variables of RMB long-run equilibrium value. The empirical findings of this study indicate that China’s exchange rate policy may have played an insignificant role in its trade surpluses.  Undervaluation or uncertainty, trade effect: Some influential centers argue that China has deliberately undervalued its currency by interventions in the currency markets. Even though the exact size of undervaluation is not known, the estimates of undervaluation vary from a little over zero to as high as 60%. In fact, without knowing the exactly estimated long-run, equilibrium RMB-USD rate, verification of whether RMB is over or under valued is rather problematic. In spite of uncertainties associated with the existence and size of RMB undervaluation, the critics of China’s exchange rate policy claim that pegging of the RMB to USD has resulted in massive trade imbalances in favor of China. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Estimating RMB Equilibrium Exchange Rate

64Copyright © Guobing Shen, Fudan University.  However, China responds that the current dollar price of the RMB is a reflection of productivity differential, and that the current nominal RMB-dollar exchange rate has little, if any, impact on the current bilateral balance of trade. It is claimed that any officially induced appreciations of the RMB would have at best only a temporary positive effect on America’s trade balance with China.  Methods of Estimation of Equilibrium Exchange Rate: The RMB long-run equilibrium studies could be classified into two categories. A set of studies based on PPP theory; another set of studies based on the economic fundamentals. These models go under a variety of names such as behavioral equilibrium exchange rate (BEER), fundamental equilibrium exchange rate, (FEER), permanent equilibrium exchange rate, (PEER), and equilibrium real exchange rate (ERER).  The FEER refers to that long-run equilibrium exchange rate which is consistent with the external and internal macroeconomic equilibrium. As a method of estimation, it specifies the equilibrium rate as a function of fundamental economic variables, abstracts from the short-term economic fluctuations, and entirely focuses on the medium-term and long-term economic conditions. Its weakness lies in difficulties of measurement, since such measurement involves a large number of parameters that relate to the current and capital accounts as well as the domestic capital and labor markets. Accordingly, the estimated results using this method become sensitive to the model’s parameters. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Estimating RMB Equilibrium Exchange Rate

65Copyright © Guobing Shen, Fudan University.  The BEER approach does not estimate the real equilibrium exchange rate per series, but it attempts to estimate the misalignment of a currency as the difference between the estimated exchange rate by the FEER method and the actual, observed exchange rate.  The BEER method uses a reduced form model of the fundamentals that determine the equilibrium exchange rate. The reduced form is specified as follows: the RMB real effective exchange rate (REER), terms of trade (tot), the relative price of the trade goods to non-trade goods (Balassa-Samuelson effect, named tnt), foreign exchange reserve (res), and the change of money supply (mon) as a measure of monetary policy. Here, we can establish the RMB behavioral equilibrium exchange rate model as follows: 5: Renminbi (RMB) Equilibrium Exchange Rate ——Estimating RMB Equilibrium Exchange Rate

66Copyright © Guobing Shen, Fudan University. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Estimating RMB Equilibrium Exchange Rate  The long-term variables influencing equilibrium exchange rate: terms of trade, the GDP growth rate, the technological advances, the price level, the interest rates, and the net capital flow. Since capital controls exist in China, the likelihood of high volatility of foreign exchange reserves in the short-run is very small. Therefore, we consider net capital flow as a long-term variable affecting the exchange rate.  The short-term variables’ influence is temporary, and they have no impact on the long-term trend of exchange rate. The typical short-term variables include instruments of the monetary and fiscal policies.  (i) Terms of trade: defined as the ratio of the export price index to the import price index.  (ii) The interest rate differential: because of capital controls, we do not use the interest rate differential.

67Copyright © Guobing Shen, Fudan University. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Estimating RMB Equilibrium Exchange Rate  (iii) Relative price of non-tradable to tradable goods: this variable can also be named as internal price ratio based on the Balassa–Samuelson model. Usually, the non-tradable prices are expressed by consumer goods price, and tradable goods price is expressed by the wholesale price in empirical tests, so internal price ratio is defined as the ratio of the domestic consumer price index to the domestic wholesale or producer price index. In China, because of widespread price controls and restrictions on free movement of workers between different sectors of the economy, the Balassa–Samuelson effect may not apply. Wang, Hui and Soofi (2007) use per capita output as a rough measure of change in the productivity in China.  (iv)Foreign exchange reserve: An increase in the foreign exchange reserve holdings implies the demand for the home currency is high, resulting in the real exchange rate appreciation.  (v) Money supply: an increase in the money supply would cause the real exchange rate to depreciate.

68Copyright © Guobing Shen, Fudan University. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Estimating RMB Equilibrium Exchange Rate  Wang, Hui and Soofi (2007) indicate that both short term and long- term variables have a unidirectional effect on the equilibrium exchange rate. The rise in the GDP, the increase in foreign exchange reserve, and the decrease in the money supply would lead to the appreciation of the real effective exchange rate. The Chinese authorities have a number of socio-political considerations in mind that act as strong countervailing forces against the United States’ pressure for China to sharply revalue the currency. These factors include Chinese aversion to succumb to foreign dictates as well as domestic economic consideration such as placing the agricultural sector of the Chinese economy in a competitive disadvantage position by artificially revaluing RMB.

69Copyright © Guobing Shen, Fudan University. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Estimating RMB Equilibrium Exchange Rate  Dunaway, Leigh and Li (2009): Because of the methodological and empirical difficulties involved in establishing the equilibrium real exchange rate for a currency and/or estimating the deviation of the actual real exchange rate from its equilibrium level, it is not surprising that researchers have come up with a wide range of estimates. This has been particularly so in the case of attempts to estimate the equilibrium exchange rate for China’s currency. At least for China, small changes in model specifications, explanatory variable definitions and time periods for estimation can lead to very substantial differences in equilibrium real exchange rate (RER) estimates. Besides methodological differences, estimation of the equilibrium current account balance can be complicated by rapid structural changes in the Chinese economy. Besides methodological differences, the variations in the elasticity estimates reflect rapid structural changes in Chinese trade.

70Copyright © Guobing Shen, Fudan University. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Estimating RMB Equilibrium Exchange Rate  The extended PPP approach is based on the assumption that PPP holds in the long run, but factors might act to prevent the actual exchange rate from converging to its PPP-determined level in the short to medium term. Taking into account the predicted influence of these factors, an equilibrium exchange rate can be calculated.  Relative productive progress in the tradable sector relative to the non- tradable sector at home causes the real exchange rate at home to appreciate. p.366  The results here point to a conclusion that equilibrium real exchange rates may not be well explained by panel regressions. The fact that these regressions produce large and relatively similar deviations of the actual estimates from the equilibrium estimates of the real exchange rate in the case of China’s currency suggests a lack of commonality across economies in both the variables that explain the real exchange rate and in their coefficients. All of these results indicate that estimates of a country’s equilibrium real exchange rate need to be treated with a great deal of caution (Dunaway, Leigh and Li, 2009, p.370).

71Copyright © Guobing Shen, Fudan University. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Policy Sequencing and RMB Equilibrium Exchange Rate 5.3: Policy Sequencing and RMB Equilibrium Exchange Rate  The policy sequencing has emerged as a major issue. One of the major issues in financial reform of emerging economies is the sequencing of capital account liberalization and more flexible exchange rate policies. Removing capital account controls may attract massive speculative capital inflows, triggering inflationary pressure that would require large revaluation of the currency with the latter’s adverse effect on export-lead economic growth. Relaxing capital account controls could have the undesirable consequences of capital flights, forcing the authorities to devalue the currency under duress. The scenario: first removing capital control and subsequently adopting a floating exchange rate regime.

72Copyright © Guobing Shen, Fudan University. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Policy Sequencing and RMB Equilibrium Exchange Rate  On March 18, 2006, the People’s Bank of China (PBOC) announced major changes in China’s capital account control policy. The policy changes consisted of relaxing restrictions on private holdings of foreign currencies. According to the new rules, Chinese residents could purchase up to $20,000 worth of foreign currencies, a 150% rise from its previous allowable sum of $8000. Furthermore, Chinese institutions were allowed to open foreign currency denominated accounts at the commercial banks. Finally, qualified Chinese insurance companies were allowed to invest in foreign securities, and Chinese commercial banks were permitted to invest in overseas securities on behalf of their clients.  What is the rationale of the Chinese authorities in adopting this particular policy sequencing? The Chinese reason that developing viable, wellfunctioning spot and forward markets is a prerequisite for adopting a more flexible exchange rate regime. A well-developed currency market is needed for Chinese banks and enterprises to hedge against foreign currency exposure. In light of well-known currency markets volatility, absent the forward and swap markets, the banks and enterprises would be exposed to unacceptable currency risks.  China prefers capital account liberalization-floating exchange rate regime sequencing.

73Copyright © Guobing Shen, Fudan University. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Policy Sequencing and RMB Equilibrium Exchange Rate  Appreciation of RMB’s real effective exchange rate is a function of increasing GDP, increasing foreign reserve, and decreasing supply of money among the other variables. Currently, all of these variables are exerting considerable pressure for RMB to revalue.  Under these conditions, Renminbi’s real effective exchange rate is bound to appreciate over the next few years. China’s policy to allow full convertibility of RMB is exactly in accord with allowing market forces to revalue the currency over the medium and long run.  Wang, Hui and Soofi (2007) shows there are no large, persistent deviations of the real effective RMB/USD exchange rate from its long-run equilibrium value. The effective rate has moved in a narrow band of plus 3% and minus 5% of the long-run equilibrium exchange rate over the last 25 years. There is no justification for a deliberate exchange rate revaluation that under the best of circumstances would have a short run effect on the real economic variables. Economics fundamentals are revaluating the currency over the long-run.

74Copyright © Guobing Shen, Fudan University. 5: Renminbi (RMB) Equilibrium Exchange Rate ——Policy Sequencing and RMB Equilibrium Exchange Rate  Increase of the foreign exchange reserve and increase in the national income in China could act as the major forces for the revaluation of RMB in near future. Based on these findings, and also based on current Chinese policies of moving RMB to full convertibility, a large revaluation of the currency may be redundant at this time. Nevertheless, a set of alternative policies are available to the policy makers in addressing China’s trade imbalance with the United States. Accordingly, the debate on China’s exchange rate policy needs to focus on other policy measures for bringing about meaningful, long-lasting, and mutually-beneficial changes in Sino-American trade relationship.

75Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Foreign Exchange Risk Exposure 6.1: Foreign Exchange Risk Exposure  Aline Muller, and Willem F.C. Verschoor (2006) focus on two primary areas of inquiry: the theoretical foundations of exchange risk exposure and the empirical evidence on the link between stock returns and currency fluctuations. Since the breakdown of the Bretton Woods fixed-parity system in the early 1970s, the volatility of exchange rates and its associated risks have become an increasingly important component of international financial management. From a theoretical perspective, it is a generally held view that exchange rate fluctuations are an important source of macroeconomic uncertainty. They should have a significant impact on firm value, regardless of whether the firm is domestically or internationally oriented.  In contrast to theoretical expectations, empirical research on exchange risk exposure appears conflicting and is mixed at best. International evidence focusing on more open economies yield more significant currency risk exposure estimates. A possible rationalization for the difficulties in documenting a measurable impact of foreign exchange risk on stock market values is that firms are aware of their currency exposures and are eliminating foreign currency risk by hedging.

76Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Foreign Exchange Risk Exposure 6.1: Foreign Exchange Risk Exposure  Stulz and Williamson (2000) decompose the overall impact of exchange rate movements on firm value distinguishing between transaction—contractual exposure, translation exposure and competitive exposure. While direct exposures (transaction, contractual and translation exposures) can be effectively managed by well-structured hedging strategies, indirect or competitive exposure provides significant variability in cash flows for most companies worldwide. Indeed, the complexity of the relationship between exchange rate fluctuations and competitiveness makes it quite difficult to correctly estimate competitive exposure. In summary, the sensitivity of firm value to exchange rate movements depends on a large number of parameters as, for instance, the nature of a firm’s activities, its import and export structure, its involvement in foreign operations, the currency denomination of its competition and the competitiveness of its input and output markets.

77Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Foreign Exchange Risk Exposure 6.1: Foreign Exchange Risk Exposure  Under strong market efficiency, the exchange rate exposure expresses the overall effect of exchange rate risk on the value of the firm. Characteristics of exchange risk exposure: Systematic errors; the potential temporal instability of firms’ currency risk exposure; the time-varying feature of exchange rate exposure; displaying a nonlinear and asymmetric behavior. While the literature on the theoretical justifications of exchange risk exposure is still evolving, financial economists have spent much of the last two decades amassing empirical evidence on foreign currency risk exposure. Although the findings of empirical studies are mixed, the bulk of the evidence suggests that exchange rate fluctuations affect, to a certain extent, shareholder wealth.

78Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Foreign Exchange Risk Exposure 6.1: Foreign Exchange Risk Exposure  Koutmos and Martin (2003): asymmetries are found to be more pronounced in the financial and non-cyclical sectors. Asymmetric responses to exchange rate movements: Asymmetric responses due to asymmetric pricing-to-market behavior; Asymmetric responses due to hysteretic behavior; Asymmetric responses due to asymmetric hedging behavior. The existence of only symmetric exposure implies that hedging decisions at the market portfolio level can be based on a single exposure estimate. The sector with the highest degree and frequency of exposure is the financial sector (75.0% of the cases). Most of the asymmetric behavior is linked to the financial and non-cyclical sectors. Over 40% of the significant exposures turn out to be asymmetric. Asymmetric exposure is found to be prevalent within the financial sector, which may be attributed to asymmetric hedging, and within the consumer non- cyclical sector, which may be attributed to asymmetric PTM and/or hysteretic behaviors. Asymmetric exchange rate exposure may explain, to some extent, the inability of most previous studies to document significant exposure.

79Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Foreign Exchange Risk Exposure 6.1: Foreign Exchange Risk Exposure  Dominguez and Tesar (2006): Exposure is correlated with firm size, multinational status, foreign sales, international assets, and competitiveness and trade at the industry level. Firms engaged in international activities are more likely to be directly affected by changes in exchange rates. Firms engaged in trade are more likely to face exchange rate risk. Firm-level dollar exposure and firm characteristics (namely a firm’s size and its industry affiliation); Firm-level dollar exposure and international activity (a firm’s activities in international markets increase the likelihood of exchange rate exposure); and Firm-level dollar exposure and international trade. Exchange rate exposure may be linked to a number of firm- and industry-level characteristics. Exposure is more prevalent in small- (rather than large- or medium-) sized firms and in firms engaged in international activities (measured by multinational status, holdings of international assets and foreign sales).

80Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Emerging Market Exchange Rate Exposure 6.2: Emerging Market Exchange Rate Exposure  Chue and Cook (2008): Because of the small size of any individual emerging market, its impact on the global financial market is limited. For this reason, we can treat world financial variables as exogenous to the emerging markets’ macroeconomic conditions. We use variables such as the US Fed Funds rate, and the yen–dollar and euro–dollar cross-rates as instruments to identify the direct effects of exchange rate movements on firm value. Our approach allows us to identify companies’ exposure to exogenous exchange rate movements, and the effect of international debt on firm performance specifically through the exchange rate channel. Given the difference in the estimates of exchange rate exposure across countries, we examine the importance of various country-level, macroeconomic variables as determinants of exposure. We regress the exchange rate exposure of a firm on various firm-level and country-level characteristics, and a sector-specific dummy variable. Firm-level variables and country-level variables each explain substantial amounts of the variation in exposure. This decline in negative exchange rate exposure coincides with a changing structure in many emerging markets’ debt. The rapid growth in derivatives markets may have increased the opportunities for emerging market firms to hedge their exchange rate risks.

81Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Emerging Market Exchange Rate Exposure 6.2: Emerging Market Exchange Rate Exposure  Muller and Verschoor (2007): The extent to which firms are exposed to exchange rate fluctuations varies with return horizons; short-term exposure seems to be relatively well hedged, where considerable evidence of long-term exposure is found. Firms with weak liquidity positions tend to have smaller exposures. Asian firms with strong liquidity positions, in terms of low dividend payout ratios, or more profitable firms, have less incentive to hedge and hence are more exposed to exchange rate fluctuations. We define the firm-specific exchange rate sensitivity, called firm-specific exposure, as the effect of exchange rate changes on the value of a firm in excess of the global market’s reaction to foreign exchange rate movements. In a world of market imperfections, extensive use of derivatives should diminish a firm’s exposure. The stronger perceptibility of long-term foreign exchange risk exposure may be due to the fact that short-term exposure may be offset by hedging activities while long-term ‘economic’ exposure is more difficult to hedge since it is not related to known transactions.

82Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Emerging Market Exchange Rate Exposure 6.2: Emerging Market Exchange Rate Exposure  In contrast with the argument that firms with greater financial leverage are more likely to hedge and hence are less exposed to exchange rate risk, our results indicate that highly leveraged firms tend to have high exposure. Short-term exposure seems to be relatively well hedged, where considerable evidence of long-term exposure is found. We find that more than 70 percent of Asian firms are significantly affected by US dollar exchange rate fluctuations in the long-term. The extent to which a firm is exposed to changes in exchange rates is generally determined by the variables that are proxies for the firm’s hedging policies. Asian internationally active firms with a low dividend payout ratio (strong short-term liquidity positions) have less incentive to hedge and hence have larger exchange rate exposures. More profitable firms are systematically more exposed to exchange rate fluctuations than less profitable firms.

83Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Emerging Market Exchange Rate Exposure 6.2: Emerging Market Exchange Rate Exposure  Jingtao Yi (2009): Since China introduced a new managed floating exchange rate regime with reference to a currency basket in July 2005, the RMB has experienced a persistent appreciation against the dollar. This move has augmented currency risks and raised the costs of production for Chinese exporters in terms of US dollar-denominated exports. Rising numbers of exporters are shunning the US dollar or devising ways to offset the impact of the falling dollar as they confront the rising costs of labor and raw materials at home. In this context, can a firm quote the price of its exports in producer currency, consumer currency or vehicle currency? Jingtao Yi (2009) finds that the euro could play an increasing role as the invoice currency of Chinese firms, although the US dollar will still play a dominant role.  Chinese exporters are likely to shift gradually from the dollar to the euro to price their exports in the face of the falling dollar, but they have to achieve a sophisticated balance between the two.

84Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Foreign Exchange Exposure of Key Institutions 6.3: Foreign Exchange Exposure of Key Institutions  Martin (2000): Differences in exchange rate exposure across the institutions may be attributed to differing degrees of risk aversion and levels of proficiency in managing the exposure. The market should recognize significant exposure for those institutions that are less risk averse and/or less proficient in managing their foreign exchange exposure. Differences in exposure across countries may be attributed to differing regulatory and supervisory requirements. In general, institutions that reveal significant exposure may be less risk averse and are attempting to achieve higher rates of return. The institutions that are not significantly exposed may be risk averse and employ proficient FX personnel and internal control systems. To the extent that the key FX institutions are equally capable of managing exchange rate risk, differences in exposure across institutions may be attributed to differences in the desire to accept more risk for higher expected returns.

85Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Foreign Exchange Exposure of Key Institutions 6.3: Foreign Exchange Exposure of Key Institutions  Chamberlain, Howe and Popper (1997): Exchange rates affect most directly those banks with foreign currency transactions and foreign operations. Even without such activities, exchange rates can affect banks indirectly through their influence on the extent of foreign competition, the demand for loans, and other aspects of banking conditions. Measures of the determinants of foreign exchange exposure: The most obvious source of currency risk comes from having assets or liabilities with net payment streams denominated in a foreign currency. Other sources of currency risk are more subtle but just as important. A bank without any foreign assets or liabilities can be exposed to currency risk because the exchange rate can affect the profitability of its domestic banking operations. They find that relatively few Japanese bank returns appear to be sensitive to exchange rate changes.

86Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Foreign Exchange Exposure of Key Institutions 6.3: Foreign Exchange Exposure of Key Institutions  Wong, Wong and Leung (2009) find that there is a positive relationship between bank size and foreign exchange exposure. This relationship may reflect the larger foreign exchange operations and trading positions of larger Chinese banks and their significant indirect foreign exchange exposure arising from impacts of the renminbi exchange rate movements on their customers. It is also found that negative foreign exchange exposure is prevalent for larger Chinese banks, suggesting that an appreciation of the renminbi tends to reduce their equity value. It is therefore likely that the banking sector’s performance will be hampered. Together with the fact that decreases in equity values generally imply a higher default risk, the effects of different scenarios of renminbi appreciation on the default risk of Chinese banks should therefore be closely monitored.

87Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Foreign Exchange Exposure of Key Institutions 6.3: Foreign Exchange Exposure of Key Institutions  For China’s banking sector, the growing internationalization of Chinese banks in both their fundraising activities and banking businesses and the lack of financial instruments available in the local market for Chinese banks to hedge their foreign exchange risk, together with the structural change in China’s exchange rate regime in July 2005, may suggest that Chinese banks in general have become increasingly exposed to foreign exchange risk. The indirect foreign exchange exposure of Chinese banks appears to be a significant, or even a dominant, component of their overall foreign exchange exposure, as Chinese banks generally have a significant portion of loans that are related to export-import activities, such as lending to the manufacturing industry, the competitiveness and profitability of which are sensitive to exchange rate movements. Compared with the cash flow approach, another commonly adopted approach which is based on banks’ financial statements data, the capital market approach has various advantages. Specifically, estimates from the capital market approach are forward looking and facilitate analyses of Chinese banks’ default risk. More importantly, it remedies the problem of a lack of observations in the cash flow approach. p.175

88Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Foreign Exchange Exposure of Key Institutions 6.3: Foreign Exchange Exposure of Key Institutions  The estimated larger foreign exchange exposure of Chinese banks may reflect the lack of financial instruments available in the local market to hedge their foreign exchange risk or perhaps their lack of experience in managing foreign exchange risk. Foreign exchange exposure tends to be different among Chinese banks, negative foreign exchange exposures are more prevalent for larger Chinese banks, suggesting that an appreciation of the renminbi tends to reduce their equity values.  This study adopts the capital market approach to examine Chinese banks’ foreign exchange exposure, which comprises the direct exposure arising from banks’ unhedged foreign assets and liabilities and the indirect exposure due to effects of exchange rate movements on cash flows, and credit risk of the banks’ customers.  There is a positive relationship between bank size and foreign exchange exposure. Larger banks tend to have more significant foreign exchange operations and trading positions. Larger banks may also have more businesses with large and international corporations, the competitiveness and profitability of which are sensitive to exchange rate movements. Foreign exchange regulations also contribute to the more significant foreign exchange exposure of larger Chinese banks.

89Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Estimation of Foreign Exchange Exposure 6.4: Estimation of Foreign Exchange Exposure  Kiymaz (2003) takes Turkey as a sample, a firm exhibits exchange rate exposure if its value is affected by changes in exchange rates. Turkish firms are highly exposed to foreign exchange risks and their values are significantly influenced by exchange rate fluctuations. The degree of exposure is more pronounced in textile, machinery, chemical, and financial industries. Moreover, firms with a higher degree of export and import involvement experience a greater foreign exchange rate exposure.  Priestley and Ødegaard (2007) present a new methodological approach to examine exchange rate exposure which takes account of the role of the market portfolio and macroeconomic variables in exposure regressions, exchange rate regimes based on periods of depreciation and appreciation, and nonlinear exposure. we show that exposure to bilateral exchange rates is statistically and economically important and that industries with extensive international trade are more often exposed than industries with low levels of international trade. Measuring exposure could be further complicated by the fact that exposure may depend on the exchange rate regime. Exchange rate exposure must be estimated relative to individual currencies, not a currency basket. Nonlinear exposure effects are also found to be statistically and economically important.

90Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Estimation of Foreign Exchange Exposure 6.4: Estimation of Foreign Exchange Exposure  Bartram, Brown and Minton (2009) investigate show firms combine three different mechanisms at their disposal for mitigating exchange rate risk. First, firms can (to varying degrees) pass through to customers the changes in costs due to exchange rate movements. Second, firms can often affect their exchange rate exposure by choosing the location and currency of costs (e.g., where factories are located). Third, firms can utilize an array of financial products, such as foreign currency denominated debt and FX derivatives, as exchange rate risk management tools. Our results show that each of these factors plays an important role in mitigating observed exchange rate exposure, and together they account for the vast majority of the discrepancy between prior theoretical predictions and observed exposures. p.2 Depending on the level of product substitutability, pass-through reduces exposure by about 10–15%. Operational hedging reduces exposure by similar amounts, while financial risk management (FC debt and FX derivatives) accounts for about another 37–43% reduction in exposure. Altogether, firms reduce their gross exchange rate exposure by about 70% via the three channels. p.2

91Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Estimation of Foreign Exchange Exposure 6.4: Estimation of Foreign Exchange Exposure  Bartram (2008): Currency matching of inflows and outflows may cancel out exposures and effectively lead to small or zero remaining exposure. The operating cash flows of the firm are significantly exposed to the exchange rates that are of key relevance for its business activities. At the same time, the multinational firm uses hedging to reduce its exposure, resulting in insignificant exposure of total cash flow.  Martin and Mauer (2005): Since exchange rate risk can affect cash flows and stock prices of firms, the exposure to this risk is a key concern for investors, analysts, and managers. As a result, there have been tremendous efforts over the past 20 years to quantify the impact of fluctuating exchange rates. Dumas (1978) and Adler and Dumas (1980, 1984) first suggested that foreign exchange exposure could be quantified as the sensitivity of stock returns to exchange rate movements. However, the complex nature of foreign exchange exposure and inadequate financial statement disclosures on the extent and management of foreign exchange risk work to impede the capital market in its efforts to assess the exposure.

92Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Estimation of Foreign Exchange Exposure 6.4: Estimation of Foreign Exchange Exposure  Another route to assessing exposure net of hedging is to examine the sensitivity of cash flows to exchange rate movements. A cash flow framework captures past exposure patterns and permits a decomposition of exposure into short- and longer-term components. This approach has the advantage of more directly measuring transaction and economic exposures. However, a cash flow framework does not incorporate expectations, nor does it evaluate the overall impact of exchange rate risk on the value of the firm. Martin and Mauer (2005) shows that currency exposure may be identified by a capital market approach, when it is not identified by a cash flow approach. And, exposure may not be identified by a capital market approach, when it is identified by a cash flow approach. p.126

93Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Estimation of Foreign Exchange Exposure 6.4: Estimation of Foreign Exchange Exposure  Generally speaking, the capital market approach is directed toward understanding the overall impact of exchange rate risk on the value of the firm. The cash flow approach is important for those concerned about firm- specific conditions, such as company executives, employees and bondholders. This approach seeks to identify cash flow patterns that result from exchange rate changes. The cash flow approach can have implications for assessing the value of the firm. If exchange rate risk is a priced factor, then the cost of equity is impacted by the degree of foreign exchange exposure. Thus, managers need to consider their exposures in ascertaining an appropriate discount rate to evaluate investment opportunities. Company managers are concerned with the cash flow consequences of foreign exchange risk, as seen in the widespread use of hedging activities by financial and non-financial firms operating across currency boundaries. Operational hedges and financial hedges are frequently utilized by firms in their management of foreign exchange exposures.

94Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Estimation of Foreign Exchange Exposure 6.4: Estimation of Foreign Exchange Exposure  Two Methods to estimate foreign exchange exposure  (1) Capital market approach: This approach estimates capital market exposure as the sensitivity of stock returns to movements in a trade-weighted exchange rate index while controlling for market movements. Eq.1 describes this traditional approach used to estimate foreign exchange exposure:

95Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Estimation of Foreign Exchange Exposure 6.4: Estimation of Foreign Exchange Exposure  (2) Cash flow approach: This approach measures foreign exchange exposure as the sensitivity of the cash flows generated by the firm to changing exchange rates. This methodology allows exposure to be decomposed into short- and long-term components by permitting contemporaneous and lagged effects of exchange rate movements. Significant foreign exchange exposure is assessed by the F-statistic generated from estimating Eq.2.  where UIt is the standardized unanticipated operating income before adjustment for depreciation for time t; Xt−q the percent change in the exchange rate factor for time t−q; c the intercept; w(q) the weights or foreign exchange exposure for time q, where q=0–L; L the lag length determined by the Akaike criterion, ranges from 0 to 12; ut the error term for time t.

96Copyright © Guobing Shen, Fudan University. 6: Foreign Exchange Exposure and its Estimation ——Estimation of Foreign Exchange Exposure 6.4: Estimation of Foreign Exchange Exposure  Measuring the overall impact of foreign exchange risk on the value of the firm traditionally has been accomplished by estimating the sensitivity of stock returns to exchange rate movements. This approach essentially relies upon the market participants to project direct and indirect effects, evaluate short- and long-term consequences, and consider hedged and unhedged positions. The strengths of this approach are its forward-looking nature and its inherent flexibility in expectations formation. The strength of the cash flow approach is its ability to decompose exposure into short and long-term components. By revealing the nature of their cash flow exposures, firms can evaluate the effectiveness of their hedging programs and/or focus their hedging efforts according to the nature of their exposures. In assessing valuation, capital market participants could also benefit from the information revealed by the cash flow method.

Guobing Shen Associate Professor of World Economy & International Finance Institute of World Economy School of Economics Fudan.

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Guobing Shen Associate Professor of World Economy & International Finance Institute of World Economy School of Economics Fudan.

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Presentation on theme: "Guobing Shen Associate Professor of World Economy & International Finance Institute of World Economy School of Economics Fudan."— Presentation transcript:

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