Monographic Study on
Chinese Finance
Guobing Shen
Associate Professor of World
Economy & International Finance
Guobingshen@yahoo.com.cn
Institute of World Economy
School of Economics
Fudan University
Topic One

RMB’s Exchange Rate, Foreign
Exchange Market and Foreign
Exchange Exposure

Discussing the academic papers
related to Topic One
Topic One: Chapter Organization
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
Copyright © Guobing Shen, Fudan University.
Slide 1-3
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-4
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
Copyright © Guobing Shen, Fudan University.
Slide 1-5
1: Exchange Rate and RMB Exchange Rate
——Exchange Rate Quotations
Currency
In US Dollar
Per US Dollar
Argentine Peso
Australian Dollar
Brazilian Real
British Pound
Canadian Dollar
Chinese Yuan
Euro
Hong Kong Dollar
Indian Rupee
Japanese Yen
South Korean Won
Mexican Peso
Russian Ruble
Swedish Krona
Swiss Franc
0.26219
0.89783
0.56386
1.63773
0.92618
0.14654
1.47102
0.12904
0.02126
0.01104
0.00083
0.07505
0.03417
0.14151
0.97371
3.81400
1.11380
1.77350
0.61060
1.07970
6.82400
0.67980
7.74960
47.03000
90.56000
1201.30007
13.32400
29.26920
7.06680
1.02700
Copyright © Guobing Shen, Fudan University.
Slide 1-6
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)
Copyright © Guobing Shen, Fudan University.
Slide 1-7
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 = w1S1 + w2S2 + ……+ wnSn (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.
Copyright © Guobing Shen, Fudan University.
Slide 1-8
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 = w1Q1 + w2Q2 + ……+ wnQn (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.
Copyright © Guobing Shen, Fudan University.
Slide 1-9
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 = PNbPT1-b = (PN/PT)bPT
(7)
Then Q = [SP*T/ PT] [(P*N/P*T)b/(PN/PT)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/ PT) is just 1, in which case the first term disappears. Then, for
given P*N/P*T, Q moves in the same direction as PT/PN.
Copyright © Guobing Shen, Fudan University.
Slide 1-10
1: Exchange Rate and RMB Exchange Rate
——Changes in exchange rates
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
Lowers the relative price of its imports
P* = P/S
P = SP*
Lowers the relative price of its exports
Raises the relative price of its imports
P* = P/S
P = SP*
Depreciation of a country’s currency:
Copyright © Guobing Shen, Fudan University.
Slide 1-11
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*)( S1/ S0) at time 1, because
$(1/S0)yield an interest of i*/S0, converted back to RMB at the rate S1.
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-12
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-13
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-14
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-15
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-16
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-17
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-18
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-19
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-20
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).
Copyright © Guobing Shen, Fudan University.
Slide 1-21
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).
Copyright © Guobing Shen, Fudan University.
Slide 1-22
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-23
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-24
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)
Copyright © Guobing Shen, Fudan University.
Slide 1-25
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-26
2: Chinese RMB Issue in Dynamic and Global
Perspective ——Chinese Yuan after the Reform
Copyright © Guobing Shen, Fudan University.
Slide 1-27
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-28
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-29
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-30
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).
Copyright © Guobing Shen, Fudan University.
Slide 1-31
3: Foreign Exchange Market and Market
Intervention in China——Structure
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
Copyright © Guobing Shen, Fudan University.
Slide 1-32
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-33
3: Foreign Exchange Market and Market
Intervention in China——Characteristics
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 prenegotiated exchange rate.
Forward and spot exchange rates, while not necessarily equal, do move
closely together.
Copyright © Guobing Shen, Fudan University.
Slide 1-34
3: Foreign Exchange Market and Market
Intervention in China——Characteristics
Figure 1: Dollar/Pound Spot and Forward Exchange Rates,
1981-2001
Copyright © Guobing Shen, Fudan University.
Slide 1-35
3: Foreign Exchange Market and Market Intervention in
China—Foreign Exchange Markets in China
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 marketdetermined. 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-36
3: Foreign Exchange Market and Market Intervention in
China—Foreign Exchange Markets in China
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).
Copyright © Guobing Shen, Fudan University.
Slide 1-37
3: Foreign Exchange Market and Market Intervention in
China——RMB Market Pressure and Intervention
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-38
3: Foreign Exchange Market and Market Intervention in
China——RMB Market Pressure and Intervention
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-39
3: Foreign Exchange Market and Market Intervention in
China——RMB Market Pressure and Intervention
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-40
3: Foreign Exchange Market and Market Intervention in
China——RMB Market Pressure and Intervention
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-41
3: Foreign Exchange Market and Market Intervention in
China——RMB Market Pressure and Intervention
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.
Source: Liu and Zhang (2009, p.85)
Copyright © Guobing Shen, Fudan University.
Slide 1-42
3: Foreign Exchange Market and Market Intervention in
China——RMB Market Pressure and Intervention
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-43
3: Foreign Exchange Market and Market Intervention in
China——Foreign Exchange Transaction
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-44
3: Foreign Exchange Market and Market Intervention in
China——Foreign Exchange Transaction
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-45
3: Foreign Exchange Market and Market Intervention in
China——Foreign Exchange Transaction
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-46
3: Foreign Exchange Market and Market Intervention in
China——Foreign Exchange Transaction

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.
Copyright © Guobing Shen, Fudan University.
Slide 1-47
3: Foreign Exchange Market and Market Intervention in
China——Foreign Exchange Transaction
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-48
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€ + (Ee$/€ - E$/€)/E$/€
Copyright © Guobing Shen, Fudan University.
Slide 1-49
4: Equilibrium in the Foreign Exchange Market
 How Changes in the Current Exchange Rate Affect
Expected Returns
Depreciation of a country’s currency today lowers the
expected domestic currency return on foreign currency
deposits.
Appreciation of the domestic currency today raises the
domestic currency return expected of foreign currency
deposits.
Copyright © Guobing Shen, Fudan University.
Slide 1-50
4: Equilibrium in the Foreign Exchange Market
Table 1: Today’s Dollar/Euro Exchange Rate and the Expected Dollar
Return on Euro Deposits When Ee$/€ = $1.05 per Euro
Copyright © Guobing Shen, Fudan University.
Slide 1-51
4: Equilibrium in the Foreign Exchange Market
 The Equilibrium Exchange Rate
Exchange rates always adjust to maintain interest parity.
Assume that the dollar interest rate R$, the euro interest rate R€, and
the expected future dollar/euro exchange rate Ee$/€, are all given.
And then: E$/€= Ee$/€ - (R$- R€)*E$/€
 Equilibrium in the foreign exchange market requires interest
parity.
For given interest rates and a given expectation of the future
exchange rate, the interest parity condition tells us the current
equilibrium exchange rate.
Copyright © Guobing Shen, Fudan University.
Slide 1-52
4: Equilibrium in the Foreign Exchange Market
——Interest Rates, Expectations, and Equilibrium
 The Effect of Changing Expectations on the Current Exchange
Rate
A rise in the expected future exchange rate causes a rise in the
current exchange rate.
A fall in the expected future exchange rate causes a fall in the
current exchange rate.
 The Effect of Changing Interest Rates on Current Exchange Rate
An increase in the interest rate paid on deposits of a currency
causes that currency to appreciate against foreign currencies.
A rise in dollar interest rates causes the dollar to
appreciate against the euro.
A rise in euro interest rates causes the dollar to depreciate
against the euro.
Copyright © Guobing Shen, Fudan University.
Slide 1-53
4: Equilibrium in the Foreign Exchange Market
——Interest Rates, Expectations, and Equilibrium
Figure 1: Effect of a Rise in the Dollar Interest Rate
Exchange rate, E$/€
E1$/€
Dollar return
1
E2$/€
1'
2
Expected
euro return
R1$
Copyright © Guobing Shen, Fudan University.
R2$
Rates of return
(in dollar terms)
Slide 1-54
4: Equilibrium in the Foreign Exchange Market
——Interest Rates, Expectations, and Equilibrium
Figure 2: Effect of a Rise in the Euro Interest Rate
Exchange rate, E$/€
Dollar return
Rise in euro
interest rate
E2$/€
2
E1$/€
1
Expected
euro return
R$
Copyright © Guobing Shen, Fudan University.
Rates of return
(in dollar terms)
Slide 1-55
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-56
5: Renminbi (RMB) Equilibrium Exchange
Rate——Evolution of RMB Exchange Rate
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-57
5: Renminbi (RMB) Equilibrium Exchange
Rate——Evolution of RMB Exchange Rate
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-58
5: Renminbi (RMB) Equilibrium Exchange
Rate——Evolution of RMB Exchange Rate
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-59
5: Renminbi (RMB) Equilibrium Exchange Rate
——Estimating RMB Equilibrium Exchange Rate
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).
Copyright © Guobing Shen, Fudan University.
Slide 1-60
5: Renminbi (RMB) Equilibrium Exchange Rate
——Estimating RMB Equilibrium Exchange Rate
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 longrun 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-61
5: Renminbi (RMB) Equilibrium Exchange Rate
——Estimating RMB Equilibrium Exchange Rate
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).
Copyright © Guobing Shen, Fudan University.
Slide 1-62
5: Renminbi (RMB) Equilibrium Exchange Rate
——Estimating RMB Equilibrium Exchange Rate
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-63
5: Renminbi (RMB) Equilibrium Exchange Rate
——Estimating RMB Equilibrium Exchange Rate
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.

Copyright © Guobing Shen, Fudan University.
Slide 1-64
5: Renminbi (RMB) Equilibrium Exchange Rate
——Estimating RMB Equilibrium Exchange Rate
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:
Copyright © Guobing Shen, Fudan University.
Slide 1-65
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-66
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-67
5: Renminbi (RMB) Equilibrium Exchange Rate
——Estimating RMB Equilibrium Exchange Rate
Wang, Hui and Soofi (2007) indicate that both short term and longterm 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-68
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-69
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 nontradable 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).
Copyright © Guobing Shen, Fudan University.
Slide 1-70
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-71
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-72
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-73
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-74
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-75
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-76
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-77
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 noncyclical 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-78
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).
Copyright © Guobing Shen, Fudan University.
Slide 1-79
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-80
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-81
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-82
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-83
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-84
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-85
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-86
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
Copyright © Guobing Shen, Fudan University.
Slide 1-87
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-88
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-89
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
Copyright © Guobing Shen, Fudan University.
Slide 1-90
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-91
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
Copyright © Guobing Shen, Fudan University.
Slide 1-92
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 firmspecific 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-93
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:
where, Rt is the stock return for time t; Rm,t the market portfolio return for time t; Xt the
percent change in the exchange rate factor for time t; β0 the intercept; βm the market exposure; βX
the foreign exchange exposure; and εt is the error term for time t.
Copyright © Guobing Shen, Fudan University.
Slide 1-94
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-95
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-96
The End!
Thank you!
Copyright © Guobing Shen, Fudan University.
Slide 1-97