Empirical Analysis on the Impact Factors of Currency Substitution in China
Ping Yi 1, Chuang Zhao 2, Xiao-ling Luo3
1
Department of Economics and Management, Tongji University, Shanghai, China
2
Department of Business, Jilin University, Jilin, China
3
Department of Business, Hunan International Economics University, Hunan, China
(Yiping1022@126.com)
Abstract - Since American financial crisis erupted in
2008, international monetary system is under the pressure of
reforming, while the superiority of RMB is recognized
increasingly. After exchange rate reformed, RMB circulates
in neighboring countries or regions widely. As for the crossborder circulation, the paper attempts to construct an
econometric model based on western currency substitution
theory, and makes an empirical analysis on the impact
factors of currency substitution in China through OLS and
principal component method. Results show that interest rate
differential is the greatest influencing factor, followed by
exchange rate while economic growth rate is indistinctive.
Finally, constructive political suggestions are given.
Keywords - Currency substitution, OLS, principal
component method, empirical analysis
I. ON THE CONNOTATIONS AND MEASUREMENT
INDEX
As for researches on currency substitution, it was first
proposed by the U.S. economist V.K.Chetty in the
American Economic Review in 1996. In the past forty
years, the academic of definition of currency substitution
was still controversial. But in brief, currency substitution
means that there are many possibly convertible currencies
in circulation in an open economy. When serious inflation
or exchange rate expectation happens, it will weaken the
residents’ confidence of domestic currency. It is also
because of the relatively low rate of the local-currency
assets return that the residents hold more foreign currency
and less local currency, and then instead by capital flight
or the circulation of foreign currency in the domestic.
There are absolute index and relative index on
currency substitution. Absolute index can be divided into
three categories: total amount of foreign currency
deposits, foreign currency deposits overseas, foreign
currency deposits domestic and overseas added cash of
residents in one country. And relative index can be
divided
into SR1  Fd / D SR2  Fd / M 2 , SR 3  Ff  Fd / M 2 ,
SR1, SR 2, SR 3 mean currency substitution rate, Fd is foreign
currency deposits in domestic financial system while Ff is
that in overseas financial system. M 2 is broad money
supply, D is local currency deposit of domestic financial
system. As relative index is more accurate than the other
and degree of currency substitution is fully reflected by
applying of broad concept of money, nearly scholars at
home and abroad use SR2 during study.
II. REASEARCH STATUS AT HOME AND
ABOROAD
Western main theories can be attributed to four
representative types: the production function theory of
monetary service is first proposed by Marc A. Miles[1][2]
,followed by the marginal utility theory of monetary
demand proposed by Micheal D.Bordo & Ehsan
U.chondhri[3],and the portfolio theory of monetary
demand proposed by David T.King[4]. Finally, theory
proposed by Canada scholar Stephen S.Poloz is the
precautionary theory of monetary demand [5]. Research of
Boyer, R & G.Kingston shows that foreign inflation rate
has significant influence on real monetary demand and
circulation velocity of local currency in the case of
currency substitution [6]. Bergstrand & Bundt conclude
currency substitution is an important impact factor of
monetary independence in the United States [7].
Chinese scholars also analyze currency substitution
of RMB on the basis of foreign researches. Li Xin-dan
researches RMB substitution by using Ramirez-Rojas
model and proposes to form exchange rate zone,
strengthen capital control and take interests rate
instruments with caution for anti-substitution[8].Yang Jun
holds that the elasticity of substitution between RMB and
U.S. dollar is low by using Johansen's co-integration
method of Miles model [9].Yue Yi-ding holds that the
main influencing factors on RMB substitution are shortterm rate and macroeconomic level by using Ortiz
model[10].Li Fu-guo holds that the nominal rate
differential at home and abroad as well as inflation rate is
the main influencing factor [11].Results got by Bian Zhicun,Yu Wan-lin and Li Shi-xin show that actual exchange
rate, domestic and foreign rate differentials, exchange rate
and CPI are larger factors[12-14].
It can be seen that development of western currency
substitution theory is a process of continuous
improvement. But the assumption of these theories is very
strict or even idealistic and the variable selection don’t
accord with Chinese actual situation, which need further
modify combining local country’s fact to make more
valuable. In addition, national scholars mainly study
currency substitution by using series analysis. However,
which factors is significant in a number of factors? Only
rare literature uses principal component analysis, and it
provides study space for this paper.
III. THE INFLUENCING FACTOR
Aiming at our national condition, the influencing
factors on currency substitution can be refined and
quantitative as follows:
1) Institutional factor includes the exchange rate
regime or monetary convertibility system. China adopts a
managed floating exchange rate system and multicurrency holders prefer to choose optimal monetary
portfolio to reduce asset loss, which strengthen the
precautionary or exchange motives.
2) Scale factor, mainly refers to national income level
or the wealth number of residents in one country. The
higher the level of national income gets, the greater the
demand of foreign currency becomes.
3) Return differential between local and foreign
currency. When foreign currency rate of return is higher,
the residents will increase holding foreign currency for
getting higher interest .While loans rate differentials of
local currency increase, currency substitution emerges as
cost of local currency increases but return decreases
4) Political and economic risks. The peaceful political
environment and steady economic growth have positive
effects on the intrinsic value of domestic currency.
Conversely, if the domestic situation fluctuates
dramatically, it is likely to lead large-scale currency
substitution and capital flight in one country.
IV. THE EMPIRICAL ANALYSIS
A. The variable selection and data interpretation
According to the theoretical analysis of the impact
factors of China’s currency substitution, this paper
sets lg( Fd / M 2) as dependent variable Y, independent
variable Xi (i  1, 2,3, 4) are loan rate differential of RMB
and foreign currency i fd ， growth rate of
GDP gdp ,inflation rate  ,the official exchange
rate e respectively, the dummy variable u equals political
and economic risks. In order to improve model’s
estimation accuracy and convince, this paper sets the
annual inflation rate measured by consumer price index
as  , direct price of RMB exchange rate to U.S dollar as
e, and gdp represents national income level,
Fd / M 2 represents degree of currency substitution interest,
rate differentials represents premium. Relative index can
optimize model and also reduce serial correlation.
Since China reformed the exchange rate in 1994, it
opened the market-oriented exchange rate. China has
changed from single and managed floating exchange rate
system in 1994 to the managed floating exchange rate
adjusted on a basket of currencies and market in 2005.
Starting from strict examination or approval of exchange
rate or compulsory settlement to the gradual relaxation of
controls, the formation mechanism becomes more market-
oriented. This paper aims at exploring the change of
currency substitution in China since the exchange rate
reforms by using annual data from 1994 to 2011.Data is
from the Word Bank database, the official website of the
People’s Bank of China and China Statistical Yearbook.
B. Model setup and regression results
Basic model of China’s currency substitution can be：
lg( Fd / M 2)   0   1ifd   2 gdp   3   4e  u
(1)
It can be further simplified as:
Y   0   1x1   2 x2   3 x3   4 x4  u
(2)
1) By using Eviews5.0, preliminary regressions results
of the model are shown in table 1:
Expression can be written as follows:
Y=-5.6584+14.3614X1+0.1086X2+0.0429X3+0.0940X4
(3)
It is can be known that adjusted R-squared value is
0.9848, indicating that explanatory power is strong. Pvalue is 0.0000, which shows equation is significant, that
is, all kinds of independent variables together do have an
obvious impact on the dependent variable. And D-W
value is 1.5716. According to k is 4 and n is 15, dl can be
checked to be 0.71, du is1.61.As 1.5716 is between them,
it doesn’t fall in the deciding localization of the first-order
autocorrelogram so the model’s autocorrelation need
further verification. Given a significant level 0.05, the
corresponding p value of X2 & X3 is 0.1563 and 0.6185,
which indicate that both are instinctive. In summary, it is
likely to have multicollinearity for the second model.
2) Reduce multicollinearity and select the best
combinations of independent variables by using principal
component analysis.
a)The adjusted R-squared values are 0.9535、0.2152
、0.0350、0.5354 though OLS method for simple linear
regression of X1,X2,X3,X4. So the first step is to retain the
best explanatory variable X1.
TABLE I
Preliminary OLS results of China’s currency substitution
Variable
C
X1
X2
X3
X4
R-squared
D-W
Coefficient
t-Statistic
-5.6584
-4.2337
14.3614
15.0448
0.1086
1.5330
0.0429
0.5139
0.0940
2.9061
0.9891
Adjusted R-squared
1.5716
Prob (F-statistic)
Prob.
0.0017
0.0000
0.1563
0.6185
0.0157
0.9848
0.0000
b) The adjusted R-squared values for binary linear
regression are 0.9605, 0.9765, 0.9838, and t-values are
0.0944, 0.003, 0.0003 by adding the rest variables X2, X3,
X4 for stepwise regression, which can be decisive to retain
X 4.
c) Continue stepwise regression on the basis of the
retained variables x1 and X4. Adding X2, adjusted Rsquared value is 0.9858, more than 0.9838 before. P value
of equation is 0.0000 and t values are 0.0000, 0.0006,
0.1268.In addition, all the correlation coefficient has
economic significance. However, adding X3, adjusted Rsquared value is 0.9829, less than 0.9838 before and p
value is 0.53, much more than 0.05, so X3 is indistinctive.
It is can be seen that X2 and X3, that is, economic growth
and inflation rate have certain multicollinearity.
3) Final regression results of adjusting model
lg( Fd / M 2)   0   1ifd   2 gdp   4e  u
Simplify as Y   0   1x1   2 x2   4 x4  u
(4)
(5)
By using Eviews5.0, the regressions results are shown in
table 2. With the same analysis,
Y=-5.0326+14.0475X1+0.1124X2+0.1056X4
(6)
Adding specific economic explanatory variables, final
regression results are as follows:
lg( Fd / M 2)  5.0326  14.0475ifd  0.1124gdp  0.1056e (7)
Comparing sixth and seventh expression, both adjusted
R-squared and p value are better than before. Especially, p
value of X4 is decline to 0.0006 from 0.0157, which
shows that there is multi-collinearity in the model before.
And it is necessary to adjust to make more convincing.
C. Analysis on results
By principal component analysis, the economic
growth rate and inflation rate have a certain degree of
multi-collinearity. In order to make results more accurate,
this paper excludes multicollinearity and gets the final
regression results. Table 2 above shows that loan rate
differentials between domestic and overseas currency,
growth rate of GDP and exchange rate are effective
TABLE II
Final OLS results of China’s currency substitution
Variable
C
X1
X4
X2
R-squared
D-W
Coefficient
t-Statistic
-5.0326
-9.4582
14.0475
19.8240
0.1056
4.7447
0.1124
1.6518
0.9888 Adjusted R-squared
1.4327
Prob (F-statistic)
Prob.
0.0000
0.0000
0.0006
0.1268
0.9858
0.0000
explanatory variables. As to parameters symbols, they are
all positive, which in accords with theoretical
assumptions. It seems from regression coefficients of
explanatory that the greatest impact factor is rate
differentials at home and abroad, indicating that rate
differentials increases by every one point and currency
substitution increases by fourteen points, according with
residents’ sensitivity to interest rate. Similarly, the
influencing coefficients of growth rate of GDP and
exchange rate are 0.1124 and 0.1056, showing that both
are insensitive to currency substitution. But seeing from ttest, exchange rate passes significant test so it has
obviously positive effects, and GDP not. It may result
from the high speed of China’s economic development
since reform and open-up along with strict financial
controls, which improve residents’ expectation of RMB as
well as limit flowing of capital. In summary, loan rate
differential is the greatest influencing factor, exchange
rate is a weak one, and both have passed significant test.
Growth rate of GDP has indirect effect on currency
substitution in China.
Why there is so big difference for the results?
Combining China’s real situation, RMB has become hard
currency in Southeast Asia and enjoy title of the second
U.S. dollars in recent years. With the establishment of
China-ASEAN Free Trade Area, the economic integration
degree with Asian countries is higher and higher, and the
scope of RMB circulation in neighboring regions or East
Asia expands continually. The passive situation of RMB
by alternative dollars is changing with China’s powerful
economic forces. So growth rate of GDP is instinctive to
China’s currency substitution, even has a passive effect to
some extent. Fully market-oriented exchange rate has a
certain impact, but it is nearly zero to China. The reason is
that the foreign exchange market mechanism is not
perfect and capital projects are not fully convertible as
well as the financial capital control is strict in China,
which prevents the residents’ true demand of foreign
exchange convertibility. All leads the weak substitution.
For rate differential of domestic and overseas currency is
a significant factor, the reason is that Chinese often need
exchange RMB to U.S. dollars on the purpose of
traveling, studying abroad or trading .Chinese are quite
sensitive to interest rate. When domestic loan rate gets
higher, residents prefer to relatively low-cost foreign
currency, so currency substitution comes into being.
In addition, American financial crisis, along with
the EURO debt crisis and Japan’s strong earthquake,
shakes their dominant position and brings opportunities
and challenges for China. Currently, China’s economic
structure is in transition, which will be beneficial to solve
the inevitable dilemma during internationalization. The
natural geographical advantages and others push RMB to
open up all over the world.
V. CONCLUSIONS AND SUGGESTIONS
On the basis of theoretical and empirical analysis
above, this paper holds that the degree of currency
substitution is still low at present and the main
influencing factor is loan rate differential of domestic and
overseas currency, followed by official exchange rate.
GDP growth is indirect impact factor. Taking China’s
actual situation into account, it needs to pay much more
attention to the following aspects.
1)Firstly, to improve the social security system and
strengthen the role of domestic demand as well as reduce
trade dependence gradually to boost economy. On one
hand, it can decrease the upward pressure of currency
substitution in the short or long term effectively; On the
other hand, it will avoid over-reliance on external
economies during domestic economic development,
which is key to solve frequent trade friction in China.
2) Secondly, to reduce loan rate of RMB and improve
the actual currency revenue, and to establish the
wonderful environment of interest rate for attracting
foreign investment; To open financial and monetary
market gradually and strengthen international investment
in the great trend of globalization to improve RMB
liquidity and the functions of trading, storage in the
international markets.
3) Thirdly, to make exchange rate stable. Our national
foreign currency reserves and total assets have shrunk
dramatically by the decreasing U.S. dollars, which is not
conductive to economy and thus reduce the residents’
confidence in investment. The favorable exchange rate
environment is strong guarantee to reduce the currency
substitution. Only by establishing a good exchange rate
formation mechanism can exchange cost be reduced and
efficiency be improved.
4) Fourthly, continue to persist in taking economic
construction as center and build a harmonious society.
Although our country’s financial system control is strict
and capital project has not yet opened fully. But with the
continued growth of economic strength and international
status, it is very likely that RMB replace the currencies of
other countries until realize regionalization.
5) Finally, to encourage RMB going out, continue
enhancing cooperation with ASEN, to start settlement
business and expand circulation of RMB in other Asian
regions, to speed up constructing offshore financial
centers of RMB in China, and based on CEPA and ECFA,
to form Greater China Currency areas led by Chinese
mainland and cooperating with Honking, Macao and
Taiwan for signing Swap Agreements.
By using these approaches and methods, RMB
internationalization will speed up. In the upward
expectation of RMB appreciation, RMB will be held more
by other foreign countries, which will decrease the degree
of currency substitution and increase anti-substitution in
China. If economy of China continues growing steadily,
the speaking right of RMB will enhance and improve in
the international
monetary systems. This paper firmly
holds that RMB can well stand side by side with U.S.
dollar and euro to become the world’s three major
currencies
in the
near
internationalization ultimately.
future
and
toward
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