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Convertibility Restriction Determination in China's Foreign Exchange Market and its Impact of Forward Pricing

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  • Yi Wang

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    (Stanford University)

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    Abstract

    Different from the well established markets such as the dollar-Euro market, recent CIP deviations observed in the onshore dollar-RMB forward market were caused by conversion restrictions in the spot market rather than changes in credit risk and/or liquidity constraint. This paper proposes a theoretical framework under which the Chinese authorities impose conversion restrictions in the spot market in an attempt to achieve capital flow balance, but faces the tradeoff between achieving such balance and disturbing current account transactions when determining the level of conversion restriction. Such conversion restriction in turn places a binding constraint on forward traders’ ability to cover their forward positions, resulting in the observed CIP deviation. In particular, the model predicts that onshore forward rate is equal to a weighted average of CIP-implied forward rate and the market’s expectation of future spot rate, with the weight determined by the level of conversion restriction. As a secondary result, the model also implies that offshore non-deliverable forwards reflect to the market’s expectation of future spot rate. Empirical results are consistent with these predictions.

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    File URL: http://www-siepr.stanford.edu/repec/sip/09-024.pdf
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    Bibliographic Info

    Paper provided by Stanford Institute for Economic Policy Research in its series Discussion Papers with number 09-024.

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    Date of creation: Apr 2010
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    Handle: RePEc:sip:dpaper:09-024

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    Related research

    Keywords: China; foreign exchange; covered interest rate parity; deliverable forward; non-deliverable forwards;

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    1. Dooley, Michael P & Isard, Peter, 1980. "Capital Controls, Political Risk, and Deviations from Interest-Rate Parity," Journal of Political Economy, University of Chicago Press, vol. 88(2), pages 370-84, April.
    2. Fung, Hung-Gay & LEUNG, Wai K. & Zhu, Jiang, 2004. "Nondeliverable forward market for Chinese RMB: A first look," China Economic Review, Elsevier, vol. 15(3), pages 348-352.
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    7. S. C. Tsiang, 1959. "The Theory of Forward Exchange and Effects of Government Intervention on the Forward Exchange Market," IMF Staff Papers, Palgrave Macmillan, vol. 7(1), pages 75-106, April.
    8. Holmes, Mark J., 2001. "Some new evidence on exchange rates, capital controls and European Union financial integration," International Review of Economics & Finance, Elsevier, vol. 10(2), pages 135-146.
    9. Guonan Ma & RobertN McCauley, 2008. "Efficacy Of China'S Capital Controls: Evidence From Price And Flow Data," Pacific Economic Review, Wiley Blackwell, vol. 13(1), pages 104-123, 02.
    10. Asani Sarkar, 2009. "Liquidity risk, credit risk, and the Federal Reserve's responses to the crisis," Staff Reports 389, Federal Reserve Bank of New York.
    11. Guonan Ma & Corrinne Ho & Robert N McCauley, 2004. "The markets for non-deliverable forwards in Asian currencies," BIS Quarterly Review, Bank for International Settlements, June.
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