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A simple explanation of biased movements of renminbi exchange rate

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  • Cho-Hoi Hui

    (Research Department, Hong Kong Monetary Authority, 55/F, Two International Finance Centre, 8, Finance Street, Central, Hong Kong, P. R. China2Institute of Theoretical Physics and Department of Physics, The Chinese University of Hong Kong, Shatin, N.T., Hong Kong, P. R. China)

  • Chi-Fai Lo

    (Research Department, Hong Kong Monetary Authority, 55/F, Two International Finance Centre, 8, Finance Street, Central, Hong Kong, P. R. China2Institute of Theoretical Physics and Department of Physics, The Chinese University of Hong Kong, Shatin, N.T., Hong Kong, P. R. China)

Abstract

The central parity of the renminbi is determined by the closing rate on the previous day according to the central parity formation mechanism following the August 2015 reform. This paper develops a simple model to study how this mechanism affects the currency’s exchange rate dynamics. The central parity is shown to be under monotonic decay or growth conditional on its rate relative to the expected exchange rate determined by a generic stochastic process. Such dynamics requires the central bank to engage in vigorous intra-marginal intervention to halt currency depreciation (or appreciation). Such upward (or downward) bias will disappear if a randomizing factor subject to market conditions is incorporated into the mechanism. The analysis is consistent with the observations in the renminbi foreign exchange market, and the theories and results in the previous studies on target zones.

Suggested Citation

  • Cho-Hoi Hui & Chi-Fai Lo, 2018. "A simple explanation of biased movements of renminbi exchange rate," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 5(04), pages 1-12, December.
    • Handle: RePEc:wsi:ijfexx:v:05:y:2018:i:04:n:s2424786318500408
    DOI: 10.1142/S2424786318500408
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    References listed on IDEAS

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    1. Yin-Wong Cheung & Cho-Hoi Hui & Andrew Tsang, 2016. "The Renminbi Central Parity: An Empirical Investigation," CESifo Working Paper Series 5963, CESifo.
    2. Werner, Alejandro M., 1992. "Exchange rates and target zone width," Economics Letters, Elsevier, vol. 40(4), pages 455-457, December.
    3. Bartolini, Leonardo & Prati, Alessandro, 1999. "Soft exchange rate bands and speculative attacks: theory, and evidence from the ERM since August 1993," Journal of International Economics, Elsevier, vol. 49(1), pages 1-29, October.
    4. António Portugal Duarte & João Sousa Andrade & Adelaide Duarte, 2013. "Exchange Rate Target Zones: A Survey Of The Literature," Journal of Economic Surveys, Wiley Blackwell, vol. 27(2), pages 247-268, April.
    5. Cheung, Yin-Wong & Hui, Cho-Hoi & Tsang, Andrew, 2018. "The RMB central parity formation mechanism: August 2015 to December 2016," Journal of International Money and Finance, Elsevier, vol. 86(C), pages 223-243.
    6. Paul R. Krugman, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 106(3), pages 669-682.
    7. Klein, Michael W., 1992. "Big effects of small interventions: The informational role of intervention in exchange rate policy," European Economic Review, Elsevier, vol. 36(4), pages 915-924, May.
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