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Convertibility restriction in China’s foreign exchange market and its impact on forward pricing

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

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    File URL: http://www.suomenpankki.fi/bofit/tutkimus/tutkimusjulkaisut/dp/Documents/2012/dp2812.pdf
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    Paper provided by Bank of Finland, Institute for Economies in Transition in its series BOFIT Discussion Papers with number 28/2012.

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    Length: 40 pages
    Date of creation: 27 Nov 2012
    Date of revision:
    Handle: RePEc:hhs:bofitp:2012_028
    Contact details of provider: Postal: Bank of Finland, BOFIT, P.O. Box 160, FI-00101 Helsinki, Finland
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    Fax: + 358 10 831 2294
    Web page: http://www.suomenpankki.fi/bofit_en/
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    1. 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.
    2. 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.
    3. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2008. "Arbitrage in the foreign exchange market: Turning on the microscope," Journal of International Economics, Elsevier, vol. 76(2), pages 237-253, December.
    4. Yin-Wong Cheung & Xingwang Qian, 2010. "Capital Flight: China's Experience," CESifo Working Paper Series 2931, CESifo Group Munich.
    5. 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.
    6. 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.
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