BOFIT Discussion Papers, Institute for Economies in Transition, Bank of Finland
No 28/2012:
Convertibility restriction in China’s foreign exchange market and its impact on forward pricing
Yi David Wang ()
Abstract: 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.
Keywords: forward foreign exchange; China; convertibility; (follow links to similar papers)
JEL-Codes: F30; F31; F33; (follow links to similar papers)
40 pages, November 27, 2012
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