RMB and CEPA

1. RMB and CEPA Stephen Yan-Leung Cheung Professor (Chair) of Finance City University of Hong Kong

2. Contents • Current debates on RMB • CEPA’s impacts on Hong Kong • Others City University of Hong Kong

3. Variable • The spot exchange rate, S, is the rate of exchange of 2 currencies for immediate delivery. • The forward exchange rate, F, is the rate of exchange rate of 2 currencies on one date for delivery at a future specified date. For example, the Euro/US dollars forward exchange rate for delivery in one year is 1.3 US$ for 1 Euro City University of Hong Kong

4. The objective is to examine several key international parity relationships, such as interest rate parity and purchasing power parity. City University of Hong Kong

5. Outline • Interest Rate Parity • Purchasing Power Parity • The Fisher Effects • Forecasting Exchange Rates City University of Hong Kong

6. Interest Rate Parity • Interest Rate Parity Defined • Covered Interest Arbitrage • Interest Rate Parity & Exchange Rate Determination • Reasons for Deviations from Interest Rate Parity City University of Hong Kong

7. Interest Rate Parity Defined Suppose you have $100,000 to invest for one year. You can do one of two things: 1. Invest in the U.S. at interest rate i$. After one year you will receive Face Value + Interest = $100,000 + $100,000 * ius = $100,000(1 + ius) City University of Hong Kong

8. Interest Rate Parity Defined 2. Trade your dollars for yen at the spot rate. You will receive $100,000 / S($/¥) in ¥. Then, invest this sum in Japan at i¥ . After one year you expect to receive [$100,000 / S($/¥)] * (1 + i¥) Hedge your exchange rate risk by selling the future value of the Japanese investment forward. You will receive now [$100,000 / S($/¥)](1 + i¥) * F($/¥) = $100,000[F($/¥)/S($/¥)](1 + i¥) City University of Hong Kong

9. Interest Rate Parity Defined Since both of these investments (1) and (2) have the same risk, they must have the same future value—otherwise an arbitrage would exist. Therefore, Investing in U.S. = Investing in Japan $100,000[F($/¥)/S($/¥)](1 + i¥) = $100,000(1 + ius) [F($/¥)/S($/¥)](1 + i¥) = (1 + ius) City University of Hong Kong

10. Interest Rate Parity Defined Formally, [ F($/¥) / S($/¥) ] (1 + i¥) = (1 + ius) or IRP is sometimes approximated as City University of Hong Kong

11. Interest Rate Parity Defined • IRP is an arbitrage condition. • If IRP did not hold, then it would be possible for a smart trader to make unlimited amounts of money exploiting the arbitrage opportunity. • This would change F, S, and i until the condition is restored. • Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds. City University of Hong Kong

12. Example If IRP failed to hold, an arbitrage opportunity would exist. A trader could engage in “Covered Interest Arbitrage”. It’s easiest to see this in the form of an example. City University of Hong Kong

13. Example Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. City University of Hong Kong

14. Example (continued) A trader with $1,000 to invest could invest in the U.S. In one year his investment will be worth $1,000(1+ i$) = $1,000(1+0.071) = $1,000(1.071) = $1,071 City University of Hong Kong

15. Example (continued) Alternatively, this trader could exchange $1,000 for £ at the prevailing spot rate, receiving $1,000 ÷ $1.25/£ = £800 Invest this amount in Britain at i£ = 11.56% for one year, expecting to receive £800(1+ i£) = £800 (1+0.1156) = £800 (1.1156) = £892.48 City University of Hong Kong

16. Example (continued) Sell forward now the £892.48 that he expects to receive in one year. He will receive now £892.48 x F360($/£) = £892.48 x $1.20/£ = $1,071 This is the same as what he would expect to receive if he invested the money in the U.S. City University of Hong Kong

17. Reasons for Deviations from IRP • Transactions Costs • The interest rate available to an arbitrageur for borrowing, ib,may exceed the rate he can lend at, il. • There may be bid-ask spreads to overcome • Capital Controls • Governments sometimes restrict import and export of money through taxes or outright bans. City University of Hong Kong

18. Purchasing Power Parity • Purchasing Power Parity and Exchange Rate Determination • Evidence on PPP City University of Hong Kong

19. Purchasing Power Parity and Exchange Rate Determination • The exchange rate between two currencies should equal the ratio of the countries’ price levels. S($/£) = P$ P£ • If U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by 3%. City University of Hong Kong

20. Evidence on PPP • PPP probably doesn’t hold precisely in the real world, because commodity arbitrage is difficult • Transactions costs (e.g. shipping costs) • Controls (e.g. tariffs and quotas). • Non-tradable goods. • Also, PPP ignores capital flows, which nowadays seem to be more important than trade flows. • PPP-determined exchange rates still provide a valuable benchmark. City University of Hong Kong

21. City University of Hong Kong

22. Fundamental Approach • Involves econometrics to develop models that use a variety of explanatory variables. This involves three steps: • step 1: Estimate the structural model. • step 2: Estimate future parameter values. • step 3: Use the model to develop forecasts. • The downside is that fundamental models do not work any better than the forward rate model or the random walk model. City University of Hong Kong

23. Technical Approach • Technical analysis looks for patterns in the past behavior of exchange rates. • Clearly it is based upon the premise that history repeats itself. • Thus it is at odds with the Efficient Markets Hypothesis. City University of Hong Kong

24. Performance of the Forecasters • Forecasting is difficult, especially with regard to the future. • As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate. • The founder of Forbes Magazine once said: “You can make more money selling advice than following it.” City University of Hong Kong

25. Current Debates on RMB • Should RMB appreciate? • What are the impact on China if RMB appreciates? • What to be done? City University of Hong Kong

26. One year RMB NDF premium/discount to the spot City University of Hong Kong

27. 1. Should RMB appreciate? • Global economy is not doing well, US dollar depreciated, Chinese foreign reserves increase. • In February, G7 meeting Japanese FS claimed “ Chinese cheap products are the main reason for the slow down of Japan and global economy”, blame on RMB’S undervalue. • In May, G8 meeting, US FS raised the issue of RMB’s appreciation. • US’s political pressure, next year, US presidential election, this will definitely be an issue. City University of Hong Kong

28. Changes of RMB cross rates in the past ten years City University of Hong Kong

29. External Reasons • Chinese deliberately undervalue RMB to maintain export’s competitiveness. • China’s trade surplus, foreign reserves up. • China exports deflation because of cheaper products. RMB’s appreciation will eliminate deflation. City University of Hong Kong

30. External Arguments • China’s export increase is NOT because of the low exchange rate. There is a continued improvement on product quality, low cost and skilled labor force, technological transfer from MNCs. • China’s product’s elasticity on exchange rate is 0.2. If RMB rate depreciates 1%, export will increase by 0.2% • RMB’s undervalue will not increase export MUCH. City University of Hong Kong

31. Account Werner International Consultancy Limited • In 2000, hourly wage of textile industry in China is 0.69 US$, 1/37 of Japan, 1/20 of US and Europe and 1/8 of Korea. For automobile industry, the China’s labor/cost per hour is 1.7% of Japan and US City University of Hong Kong

32. 2002 U.S. Goods Exports, Imports and Trade Balance, by Region Millions of dollars, on a Census basis not seasonally adjusted City University of Hong Kong

33. External • Chinese cheap products export “deflation”; the main reason for global economy’s slowdown. • China’s trade, 5% of the global trade • China’s export to Japan, accounts for 2% of the Japan’s GDP • Mostly low-end products • Imported materials • Should not be responsible for the global economy’s slowdown City University of Hong Kong

34. Imports and exports of China by main countries in 2003 quarter 1 Source: Customs General Administration People’s Republic of China City University of Hong Kong

35. US productivity and related data in manufacturing, percentage changes, 1949-2000 (percent per year) Source: The Bureau of Labor Statistics of the U.S. Department of Labor City University of Hong Kong

36. Internal Reasons • Despite high economic growth, banking system is fragile, income gap, and SOEs reform • Unemployment problem. despite high economic growth, unemployment is stills a big problem because of the population growth and surplus labor form the rural areas. The fast growth in export-related industries ease part of the problem City University of Hong Kong

37. Internal Reasons • Fragile banking system, NPL problem, capital adequacy ratio low (international level). In 2 years, according to WTO, China will have to open the bank industry, more competition. RMB’s appreciation will worsen the problem. • SOEs reform, in 2002, more than 30% SOEs record profit, the total was 260 billion RMB. If RMB appreciates, this will worsen the SOEs profitability City University of Hong Kong

38. 2. Impacts on Chinese Economy • Worsen the investment environment, slow down the inflow of FDI. This will encourage the inflow of hot money to speculate on the RMB’s further appreciation • Negative impacts on under-privileged sectors, such as agricultural, mining (steel) business. City University of Hong Kong

39. 2. Impacts on Chinese Economy • Increase deflation pressure. RMB’s appreciation may increase import and decrease export. This may worsen the oversupply problem in China. • More importantly, RMB appreciates will leads to the RMB’s exchange rate instability and expectation of further appreciation, which may cause more inflow of funds for more speculation. City University of Hong Kong

40. 2. Impacts on Chinese Economy • RMB’s appreciation may not be advantages fro US & Japan. • China’s GDP accounts for 3.5% of global economy. • China trade accounts for 5% of global trade • During the past decade, China’s cheap products contribute to the US’s high growth rate and low inflation rate, RMS’s appreciates may increase cost of US import and inflation will return City University of Hong Kong

41. China has been the most important US treasury securities investor. Up to June 2003, China has bought 122.5 billion US government bonds, accounts for 1/3 of China’s reserves • China contributes to the US’s refinancing activities • Maintaining the US’s low interest rate environment • RMB’s appreciates demand for US’s securities declines City University of Hong Kong

42. 2. Impacts on Chinese Economy • RMB appreciates may ease the pressure for US SMEs (manufacturing). • Bad for MNCs. MNCs accounts for 54% of the China’s export. • RMB appreciates may have negative impacts on investment, purchasing and production, e.g. Walmart, China’s products accounts for 70% of its products. City University of Hong Kong

43. Short-term measures (current account) • Encourage more imports; raw materials and oil. Reduce subsidies for export industries. • Allow enterprise to keep more foreign reserves. City University of Hong Kong

44. Short-term measures (capital account) • 480 billion US$ of FDI during the past 2 decades. • For strategic areas, such as Western part of China • Encourage more hi-tech or more value-added related • QFII, restriction on short-term portfolio investment. Tobin case may be used. • Regulatory control on hot money. City University of Hong Kong

45. Conclusions • In 2003, China’s export is 38 billion US$, ranked after US & Germany. Foreign reserves exceeded 365 billion US$. How to use this reserve efficiently. • Encourage Mainland enterprises for overseas expansions. • QDII City University of Hong Kong

46. International (regional) Integration • Economic integration enhance cooperation in economic and trade activities among different economies. E.g. Europe, Latin America, North America and South-Ease Asia. • Free Trade Area • Remove (most) trade barriers, e.g. tariff to promote trade among member economies, such as NAFTA, ASEAN City University of Hong Kong

47. International (regional) Integration • Customs Union • Member economies are required to remove all tariff, have a unified trade policy, e.g. EC and Caribbean EC • Common Market • No trade barriers among member economies • Unified trade policy • Factors of Production can move freely among members economies , e.g. EU before Euro • Economic Union • Common market features and a single currency (EU) City University of Hong Kong

48. International (regional) Integration • Political Union • One step further the economic integration, having one single government, e.g. U.S.A. Step-by-step Lower tariff → eliminated trade barriers → Free-flow of factors of production → Unified tariff and external trade policies → Unified currency, fiscal policy, tax, exchange, form of economic union → One single government City University of Hong Kong

49. International (regional) Integration Experiences • Win-win situation • Create more opportunities for member economies • Mobility of factor of productions, comparative advantages • Resources allocation becomes more efficient. • Better over whole economic performance City University of Hong Kong

50. HK & Mainland economic cooperation • Before CEPA • Private sector • Barriers; tariffs; bounder; little mobility on factors of production City University of Hong Kong