rmb and cepa stephen yan-leung cheung professor (chair) of finance city university of hong kong

RMB and CEPA

Stephen Yan-Leung Cheung

Professor (Chair) of Finance

City University of Hong Kong

Stephen Cheung City University of Hong Kong 2

Contents

• Current debates on RMB

• CEPA’s impacts on Hong Kong

• Others


Variable

1.The spot exchange rate, S, is the rate of exchange of 2 currencies for immediate delivery.

2.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


• The objective is to examine several key international parity relationships, such as interest rate parity and purchasing power parity.


Outline

• Interest Rate Parity

• Purchasing Power Parity

• The Fisher Effects

• Forecasting Exchange Rates


Interest Rate Parity

• Interest Rate Parity Defined

• Covered Interest Arbitrage

• Interest Rate Parity & Exchange Rate Determination

• Reasons for Deviations from Interest Rate Parity


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)



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¥)



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)



Formally,

[ F($/¥) / S($/¥) ] (1 + i¥) = (1 + ius) or

S

F

i

i

¥

$

1

1

IRP is sometimes approximated as

S

(F- S) ) -i(i ¥ $



• 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.


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.


Example

Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.

Spot exchange rate S($/£) = $1.25/£

360-day forward rate F360($/£) = $1.20/£

U.S. interest rate i$ = 7.10%

British interest rate i£ = 11.56%


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


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


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.


Reasons for Deviations from IRP

• Transactions Costs– The interest rate available to an arbitrageur for b

orrowing, 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 exp

ort of money through taxes or outright bans.


Purchasing Power Parity

• Purchasing Power Parity and Exchange Rate Determination

• Evidence on PPP


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%.


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.


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.


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.


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.”


Current Debates on RMB

• Should RMB appreciate?

• What are the impact on China if RMB appreciates?

• What to be done?


One year RMB NDF premium/discount to the spot


1. Should RMB appreciate?

• Global economy is not doing well, US dollar depreciated, Chinese foreign reserves increase.– In February, G7 meeting Japanese FS claimed “ Chin

ese 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.


Changes of RMB cross rates in the past ten years

Against 01/93-01/94

01/94-10/97

10/97-01/02

01/02-01/03

01/93-01/03

01/94-01/03

140/97-01/03

Euro -28.96% 2.75% 33.24% -20.30% -22.49% 9.12% 6.20%

Yen -42.50% 16.18% 11.88% -10.93% -33.42% 15.78% -0.34%

Korean Won -32.08% 24.48% 35.99% -10.84% 2.50% 50.92% 21.24%

New TW Dollar -31.10% 21.34% 14.08% -0.58% -5.17% 37.63% 13.42%

Singapore Dollar

-35.82% 3.50% 17.10% - 5.65% -26.61% 14.35% 10.48%

Malaysia Ringgit -30.04% 26.70% 13.70% -0.02% 0.76% 44.03% 13.68%

Philippine Peso -25.79% 32.96% 46.68% 5.08% 52.08% 104.94% 54.13%

Thai Baht -34.04% 65.08% 9.92% -2.89% 16.22% 76.21% 6.74%


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.


ExternalArgumentsA. 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.


• 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


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

Total -470,104

North America -86,962

Western Europe -89,218

Eastern Europe, Former Soviet Reps. -8,283

Pacific Rim -215,005

South/Central America -17,902

OPEC -34,482

Other countries -36,367Source: U.S. Commerce Department, February 2003


ExternalB. 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


Imports and exports of China by main countries in 2003 quarter 1

Country (Region)

Dollars (billion USD) % change when compare with 2002 Quarter 1

Trade Balance

Export Import Export Import Export-Import

Japan 12.70 15.74 2.39 5.55 -3.04

US 17.66 7.93 3.40 3.99 9.73

Europe 14.14 11.08 4.19 3.84 3.06

Hong Kong 14.89 2.48 2.91 1.50 12.41

South East Asia 6.14 9.70 3.02 6.43 -3.56

Korea 4.02 9.16 2.80 3.77 51.4

Taiwan 1.84 10.28 4.50 2.18 -8.44

Russia 1.08 2.18 6.75 2.11 -1.10

Australia 1.25 1.50 3.67 2.19 -0.25

Canada 1.14 1.02 3.22 21.9 1.2Source: Customs General Administration People’s Republic of China


US productivity and related data in manufacturing, percentage changes, 1949-2000 (percent per

year)1949-2000

1949-1973

1973-1979

1979-1990

1990-1995

1995-2000

1999-2000

Productivity

Multifactor productivity1 1.2 1.5 -0.6 1.1 1.3 2.1 1.9

Output per hour of all persons 2.8 2.6 2.2 2.6 3.3 4.3 4.0

Output per unit of capital services -0.4 0.0 -2.1 -0.8 0.6 0.1 -1.2

Sectoral output 3.3 4.0 2.5 2.0 3.1 4.1 2.5

Inputs

Hours 2 0.5 1.4 0.3 -0.7 -0.1 -0.2 -1.4

Capital services 3.7 4.0 4.7 2.8 2.5 4.0 3.8

Energy 2.7 4.9 0.8 0.3 1.8 0.5 2.8

Non-energy 3.0 2.3 6.2 1.7 3.5 4.5 0.9

Materials

Purchased business services 2.8 5.1 5.4 1.7 3.5 1.0 1.0

Combined inputs 3 2.1 2.4 3.1 0.9 1.8 2.0 0.7

Source: The Bureau of Labor Statistics of the U.S. Department of Labor


Internal Reasons

• Despite high economic growth, banking system is fragile, income gap, and SOEs reform

a) 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


Internal Reasons

b) 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.

c) 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


2. Impacts on Chinese Economy

a) 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

b) Negative impacts on under-privileged sectors, such as agricultural, mining (steel) business.



c) Increase deflation pressure. RMB’s appreciation may increase import and decrease export. This may worsen the oversupply problem in China.

d) 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.


2. Impacts on Chinese Economye) RMB’s appreciation may not be adva

ntages fro US & Japan.– China’s GDP accounts for 3.5% of glob

al economy.– China trade accounts for 5% of global t

rade– 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


– 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



• 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.


Short-term measures (current account)

• Encourage more imports; raw materials and oil. Reduce subsidies for export industries.

• Allow enterprise to keep more foreign reserves.


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.


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


International (regional) Integration

1. Economic integration enhance cooperation in economic and trade activities among different economies. E.g. Europe, Latin America, North America and South-Ease Asia.

a. Free Trade Area– Remove (most) trade barriers, e.g. tariff to

promote trade among member economies, such as NAFTA, ASEAN



b. Customs Union– Member economies are required to remove all tariff,

have a unified trade policy, e.g. EC and Caribbean EC

c. 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

d. Economic Union– Common market features and a single currency (EU)



e. Political Union– One step further the economic integration, having

one single government, e.g. U.S.A.Step-by-stepLower 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



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


HK & Mainland economic cooperation

• Before CEPA

– Private sector

– Barriers; tariffs; bounder; little mobility on factors of production



• CEPA– No tariffs on selected products made in HK– Market access fro HK services industries– Plus telecommunication, definition of ‘HK company’ a

nd ‘made in HK’– Long-term goal is to open up the mainland market an

d to enhance free flow of factors of production

• CEPA is considered to be more than NAFTA but less than EU.



• CEPA will bring long-term impacts on the Pearl Delta region

1. Individual Travel will enhance human and capital flow

2. Further infrastructure project cooperation in the region, e.g. 西部通道 ,港珠澳大橋及粵港澳高速鐵路

3. RMB business4. Macro-economic policy cooperation

– Cooperation between HK & provincial governments

5. Enhance cooperation on industries– HK servicing industries, such as financial industries, h

igh value-added manufacturing industries


Hong Kong’s advantages

• Legal System

• Intellectual property right protection

• Information system

• English

• International network


Industrial structure of Hong Kong (%)

Year

Manufacturing Industry

Services industry

Others

1980 23.6 67.3 9.1

1985 22 69.5 8.5

1990 17.5 74.4 8.1

1995 8.3 83.7 8

2000 5.8 85.7 8.5

2001 5.2 86.5 8.3Source: Hong Kong Census and Statistical Department


Division of Labor

1. Between Hong Kong and Pearl Delta Region

a. Hong Kong– Product development– Design– Trading– Logistic– Management– Supply chain management


Division of Labor

b. Pearl Delta Region

– Manufacturing process

– Some R&D

– Purchasing


Division of Labor

1. Between Hong Kong and Shanghaia. Hong Kong

– Private banking services– Funds management– Funds raising for enterprise– Derivative instruments


Comparison of economic structure in small and medium economy

Primary Production

Secondary Production

Tertiary Production

Hong Kong (2001) 0% 14% 86%

Singapore (2001) 0% 33% 67%

Taiwan (2000) 2% 32% 66%

South Korea (2002) 4% 42% 54%

Switzerland (2002) 2% 34% 64%

New Zealand (1999) 9% 23% 69%

Ireland (2001) 4% 36% 60%

Sweden (2001) 2% 29% 69%

Norway (2000) 2% 31% 67%Source: The world fact book 2002, CIA, United States


Division of Labor

b. Shanghai

– Trade finance

– Retail banking

– Consumer banking


• CEPA aims at promoting more mobility of FPs between Hong Kong and Mainland, to enable Hong Kong to become ‘part of Chinese economic system’.


Conclusion

• Further mobility of FPs

• Cross-border infrastructural projects

• Legal system integration

• Financial regulation

• Recognition of professional qualification

• Environmental and security issues

rmb and cepa stephen yan-leung cheung professor (chair) of finance city university of hong kong

Documents

rate of exchange rate

rate parity slide

spot rate

spot exchange rate

exchange rate risk

power parity

forward exchange rates

s easiest