Exchange Rate Dynamics, Intervention and Regime Shifts in China: A Market Microstructure Analysis

Abstract

This thesis applies the market microstructure approach to investigate exchange rate dynamics, intervention and regime shifts in China’s exchange rate system. This research first examines exchange rate determination and dynamics from a microstructural perspective. An index of order flow is constructed in the Chinese context to reflect excess demand pressure. A VAR model is then estimated to explore to what extent order flow may explain long-term determination and short-term fluctuations of the renminbi exchange rate. Focusing on the cointegrating relationship between cumulative order flow and the exchange rate of the RMB against the US dollar, this research find that in the new Chinese exchange rate regime in place since 2005, order flow is able to explain a significant part of fluctuations in the RMB-dollar exchange rate.

China is internationally noted for its intervention in the foreign exchange market. Based on high-frequency data this thesis adopt a multi-dimensional approach to explore how interventions are conducted in China, what the consequences are, and to what extent they are effective. This thesis identify evidence of China’s extensive intervention and find that the authority is more likely to intervene to curb devaluation. Decomposition analysis shows that the direct impact of intervention on the exchange rate is more important than the impact via order flow. Intervention via the central bank’s involvement in trading is effective in influencing both the exchange rate and order flow, but tends to increase volatility. Intervention by the central bank’s varying the central parity condition plays some role in ‘leaning against the wind’, but cannot reverse the trend.

China announced the reform of its exchange rate system in 2005. The reform was disrupted by the breakout of the global financial crisis around 2008, but was reiterated in 2010. The thesis analyses the behaviour of China’s exchange rate policy since then. This research detect 21st June 2010 as the date of regime shift, since when the RMB has been allowed greater room for flexibility, and consequently exchange rate volatility has increased. This research unearths evidence confirming that the renminbi no longer pegs only to the dollar. During the crisis period, deviations from the central parity rate (CPR) increase the possibility of government intervention, and the intervention correlates with bid-ask exchange rate spread. The Chinese monetary authority is found to act to keep the exchange rate stable. In the post-crisis period, the correlation becomes time-varying and the government prefers the RMB exchange rate to gradually appreciate. This research finds evidence that appreciation of the RMB exchange rate is order flow driven during the post-crisis period.

There is a significant negative currency exposure during the financial crisis, caused by changes in the RMB exchange rate, indicating that the Chinese stock market exhibits a negative reaction in the period. However, no significant impact is found in the post- crisis period. In order to modify the exchange rate exposure to fluctuations of the US dollar, the Chinese government seems to have adopted the relatively more efficient exchange rate regime to handle the effects of the global financial crisis.