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

Yi David Wang

No 28/2012, BOFIT Discussion Papers from Bank of Finland, Institute for Economies in Transition

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 con-version 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 JEL: F30, F31, F33.

JEL-codes: F30 F31 F33 (search for similar items in EconPapers)
Date: 2012-11-30
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Published in Published in Journal of Banking and Finance, Volume 50, January 01, 2015, Pages 616-631.

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