Master Thesis: Evaluation of China's FOREX Policy: Equilibrium Exchange Rate Perspective. Author: - Qiriga Supervisor: Ing. Vilém Semerák M.A., PhD. Academic Year: 2018/2019 Abstract This thesis investigated China's foreign exchange policy from the equilibrium exchange rate perspective, using the Fundamental Equilibrium Exchange Rate model with multiregional dimension. The core question is whether Renminbi is misaligned (over- or undervalued) from 2001 to 2017. The result indicated that the bilateral nominal exchange rate of Renminbi against the US dollar was undervalued from 2002 to 2013, reaching a peak of 34.2% in 2007. In the rest of the years, it was overvalued slightly against the US dollar. As to the real effective exchange rate (REER) of Renminbi, it was overvalued in the first three years of the 2000s, then went through the period of undervaluation of 9 years, with a smaller degree compared with the bilateral exchange rate. It is shown that from 2013 the REER of Renminbi had been overvalued for several years until it was undervalued again in 2017 by 2%. Keywords FEER, Renminbi, exchange rate misalignment, multinational model, real effective exchange rate

This paper analyzes the extent of foreign exchange rate exposure in Hong Kong, Japan and Singapore in both firm level and industry level in the period of January 1996 to January 2011 by regressing the stock return of a particular industry or firm on exchange rate changes while controlling for overall stock market movements. It is found that exchange rate movements do affect firm and industry value in a manner consistent with expectation and the extract of unexpected exchange rate changes from actual exchange rate changes have little influence on the testing results of exposure. It is also proved that exchange rate regime plays an irreplaceable role in drawing the structure of exchange rate exposure of a country.

There have been different degrees of exchange rate disequilibrium in the developing countries during recent transition or reform periods. The level of the exchange rate and its misalignment can have significant impacts on agricultural policy measures such as the Producer Support Estimates (PSEs). However, little efforts have been made to explicitly take into account the issue of exchange rate misalignment. In the conventional PSE studies the prevailing actual (nominal) exchange rates are usually used. There is general agreement that the use of actual exchange rates may introduce a bias in the PSE calculations, and that this bias can be substantial when the actual rates are significantly out of equilibrium, but there is much less agreement on the most appropriate alternative. This dissertation proposes a theoretical and an empirical model for estimating equilibrium exchange rates. Within the context of these models, the equilibrium exchange rates are argued to be determined by a group of real economic fundamentals. These fundamentals within this study include technological progress (Balassa-Samuelson effect), levels of government expenditure, world interest rate, net capital inflows, terms of trade, and openness of the economy. Base on various time series techniques and using data from India and China, sensible long-run relationships are identified between the real exchange rate and these economic fundamentals. The long-run co-integrating relationships are used to derive the equilibrium exchange rates and to gauge corresponding misalignments for the currencies in the two countries. The relevance and usefulness of the exchange rate equilibrium and disequilibrium in the calculation of the PSEs for India and China are then discussed. Results from the commodity-specific measures including the Market Price Support (MPS) and the PSE show that agricultural support levels are quite sensitive to alternative exchange rate assumptions. Specifically, exchange rate misalignments have either amplified or counteracted the direct effect on agriculture from sectoral-specific policies. With a few commodity exceptions such an indirect effect in both countries is relatively small in magnitude and dominated by the direct effect. This is also the case when the indirect effect rises substantially as a result of more misaligned exchange rates. Counterfactual MPS measure calculated assuming the exchange rate is in equilibrium with different exchange rate pass-through is also presented. It is shown that when no exchange rate pass-through to domestic prices occurs, the transfer of the indirect effect of exchange rate misalignment into the counterfactual MPS is full. But when there is exchange rate pass-through, even though partially, the transfer of indirect effect is significantly smaller. Results based on the commodity-specific PSE show that the exchange rate effect also depends on the relative importance of different PSE components. In addition to a positive impact on the direct effects measured by commodity-specific PSE compared to those measured by commodity-specific MPS, the increasing share of budgetary expenditures in India's agricultural support in recent years has resulted in more pronounced indirect effects. For China, the exchange rate effects are more similar between the PSE and the MPS measures at the commodity level because of the dominance of the MPS component relative to the budgetary payments in the PSEs. Moving from commodity-specific to aggregate measures, one can observe a similar pattern of agricultural support. However, the exchange rate effect measured by the total PSE appears to be more important: it becomes several times larger in magnitude than the direct effect in periods of severe exchange rate misalignment. The exchange rate effect when the PSE is "scaled up" from covered commodities to an estimate for the total agricultural sector is also demonstrated even though the assumption imposed by scaling-up may be unrealistic if price support is concentrated among those products included in the analysis. Since the commodity coverage in both countries tends to be incomplete and the scaling-up procedure leads to a total MPS component of greater magnitude, larger exchange rate effects are found in the scaled-up than the non-scaled-up version of the total PSEs. The impact of scaling-up on the indirect effect is proportional to the share of covered commodities in the total value of agricultural production. Again for the PSEs at both the commodity and aggregate levels, the counter factual measures indicate a full transfer of indirect effect of exchange rate when no exchange rate pass-through is assumed. A large portion of the indirect effect disappears when incomplete exchange rate pass-through is assumed resulting in a smaller transfer of the effect to the counter factual PSEs. / Ph. D.

This thesis analyses the relationship between the increasingly important sovereign CDS spreads and exchange rates, from a macroeconomic perspective. It attempts to address an existing gap in the empirical literature, which to date has paid limited attention to the role of exchange rates in influencing sovereign CDS spreads, and vice versa. In exploring the relationship between sovereign CDS markets and foreign exchange markets, I find relatively strong evidence of a causal relationship between these two variables. In a longer-term cointegrating relationship, I find that sovereign CDS spreads have different impacts (positive or negative) on exchange rates depending on the structural characteristics of the domestic export sectors of the countries studied. Turning to the second moment of exchange rates and sovereign CDS spreads, I examine the relationship between the volatility of sovereign CDS spreads and the volatility of exchange rates for developed economies (proxied by an index containing 10 Eurozone countries) and emerging economies (proxied by Brazil and Russia). My findings point to different mechanisms of transmission between sovereign CDS markets and foreign exchange markets with regard to developed and emerging economies: for developed economies, exchange rates affect sovereign CDS spreads through the volatility, whilst in emerging economies the exchange rates affect sovereign CDS spreads at the price level. To further analyse the determinants of sovereign CDS spreads, I incorporate additional macroeconomic fundamentals in addition to exchange rates into a model to explain sovereign CDS spreads. The results show that sovereign CDS spreads are indeed driven by most macroeconomic fundamentals. However, these results do not hold during periods of economic turmoil, in which the rising risk aversion of investors becomes a principal influence behind the sovereign CDS spreads. As changes in exchange rates are able to capture changes to risk aversion through trading in foreign exchange markets, the exchange rate retains its explanatory power to sovereign CDS spreads in ‘normal’ as well as ‘crisis’ conditions. Overall, the study provides strong support for the claim that exchange rates are an important determinant of sovereign CDS spreads, in addition to the interest rate which is highlighted in the literature review. The exchange rate – as an important fundamental indicator – can reflect the general domestic economic status, the relative international competitiveness of countries, as well as capture changes in risk aversion among investors. Therefore, using exchange rates to explain sovereign CDS spreads can help to account for both domestic and international dimensions of the ‘health’ of an economy as well as changes in investors’ attitudes.

non

none

Thesis advisor: Jaromir Nosal / This dissertation comprises three self-contained essays that investigate the determination and transmission of exchange rate fluctuations, as well as the impact of import quality on consumers’ gains from globalization. In the first chapter, “Decomposing the (In)Sensitivity of CPI to Exchange Rate", I examine the role of domestic frictions – distribution costs, variable markups and nominal rigidities – in explaining the low sensitivity of domestic prices to exchange rate fluctuations. I begin by modeling what the sensitivity of CPI to exchange rates is expected to be, given the presence of insensitivity in border prices and domestic frictions. Distribution costs, such as transportation and wholesaling costs, introduce a wedge between the retail price, on one side, and the border price of imports and the domestic producers’ costs, on the other. Similarly, domestic firms do not fully adjust their price to changes in their own cost because of changes in the desired markup or because prices are sticky. These frictions introduce wedges between the change in domestic producers’ costs and border prices following an exchange rate shock, and the response of domestic consumption retail prices. Using firm and transaction data from Chile, I document that domestic frictions account for 60% of the overall insensitivity of domestic CPI. Moreover, the presence of domestic frictions also impacts the sensitivity of domestic CPI: contrary to previous literature, most of the sensitivity arises from the direct consumption of imported final goods, rather than through the costs associated to imported inputs in the production of domestic goods. This is because domestic frictions dampen the response of domestically produced goods more significantly. In addition, I quantify a rich heterogeneity in the sensitivity across products, which stems from the interaction of domestic frictions and import exposure. These heterogeneities are relevant for the overall (in)sensitivity, as sectors with higher import exposure face also larger frictions. Overall, my results showcase the importance of domestic frictions and their heterogeneity in studying the response of domestic prices to exchange rate fluctuations, with implications for monetary policy in open economy and redistribution dynamics. In the second chapter, “Strategic Behavior and Exchange Rate Dynamics", joint work with L. Pollio, I examine the impact of heterogeneous investors with different degrees of price impact on exchange rate behavior. The huge trading volume in the currency markets, about $6 trillions per day, is highly concentrated among the market-making desks of few large financial institutions. However, models of exchange rate determination assume that investors take the equilibrium price as given, ignoring the presence of a few large investors who recognize the price impact of their decisions and can exert pressure on market prices. We incorporate heterogeneity in price impact, following of Kyle (1989), into a two-country, dynamic monetary model of exchange rate determination. Our theory of exchange rate determination with heterogeneity in price impact reveals that market structure is a key determinant of exchange rate dynamics. Strategic investors recognize their price impact, which leads them to trade less on any information and reduce the information loading factor of the exchange rate (price informativeness). The presence of strategic investors explains the weak explanatory power of macroeconomics variables in predicting exchange rates (exchange rate disconnect puzzle) and the excess volatility of the exchange rate relative to fundamentals (excess volatility puzzle). We also provide empirical evidence that supports our theoretical predictions by using trading volume concentration data from the NY Fed FXC Reports for 18 currencies from 2005 to 2019. We extend our theoretical framework to include another dimension of heterogeneity among investors, information heterogeneity, that provides similar qualitative predictions in terms of exchange rate dynamics. We demonstrate that both dimensions of heterogeneity are quantitatively relevant in explaining the disconnect of exchange rates and their excess volatility. In the third chapter, “The Quality of US Imports and the Consumption Gains from Globalization", joint work with D. Lashkari, I examine the role of quality improvement in shaping the gains from trade. The existing empirical literature indicates that globalization has offered consumers around the world access to a wider variety of products at cheaper prices. However, since the available data typically lacks detailed information on product characteristics, we may underestimate the value of imports for consumers if the quality of goods within each product rises over time. To overcome this limitation, we propose a novel methodology to estimate demand elasticity and infer unobserved quality using only data on prices and market shares. Our approach builds on the standard framework that models product quality as residual demand. This framework requires estimating price elasticities and the standard approach assumes CES demand and imposes uncorrelated supply and demand shocks. However, the latter assumption is untenable if we associate demand shocks with quality and generates an upward bias in the estimates of price elasticities. Our strategy circumvents this problem by restricting the dynamics of product quality to a Markov process. We apply our new methodology to the US customs data (1989-2006), and find that quality improvements contribute the most to the gains from trade in the US. Quality improvements have lowered the price of US imports relative to the CPI by 17%, with Chinese products contributing the most. In comparison, import prices have fallen by around 11% relative to the CPI and increasing variety has contributed an additional 4%. These findings demonstrate that accounting for quality is essential to better understand and measure the effects of international trade. / Thesis (PhD) — Boston College, 2023. / Submitted to: Boston College. Graduate School of Arts and Sciences. / Discipline: Economics.

The main focus of the paper is the problem of exchange-rate exposure of Swedish firms between Jan, 1st 2002 and Sep, 27th 2006. Defined as “a measure of the potential for a firm’s profitability, net cash flow, market value to change because of a change in exchange rates”, the problem of exchange rate exposure is investigated, making use of the “Market Value Approach” (also known as “Stock Market Ap-proach”), with certain additional extensions. With Sweden being a very open economy with strong export orientation, we expected to find a greater number of firms showing significant ex-change rate exposure to one or more of the chosen 6 bilateral exchange rates (SEK/EUR, SEK/USD, SEK/DKK, SEK/NOK, SEK/GBP and SEK/JPY). Also, companies are divided into categories with respect to their main operating activity. The empirical study finds 78% of all companies in the sample with significant exposure, with dominance of lagged effect over con-temporaneous. This percentage is higher than found in previous empirical studies, being in sup-port of the suggestion that relation exists between economy openness and exchange rate expo-sure of firms. However, the significant cross-section differences across categories and the high level of heterogeneity within categories deter us from determining the sign, direction and magni-tude of the exchange rate exposure. Suggestions are made for further studies and possible exten-sions of the topic of the present paper.

<p>The main focus of the paper is the problem of exchange-rate exposure of Swedish firms between Jan, 1st 2002 and Sep, 27th 2006. Defined as “a measure of the potential for a firm’s profitability, net cash flow, market value to change because of a change in exchange rates”, the problem of exchange rate exposure is investigated, making use of the “Market Value Approach” (also known as “Stock Market Ap-proach”), with certain additional extensions. With Sweden being a very open economy with strong export orientation, we expected to find a greater number of firms showing significant ex-change rate exposure to one or more of the chosen 6 bilateral exchange rates (SEK/EUR, SEK/USD, SEK/DKK, SEK/NOK, SEK/GBP and SEK/JPY). Also, companies are divided into categories with respect to their main operating activity. The empirical study finds 78% of all companies in the sample with significant exposure, with dominance of lagged effect over con-temporaneous. This percentage is higher than found in previous empirical studies, being in sup-port of the suggestion that relation exists between economy openness and exchange rate expo-sure of firms. However, the significant cross-section differences across categories and the high level of heterogeneity within categories deter us from determining the sign, direction and magni-tude of the exchange rate exposure. Suggestions are made for further studies and possible exten-sions of the topic of the present paper.</p>

The dissertation investigates the issues pertaining to China’s fixed exchange rate policy and attempts to appraise the case for greater exchange rate flexibility. The thesis addresses three objectives: First, a critical appraisal of China’s exchange rate policy in the light of theoretical and empirical literature supporting greater flexibility in exchange rate; second, it builds a monetary dual exchange rate model and analyses in a dynamic theoretical framework the impact of nominal demand and price shocks due to over and undervalued currency. Third, using Chinese macroeconomic data it empirically examines the factors determining China’s real exchange rate fluctuations. After presenting a brief history of China’s exchange rate policy in the post-war period, an assessment of China’s fixed exchange rate policy is made, including the costs of maintaining its current peg. It is argued that the literature on China’s exchange rate regime has not reached a consensus, and further theoretical arguments are appraised regarding the reluctance to move to a more flexible exchange rate regime. A theoretical dual exchange rate monetary model, in the spirit of Flood and Marion (1983), is then developed to analyse the dynamics in the responses to nominal and real shocks. This provides a theoretical basis for analysing the underlying working mechanism and policy implications under some degree of capital control, to resemble the Chinese exchange rate regime. In the light of the theoretical analysis, empirical research is conducted using a structural vector auto-regression (SVAR) model to examine the effects of real exchange rate fluctuations to nominal and real shocks (represented by inflation and real GDP), in order to determine the case for exchange rate flexibility. Both the theoretical and empirical analyses complement to inform the ongoing debate on whether the current exchange rate regime in China should be made more flexible, and whether a more flexible regime is appropriate in stabilising the effects of macroeconomic shocks. The empirical findings reveal that the responses of the real exchange rate to nominal IX demand and real supply shocks are consistent with a managed exchange rate system that currently operates in China. In particular, the results show that, as China has been under a fixed exchange rate arrangement for much of the estimation period, the real exchange rate appreciates immediately in response to a positive nominal shock. The use of quarterly Chinese data in this study, which no previous study on China has used, makes it possible to identify to a greater degree the initial appreciation impact of a positive nominal shock on the real exchange rate, although the results are generally consistent with the previous study by Wang (2004) using annual data. The study finds that supply shocks are dominant in the fluctuations of output growth, and while both nominal and real shocks are significant the nominal contributes more than real shocks in real exchange rate fluctuations. Overall, these findings are consistent with other studies for developing countries and support a case for greater exchange rate flexibility for China.