CHINESE YUAN AND US DOLLAR

Chinese Yuan and US Dollar

Chinese Yuan and US Dollar

1. Introduction

By definition, the Foreign Exchange Market is a market1 in which different currencies can be exchanged at a specific rate called the foreign exchange rate. We can anticipate the huge importance of the foreign exchange rate if we can just consider the influence of it on the imports and exports of a country. For example, let's assume a currency appreciation2 - the euro against the US dollar. Firstly, the exports of the European Union (E.U) nations will become 'expensive' for the United States of America (USA), which among other things means that E.U product will lose in terms of competitiveness. Secondly, such a currency appreciation will be to the benefit of E.U imports, should those be payable in US dollars. Conversely, a depreciation3 of the euro against the US dollar will cause an opposite impact. On the other hand, the rapid growth of international trade (both the import penetration4 and the export ratio5) during the last decades, which was mainly due to the increase of the open economies, enhances the significance of the foreign exchange rates.

China's exchange rate policy

Exchange rate economics is characterized by a number of anomalies, or puzzles, which we struggle to explain on the basis of either sound economic theory or practical thinking. Put more simply, the international finance profession has not yet been able to produce theories and, as a consequence, empirical models that allow us to explain the behaviour of exchange rates with a reasonable degree of accuracy. This failure is witnessed by a variety of phenomena, and this paper analyses three specific ones.

The first puzzle analysed is the 'forward bias puzzle,' relating to the fact that the foreign exchange market is not only informationally inefficient, but it appears to be so inefficient that the forward market-capturing market expectations of future movements in exchange rates may systematically predict future exchange rate movements in the wrong direction (Fama 1984). The second puzzle relates to the often documented lack of any strong tendency of exchange rates to move in sync with relative prices, which is what one would expect if purchasing power has to remain constant across countries over long periods of time in a world with international arbitrage in goods markets - this is usually termed the 'purchasing power parity' puzzle (Rogoff 1996). The third puzzle, which in some respects encompasses the previous two, is the missing link between nominal exchange rates and the menu of economic or financial fundamentals that international economics theory suggests should drive exchange rates - this phenomenon is termed the 'exchange rate disconnect' puzzle (Obstfeld and Rogoff 2000). In essence, fundamentals appear to be unable to explain both the actual level of exchange rates - not only daily, but even monthly, quarterly, and annually - and their volatility.

China's exchange rate policy in 1950s and 1960s was mostly determined by the nation's geo-political, security, and strategic interests, and economic calculations played little or no role in the exchange ...