The Analysis On The Effects Of RMB Exchange Rate On Business Cycles And Asset Prices

The acceleration of the process of globalization strengthens the international communication and cooperation.The exchange rate, as the intermediate between one economy and the other, has been the focus of the world. On the one hand, as one of the most important prices in the economy, exchange rate measures the exchange ratio between two currencies and compares the competitiveness of commodities of different countries. Therefore, one country can be more efficient in the production of goods than another, and thus, the productivity of the whole world is improved. On the other hand, the international trade becomes more uncertain and costly because of the regular variation of the exchange rate. Together with the faster and faster flow of the capital over the world, these effects make the international financial market extremely unstable. The eruption of finincial crisis in late-90s may suggest a series of the problem. All of these crises have the characteristics of simultaneous collapse of exchange markets and financial markets in the countries. Hence, under the circumstances of more openness of the world, the volatility of exchange rate has been becoming one of the main factors which affect the stability of economic growth and financial market. The unrecognization of the possible impact of the exchange rate is a huge pressure on the development of the economy and may carry many potential problems in the future. After the managed floating exchange rate system is adopted for RMB exchange rate, the volatility of RMB exchange rate rises significantly. How would this affect Chinese financial stability and economic growth? This is necessarily a research topic for scholars to contribute to the literature.This thesis aims to provide answers to the above questions through theoretical analysis and empirical examination and it is also one of the very earlier study in the literature to research the asset pricing model under open economy. In the theoretical analysis, I derive the open economy asset pricing model (OEAP) and define the exchange-rate-multiplier. Based on the model and the multiplier, I analyse the relationship between exchange rate and asset risks. In empirical investigation, I deduce the factor pricing model from OEAP and test the linear factor model using Chinese macro data with financial market data. Generally speaking, the econometric method in this thesis belongs to the structural model.The core contribution of this thesis can be divided into three parts. Firstly, I analyse and discuss the relationship between the exchange rate and the business cycle in Chapter4. The aim of this part is to verify the hypothesis of the OEAP model. By using the VAR model, variance deposition and impulse response function analysis, I give some concrete evidences supporting the hypothesis. Secondly, I explore the effects of exchange rate on asset risks and asset pricees in Chapter5. This Chapter is also the key part of the whole thesis. And I analyse the representative agent’s consumption-portfolio choice in an open economy and derive the OEAP model, and investigate the pricing role of exchange rate in asset prices. Thirdly, I explore the connection between financial market and the real economy in Chapter6. This part is an empirical application of the OEAP model. Since the stochastic discout factor (SDF) reflects the risks of the assets and indicates the states of the economy, moreover, as it contains two important variables, i.e., exchange rate and inflation rate, under open economy framework, I investigate the explanation power of the SDF to business cycles and volatilities.The main results can be summarized as follows.First, there is no apparent link between exchange rate and GDP in the sample of1952-1978. In the sample of1979-1993, the exchange rate is positively related to GDP, which indicates that the output increases with the RMB depreciation. However, the direction of the two variables becomes negative in the sample of1994-2010, which means that the output increases with the RMB appreciation in this period.Second, for the two variables, GDP and exchange rate, I use the Granger causality test to determine which variable is useful in forecasting the other. The results show that exchange rate could Granger cause GDP in the sample of1979-2010, and there is no significant Granger causal relationship between the two variables in the sample of1952-1978.Third, the OEAP model shows that the asset risk (price) will increase (decrease) with the volatility of the exchange rate. The mechanism underlying this process is as follows. When the exchange rate fluctuates, it changes consumers’ real wealth and the marginal utility and amplifies the negative covariance between the marginal utility and the asset return, which measures the asset risk.Fourth, I derive the exchange rate exposure based on factor-pricing model and show that when asset return negatively covarys with the exchange rate, it has more risk.Fifth, the empirical results show that there are two characteristics of the stock returns in Chinese stock market, i.e. the cross-sectional variation in the expected stock returs and the countercyclical variation in the equity premium. In an equilibrium asset pricing model, the difference of cross-section in equity premium must be explained by the risk across the different stocks. Similarly, time variation in the equity premium must be explained by the time variation of risk. This paper proposes a simple explanation in both cross-sectional and countercyclical variation in the equity premium.Finally, the stochastic discount factor under open economy may be the latent variable which connects the real economy with the finanacial market. I show that stochastic discount factor vary countercyclically with the GDP, and the volatility of the stochastic disount factor can be a good indicater of the volatility of the economy.