The Dynamic Relationship Between The USD/CNY Exchange Rate And Stock Prices

In the recent years, we has witnessed significant changes in the Chinese financial system such as the gradual elimination of capital inflow barriers and foreign exchange restrictions, or the adoption of more flexible exchange rate arrangements, such as Chinese government began to institute a floating exchange rate regime in2005. Researching on the dynamic relationship between the USD/CNY exchange rate and Chinese stock prices has consequently become more complex and has received more research interest than before.Against this backdrop, we attempts to reexamine how changes in the USD/CNY exchange rate and Chinese stock prices are related to each other, both in long as well as short run, taking into account the dynamic effects by including VEC model and impulse response function from21July2005to31December2012. The purpose of this study is to shed light on the long-run equilibrium relationship and the short-run causal relations. Furthermore, we focus on investigating the short-run dynamic relationship between two economic variables in whole sample period via applying VECM and impulse respond function.The paper is organized as follows:1. IntroductionIn this section, we present the classical cases to explore the causal nexus between exchange rates and stock prices. And also we review a lot of relevant literatures about the dynamic relationship between exchange rates and stock prices. We find that there is an ambiguous relationship between exchange rates and stock prices, namely, not clear causal direction of them.2. Review of Relevant Exchange Rate DeterminationWe deeply analyze the two theory of exchange rate determination to explore the causal relationship between exchange rates and stock prices.The’Flow-oriented’models of exchange rate determination (Dornbusch and Fischer,1980) focus on the current account of the balance of payment. These models hypothesize that exchange rate changes influence international competitiveness and trade balance, impacting real income and output, which in turn affects current and future cash flows of companies and stock prices. Stock prices, usually defined as a present value of future cash flows of companies, should adjust to the economic perspectives. Therefore, flow oriented models symbolize a positive relationship between stock prices and exchanges rates with direction of causation running from exchange rates(direct exchange rate quotation) to export-oriented listed company’s stock price.The’Stock-oriented’models of exchange rate determination (Frankel,1983), concentrates on the capital account as a significant determinant of exchange rate dynamics. A rise in domestic stocks prices leads to the appreciation of domestic currency through direct and indirect channels. A rise in prices encourages investors to buy more domestic assets simultaneously selling foreign assets to obtain domestic currency indispensable for buying new domestic stocks. The described shifts in demand and supply of currencies cause domestic currency appreciation. The indirect channel grounds in the following causality chain. An increase in domestic assets prices results in growth of wealth that guides investors to increase their demand for money, which in turn raises domestic interest rates. Higher interest rates attract foreign capital and initiate an increase in foreign demand for domestic currency and its subsequent appreciation. Therefore, stock price innovations may affect, or be affected by, exchange rate dynamics.Clearly, there is not theoretical consensus on the existence of relationship between exchange rates and stock prices. Against this backdrop, this paper attempts to examine how changes in exchange rates and stock prices are related to each other, both in long as well as short run.3. Empirical analysisIn light of the global financial crisis, we divide sample observations into3sub-periods to better dissect the dynamic relationship between the USD/CNY exchange rate and Chinese stock prices. Period1(pre-crisis period) covers from July21,2005to July31,2007; Period2(during crisis period) starts on August1,2007and ends on May3,2009; Period3(post-crisis period) continues from May4,2009through December31,2012. All data points are transformed into logarithmic scale. Stock prices are measured using the daily (five days a week) closing prices of the SSE (Composite Index of Shanghai Stock Exchange). Similarly for the USD/CNY exchange rate, five day-a-week daily, nominal observations (Yuan per US Dollar) are gathered from the State Administration of Foreign Exchange. Daily observations of the USD/CNY exchange rate and Chinese stock prices were gathered and analyzed using the EViews6.0statistical package.We testes the dynamic relationship between the USD/CNY exchange rate and Chinese stock prices via applying E-G two step method and Johansen co-integration test, short-term adjustment mechanism of VECM, Granger causality test (both VAR and VEC) and short-run dynamic of impulse response function to get further insight into the long and the short run dynamic relations over the3sample sub-periods.After performing analysis and tests of short-run dynamics between the USD/CNY exchange rate and Chinese stock prices, we have come to the following conclusions.(1)E-G two step method and Johansen maximum likelihood method suggest that there is a co-integrating relationship between the USD/CNY exchange rate and Chinese stock prices in3sub-periods.(2)Only the causal relation from Chinese stock prices to the USD/CNY exchange rate in the post-crisis period. Lag2-day or3-day stock returns in the past were a result of the attractiveness and higher demand for stock investments, which, from portfolio substitution effects, was associated with a high demand for domestic stocks. This implies foreign investors need more RMB to invest Chinese stocks. Thus, high interest rates in the past are associated with a appreciating currency in the long term, which is consistent with Stock-oriented model. But the Granger causality relationship disappears for the longer horizon.(3)The VECM presents the USD/CNY exchange rate and Chinese stock prices has a short-term dynamic adjustment mechanism. The lagged exchange rate movements do have a significant impact on Chinese stock prices in the study.(4)The impulse response function depicts the dynamic relation is more significant and stronger in the recession period (during financial crisis) than in other periods(period1and period3). However, we find only limited evidence for the asymmetric effect. Based upon the results of the empirical tests, we also explain the empirical results from statistical and economical significance coupled with Chinese macroeconomic environment.4. RecommendationsAccording to the previous analysis, we make some suggestions and recommendations.For the Chinese foreign exchange market:①Chinese government needs to further improve the RMB exchange rate formation mechanism.②implement incremental capital projects open.③inhibition of short-term international capital speculation.For the stock market:①further improve the stock price formation mechanism.②strengthen information disclosure norms and enforce listed companies governance.③reinforce the supervision of the international capital flows and establish across-market circuit breakers.