Study On The Applicability Of The Interest Rate Parity In China

With the deepening of world economy integration, the economic ties between countries have become evermore closer. International trades, foreign direct investment, foreign indirect investment, international credit activities of banks have gained speed. The exchange rate is becoming the focus of all foreign economic activities of enterprises and investors. Due to the fluctuations of RMB exchange rates after the People’s Bank of China decided to relax controls, enterprises and investors face growing foreign exchange risk. In order to hedge and manage the foreign exchange risk, enterprises and investors must pay attention to exchange rate forecasting and market judgment. Although the interest rate parity theory has many defects, the theory has been most commonly used to explain exchange rate behaviors. So is the interest rate parity theory applicable in China? The RMB exchange rate pricing is reasonable? Is China’s foreign exchange market efficient or not? These are the purposes addressed by this paper.On the basis of latest developments of China’s money market and foreign exchange market, this paper samples the time series data of Shibor, the RMB exchange rate against the dollar and the dollar Libor to study the applicability of IRP in China. The sample data spanning from March 2009 to the end of 2012 contains one week, one-month and three-month time series. The main empirical methods used in this paper are the static and the DCC-MGARCH model. Although the empirical results of DCC-MGARCH model are better than static empirical results, the two empirical tests reached the same conclusion:IRP theory is not applicable in China; RMB exchange rate pricing is not reasonable and China’s foreign exchange market is not an efficient market.Among many factors, the main reason that interest rate parity theory is not applicable in China is that the pricing of the RMB is not market-based and the foreign exchange market is not mature in China. In order to provide a more transparent and rational market environment for the RMB exchange rate pricing, China should steadily promote market-oriented reforms and build up the infrastructure of the foreign exchange market.