The Effects Of Renminbi Exchange Rate On Chinese Monetary Policy And Its Efficiency

The People’s Bank of China had a reform on RMB exchange rate regime on July21,2005and announced that China would perform “a managed floating exchange rate regimebased on market supply and demand with reference to a basket of currencies”. The RMBexchange rate regime was changed from being fixed to being floating, triggering a series ofacademic questions about the coordination mechanism between the exchange rate andmonetary policies. These questions including:(1) After the reform, how is the degree ofthe development of China’s foreign exchange rate market comparing with the developedmarkets in the United States and Europe?(2) Whether this reform of RMB exchange rateregime can improve the efficiency of monetary policies in China?(3) After performingmanaged floating exchange rate regime, what are the effects of exchange rate uncertaintyon monetary policy?(4) What are the effects of monetary policy on the exchange rates ofRMB?(4) What are the dependent relationships between exchange rate policy andmonetary policy? Are there any active and passive relationships?(5) Considering theirrelationships, how does China perform exchange rate policy and monetary policy in thefutures to improve the efficiencies of these policies?To find out the answers of abovementioned questions, this paper investigates thelinkages between Chinese exchange rate policy and monetary policy in these several ways:First, employing the multifractal detrending moving average (MF-DMA) algorithm, weinvestigate the efficiencies of Shanghai Interbank Offered Rate (SHIBOR) and RMBexchange rate markets, and compare them with developed markets in the U.S. and Europe.The evidence indicates that Chinese interest rate market and exchange rate markets displaythe significant properties of long-range dependence and multifractality, implying themarket inefficiency. Furthermore, the degrees of long memory and predictability ofChinese markets are higher than those of developed markets, implying the higher degreesof market efficiency.Second, employing a structural vector autoregressive model (SVAR), we investigate the effects of exchange rate regime reform on the monetary policy and its efficiency. Theresults based on impulse response functions indicate that before the reform the effects ofmonetary policy on inflation rate or economic boom index are very weak, implying thelower degree of policy efficiency. After the reform, the monetary supply and interest rateboth have significant impacts on inflation rate, indicating the improvement of policyefficiency. The effects of exchange rate policy on monetary policy also become strongerafter the reform. The empirical findings also indicate that the classical theories such as theMudell-Fleming model and Interest Rate Parity cannot be used to describe the situations inChina. We also employ the nonlinear Granger causality test to examine the nonlinearlinkages among variables and our findings support the results based on linear SVARmodels.Third, this paper investigates the relationships between exchange rate policy andmonetary policy (interest rate) from the perspective of volatility. Employing multivariateGARCH models, we find the significant volatility spillovers between RMB exchange ratesand interest rates. Specifically, the increase in interest rate volatility can result in theincrease in the exchange rate volatility but not vice versa. For the purpose of observing theout-of-sample performances of the models, we employ multivariate GARCH models toforecast the volatilities of exchange rates and interest rate, and compare their forecastingperformances with the univariate GARCH model. The empirical results indicate thatmultivariate GARCH models which consider the volatility spillovers can outperformunivariate GARCH under some criterions of loss functions. This finding also furtherconfirms the linkages between exchange rate volatility and interest rate volatility in China.Additionally, based on multivariate GARCH, we also find that using exchange rate canpartly hedge the risk of interest rate.Finally, based on the empirical results, this paper also provides some policysuggestions. These suggestions include developing foreign currencies offered market andthe derivative markets of RMB, increasing the elasticity of RMB exchange rate andpromoting the process of the marketization of interest rate.