Analysis On Relationships Among The RMB Exchange Rate, Interest Rate And The PBoC's Assets And Liabilities

Central bank's balance sheet is the basis of monetary policy implementation. A healthy balance sheet (including rational assets-liabilities size and structure as well as a strong financial strength) is much essential for the central bank to deal with successfully major changes in macroeconomies through conducting monetary policies, whereas an unhealthy balance sheet, that is, an expanded size and an unbalanced structure in assets-liabilities as well as substantial financial losses, would bring massive risks to the country. As for China, the People's Bank of China (PBoC) is suffering from problems in this area over the past decades. Its balance sheet is over-expanded and its assets-liabilities structure is unbalanced, which further leads to a weak financial condition and excess supplies of monetary base and monetary aggregate. Actually, these problems have much to do with the fact that the Renminbi (RMB) exchange rate and interest rate regimes are not entirely market-oriented. On one hand, it is the goal of the PBoC to keep the RMB exchange rate stable that leads to balance sheet and money supply expansion, while on the other hand it is the interest control that keeps monetary sterilization sustained and inflation rates in control. In general, the PBoC's assets and liabilities are closely related to the RMB exchange rate and interest rate.Based on these facts, this paper centers on the following noteworthy questions, that is, whether or not the RMB exchange rate and interest rate regimes are important factors contributing to the PBoC's assets-liabilities unbalance; if they arc, then in which ways they cause such an unbalance; with a long enough time horizon how the RMB exchange rate and interest rate would be affected by the PBoC's assets-liabilities unbalance; what're the real relations among the RMB exchange rate, interest rate and the PBoC's assets-liabilities; and whether the marketization of exchange rate and interest rate formation is helpful for solving the PBoC's assets-liabilities unbalance, or bring substantial risks to the Chinese economy. According to the logic sequence of "raising problem, analyzing problem and solving problem", this study is organized as follow:Chapter one is the introduction. The section firstly introduces research backgrounds and research implications of this study, and subsequently summarizes and comments foreign and domestic literature, and lastly illuminates research topics, perspectives and organization of this study.Chapter two simply reviews classical monetary theories regarding our research topics. These theories consist of purchasing power parity, interest rate parity, capital market method of exchange rate determination, Mundell-Fleming model and money supply theory. It is helpful for us to deeply understand the realistic relations among the RMB exchange rate, interest rate and the PBoC's assets-liabilities.Chapter three gives an overall review and an statistical description of the evoluation of China's exchange rate and interest rate policies, as well as the PBoC's balance sheet change in1994-2013. Comparing with balance sheets of the U.S. Federal reserve, bank of Japan and the European central bank, evidences of the PBoC's assets-liabilities unbalance can be found for China. Subsequently, by reviewing the RMB exchange rate and interest rate policies over the past decades, we find that the PBoC's assets-liabilities unbalance is actually associated with the RMB exchange rate and interest rate policies, and this association can be summarized as:exchange rate stabilization-balance-of-payments surpluses-foreign exchange intervention-increasing foreign reserves-monetary sterilization operation-the PBoC's balance sheet expanded with the assets-liabilities structure unbalanced. The association supplies factual background for us to construct a theoretical framework and conduct empirical analyses later.Chapter four develops a straightforward monetary policy framework with multiple instruments and targets in the context of New-Keynesian model, based on monetary policy practices of emerging market economies, such as China. These emerging economies often keep their exchange rates basically stable through foreign exchange interventions. Within this framework, we explore central banks'policy reaction functions with regard to foreign exchange invention, the issuance of central bank bills and the adjustment of deposit reserve rate; the optimal asset portfolios of commercial banks and private sector are discussed as well. We subsequently conduct a steady-state analysis and the ensuing results are as follows: when the exchange rate is kept below its equilibrium level and hence central banks'foreign exchange reserves increase remarklably, the interest rate of central bank bills and deposit reserves would probably be set at a lower level while the interest rate of commercial bank loans would be set at a higher level. In this way, commercial banks and private sector would bear a large part of central banks'sterilization costs and central banks'monetary sterilization could be sustained. However, the problem arises here is that the returns of financial assets cannot be freely determined by the market forces and financial repression and the distortions in interest rates come into being as well.Chapter five constructs four different models based on the above-mentioned policy reaction functions for central banks, in order to examine how central banks that are obliged to keep exchange rates and prices level stable simultaneously would response to exchange rate and interest rate changes and then how their balance sheets would be affected. We employ China's data in1999:02-2013:12and conduct bound tests and error-correction analyses based on autoregressive distributed lag error-correction model (ARDL-ECM). The empirical results are as follows:(1) China's export-oriented economic strategy and the ensuing exchange rate arrangements (including strict foreign exchange purchase and sale system, foreign exchange intervention, daily volatility restriction, etc.) are key factors contributing to continuous increases of net foreign assets (NFA) and total assets of the PBoC, and also the factors leading to a significant rise in the ratio of NFA and total assets and a significant fall in the ratio of net domestic loan (NDL) and total assets;(2) given expansion and unbalance in the PBoC's balance sheet as well as a thin bond market for present China, the PBoC has to sterilize excess base money by issuing central bank bills and/or enhancing deposit reserve rate;(3) unlike the RMB exchange rate, the rate of interest has a weak and negative effect on the PBoC's assets and liabilities, and particularly it affects significantly the PBoC's decisions on monetary sterilization in the long run, because the PBoC also takes the profitability of commercial banks and private sectors into account when it achieves sterilization of excess money at lower costs.Chapter six tries to reveal how changes in the RMB exchange rate and interest rate affect the PBoC's financial strength, or how the PBoC's financial strength would be affected when the RMB appreciates and interest rate rises. For this purpose, we calculate the PBoC's financial strength in1996-2013, and then examine the dynamic correlations among the RMB exchange rate, interest rate and the PBoC's financial strength, by applying DCC-GARCH models. The results from calculation of the PBoC's financial strength show that the PBoC is profitable during1996-2013when the capital losses caused by the RMB appreciation are not included, whereas suffers great losses in six years of the sample period once the capital losses included. And the results from dynamic correlation estimations show that appreciation of RMB relative to the U.S. dollar, Euro and Yen significantly worsens the PBoC's financial strength, and the RMB interest rate has complicated effects on the PBoC's financial strength. However, in general, since the correlation between interest rate and the PBoC's financial strength is weak enough, the PBoC's financial strength would be slightly affected by rising interest rate.Chapter seven constructs theoretical models based on Fisher's monetary quantitative equation, Fisher effect, relative purchasing power parity and flexible-price monetary model, and subsequently tries to reveal how the PBoC's assets-liabilities unbalance would affect the RMB exchange rate and interest rate in the long run. It is expected that the long-term relationships among the RMB exchange rate, interest rate and the PBoC's assets-liabilities could be conflicted with the classical theories because China's exchange rate and interest rate marketization haven't been completed. However, by employing EGARCH model and conducting maximum likelihood estimation (MLE), as well as adopting data in the period2002:06-2013:12, our results are proved to be greatly consistent with the monetary theories and be statistically significant. This implies that the RMB exchange rate and interest rate marketization are strengthened during the period on one hand, and on the other hand, with the marketization deeply promoted and hence flexibilities of exchange rate and interest rate enhanced in the future, the PBoC's balance sheet expansion together with an unbalanced assets-liabilities structure would bring a significant depreciation pressure to the RMB exchange rate and impress complicated impacts on the RMB interest rate.Chapter eight summarizes the conclusions of this paper and subsequebtly provides policy implications regarding how to mitigate the PBoC's assets-liabilities unbalance and how to promote the RMB exchange rate and interest rate marketization simultaneously. Besides, we point out the future research topics.Compared with existing literature, this study extends research perspectives to the relations among the RMB exchange rate, interest rate and the PBoC's balance sheet, and further relates the RMB exchange rate and interest rate marketization to the PBoC's balance sheet. This study also develops a monetary policy framework with multiple instruments and targets based on China's monetary policy practices. Addtionally, taking data generating process of variables and research objectives into full consideration, this study employs the most suitable econometrical tools to conduct empirical tests. As a result, this study has great theory values and practical implications.