Stock Prices And Exchange Rate Appreciation

After a long period of stagnancy, China's stock market started its adjustment in 2006, followed by an astounding uprising. However, with the continuous and rapid upward movement of the stock price, major concerns emerge regarding the overvaluation in the stock market. There are worries that the stock bubble may exert negative impact on the economic development. Almost in the meantime, the reform of RMB exchange rate regime began. Afterwards, RMB began its appreciation against USD incessantly, and the expectation of a further appreciation results in the inflow of speculative capital through various channels. These hot money profits not only from the RMB appreciation, but also from its speculation in the stock market, thus affecting the stock price directly or deviously. Therefore, the upward movement of stock price should take into account the impact of exchange rate, which should be considered not only a linkage between domestic and international capital market, but also a major arbitrage target.In this circumstance, this paper addresses the issue of the current stock bubble in China, discusses the role of exchange rate, and proposes certain notable aspects.As for asset bubble, economists construct various models. In the framework of rational expectation, economists models rational bubble, which has evolved into a systematic theory. Rational bubble theory has presented us an ideal methodology to understand the current stock bubble and this paper would utilize this framework to conduct our analysis and empirical tests. The results of this papers show that the volatility in China's stock market has exceeded the theoretical volatility which can be supported by the market fundamentals, and this should be deemed as an outstanding sign of existent stock bubble. Moreover, the bubble's degree measured respectively by P/E and fundamental value indicates the severity of the current stock bubble. In the setting of an open economy, the rational bubble with an exchange rate factor has been deduced. The bubble form implies that the currency appreciation would result in explosive bubble should certain conditions fulfill. According to this stock price with exchange rate, this paper has set factor models both in the format of single equation and simultaneous equations. The regression shows that the appreciation would provide statistically significant boosting impact on the stock price. Finally, this paper conducted a further empirical test on the exchange rate influence based on the CAPM. Our test indicates that there is no significant effect in this respect. This result also implies China's financial openness has not yet reached such extent that exchange rate has become the systematic risk factor determining the required rate of return for risky assets, and the domestic CAPM is still applicable.This paper concludes that in current economic setting, to address the impact of RMB appreciation or the expectation related on the stock bubble, certain measures have to be taken. On the one hand, restrictions should be placed on RMB exchange rate fluctuation, preventing dramatic appreciation to bring about related explosive bubble. On the other hand, capital controls in certain aspects and during certain periods would be of help to reduce expected return of hot money and therefore play significant role in curtailing stock bubble. Meanwhile, in the long term, the policy orientation would be to enhance the role of domestic demand in economic development, to perfect the financial supervision regime and finally shape a healthy financial market.