Linkage Between Stock Price And RMB’s Exchange Rate In China

Securities market and foreign exchange market are two critical parts of international financial markets. With the integration of world economic and the globalization of finance, it is of great significance to study the linkage of securities market and foreign exchange market in our country.In 2005, two significant events in the history of Chinese finance market happened:split-share structure reform and exchange rate reform of RMB. Along with the execution of the two reforms above, the formation of exchange rate and stock price may be more market-oriented.Due to historical reasons, before split-share structure reform, there is a separation between tradable shares and non-tradable shares. Moreover, a large part of non-tradable shares can’t be traded in the securities market. So, in this situation, the scale of tradable shares for a single listed company, and the stock price doesn’t reflect the market information exactly. Along with split-share structure reform, all the shares of enterprises in China can be in entire circulation. The formation of stock price will be more market-oriented, and then securities market in China is gradually converged with the international securities market.On July 21th,2005, a great reform had been happened to the RMB exchange rate formation mechanism. The PBOC announced the abandonment of the RMB pegged to the dollar, and began to implement a market-based, referenced to a basket of currencies and managed floating exchange rate regime. With the exchange rate reform, the floating space of RMB’s exchange rate has expanded; the volatility and flexibility of exchange rate have all been increased; the regulating effect of the market is more and more evident. In one word, the formation mechanism of RMB exchange rate is more market-oriented.Looking back at market performance, Since split-share structure reform and exchange rate reform, China’s stock market experienced a huge adjustment like a roller coaster. At the end of 2005, China’s stock market became a bull market, and the Shanghai A-share index continued to rise. On October 17th,2007, the index reached the peak 6337 point. Then after some shocks in stock market, stock market index began to go down.Especially after the eruption of the sub-prime mortgage crisis, the stock market fell into a bottom and the stock market index began to rise slowly after a long time. Exchange rate, after exchange rate reform, is rising with fluctuation. On August 31th,2009, the exchange rate of RMB has continued to rise 17%, which is inextricably linked with the good development of China’s economy. After the eruption of the sub-prime mortgage crisis, the export has been shocked by the decreased demand of foreign countries. However, there is still appreciation expectation for RMB’s exchange rate, because in the China’s foreign exchange market the dollar is still in an oversupply situation.At the point of view of general economic theory, there may be some internal affiliation between exchange rate and stock price. The continuous rising of RMB exchange rate will be accompanied by the rising of stock market; the rising of the stock market should bring a decline in the exchange rate and the currency appreciation. However, the situation of our country is not very consistent with theory. So in the end what kind of relation is between the RMB exchange rate and China’s stock market? Is there any kind of theoretic linkage between them, or partly? What’s more, what are the conduction pathways for the linkage, and the degree of the linkage? Discussion of these issues will be of great importance and significance for risk management and grip the laws of our country’s economy.In order to make clear the linkage between RMB exchange rate and stock price, the paper is arranged as follow:In the first part, the existing literatures are reviewed.At abroad, there are some researches about linages between stock index and exchange rate aimed at developed capitalist countries (such as the United States, Britain, France, Germany, Japan, Italy and the Netherlands); there are also some researches aimed at emerging markets. Some researchers are targeted at Asian countries, and some others targeted at one single country. There are differences between their sample spacing and empirical method, so the results are different. Some get the conclusion that there is two-way causal relationship between the exchange rate and stock prices, while some thought that the relationship is one-way and its direction for short and long term effects are different.At home, the researches about the linkage between exchange rate and stock index started relatively late. In some researches, there is no co-integration relationship between stock price and exchange rate. Vector Auto-regressive Model is established; Granger causality test is employed; then the corresponding pulse analysis and variance decomposition analysis are employed to study the relationship between variables. In some other researches, there is co-integration relationship between stock price and exchange rate. Then Vector Error Correction Model is established to study the long-term and short-term linkage. ARDL model is established to prove the impact of exchange rate on stock price and volatility sensitivity in some researches. There are also some others that only establish simple regression models. In the same way, the results are different due to the differences in sample spacing and empirical method.In the second part, some theoretical analyses about the linkage between stock price and exchange rate are presented.First, the general model of the linkage between stock price and exchange rate are studied, which include the derivation of a simple model about the correlation of these two variables, and two mature models:the flow-oriented model and stock-oriented model.Gordon model and interest parity theory are employed in the derivation of the simple model, and the conclusion is that there is a positive linage between stock price and exchange rate, which is the foundation of research on linkage between stock price and exchange rate. The opinions of flow-oriented model are that:the exchange rate movements will impact on stock price, and this impact is one-way. The opinions of equity-oriented model are that:the exchange rate movements will impact on stock price, and changes in stock prices will have an impact on the exchange rate. Namely, this impact is two-way. Second, the conduction pathway for the linkage between stock prices and exchange rate are studied. The main pathways for impact of exchange rate on stock price are:interest rate, international capital flows, money supply mechanism, international trade. The major mechanisms for impact of stock price changes on exchange rate are:portfolio mechanisms and money demand mechanism.Finally, the influence factors of transmission mechanism between exchange rate and stock price are discussed, which primarily aimed at fixed exchange rate regime and floating exchange rate regime. Under the conditions of two kinds of exchange rate formation mechanism, the conduction effect between stock prices and exchange rate are analyzed briefly.In the third part, vector auto-regression model is established to study the relationship between stock price and exchange rate, which is based on the researches at home and abroad. The data in this thesis is China’s Shanghai A-share Index and the RMB exchange rate against the U.S. dollar,997 groups of data in all. At first, starting with some simple researches on the correlation graphs of stock prices and exchange rates, stability test is employed on stock price and exchange rate sequences. The test result shows that the logarithmic sequences of stock price and exchange rate are non-stationary series. After a first-order differential, the sequence becomes a stationary sequence. And then, co-integration test is employed to determine the long-run equilibrium relationship between the two sequences. The result of Johansen co-integration test shows that there is co-integration relationship between exchange rate and stock price. Finally, the vector error correction model (VEC) is established to test the long-term and short-term causal relationship between the two sequences. The conclusion is that:in both long term and short term, there is one-way causal relationship from exchange rate to stock price, while we can’t find the causal relationship from stock price to exchange rate.In the fourth part, according to the results of part three, some interpretations are presented. The conclusion, that there is one-way causal relationship from exchange rate to stock price, is consistent with the traditional flow-oriented model, which is related with the restricted free flow of capital. Because, the impact of exchange rate changes on stock prices become effective mainly by means of international trade pathway in our country, Changes in the exchange rate will influence the import and export expected value and profit expectations of listed companies. Then the valuation of people on the listed companies will be changed, and the stock prices change. The reasons that there is no causal relationship between stock price and exchange rate are as follows:Firstly, interest rate marketization has not been implemented fully in our country. The changes of stock price can’t change exchange rate, although the changes can affect the residents’ income and wealth. Secondly, the capital financial accounts of international payments haven’t fully liberalized, which cut off the pathway from stock price to exchange rate, and stock market fluctuations can’t affect foreign exchange market effectively.Thirdly, RMB has achieved free-floating to a certain degree, but still under control, making the exchange rate’s reaction on the stock market to be weakened.There are one-way long-term and short-term linage between securities market and stock market, but this transmission mechanism is not entirely. In the critical period for improving the foreign exchange system reform and regulating the domestic financial market development, in order to improve China’s stock market’s ability to resist risks, foreign exchange risk must be paid attention to and some strict preventive measures should be taken to avoid that international speculative capital flows in the foaming industry, such as securities, foreign exchange and so on.