Challenges That China’s Foreign Exchange Regime Is Confronted With

Due to the CNY deviation from interest parity and the spread between CNY and CNH, there are arbitrage opportunities that motivate speculators. However, in the past decades, China’s strict capital control did not allow arbitrage. With the openness of the current account, speculators find that capital flows through the current account are not limited anymore and corporations’foreign exchange reserves are not statutorily sold to designated banks. As a result, false international trade has become an important means of carry trade. There are less regulations on capital flows through the current account. It is difficult for customs and other regulatory authorities to review the authenticity of trade case by case, due to tremendous amounts and categories. Trade companies usually close deal with their offshore affiliations or related companies. Besides false international trade, financial product and offshore settlement of foreign exchange are other important channels for carry trade, which is more difficult to estimate the scale. As a result, false international trade is the major concentration of the research.Theoretically, in the famous impossible trinity, China has chosen the stable exchange rate and the monetary independence, at the cost of capital mobility. In fact, CNY is crawling-pegging to USD, and capital control is imposed. Though the openness of the capital account does not make much progress recently, the de facto increasing capital mobility caused by false international trade will have a significant impact on the policy combination in the impossible trinity. When capital control fails, either the stable exchange rate or the monetary independence may not be hold. For increasing the convertibility of the capital account is the irreversible trend, China’s monetary authorities may have to re-choose in the impossible trinity. But it does not necessarily mean giving up certain policy targets. Target Zone theory implies that central banks can maintain monetary independence and capital mobility, when the foreign exchange rate is allowed to fluctuate in a wider zone. It is an important transitional process from fixed rate to floating rate.According to the empirical analysis in the thesis, arbitrageurs are sensitive to deviation from CIP and spread between CNH-CNY. On the contrary, carry trade will reduce the deviation of CIP and UIP, and the spread of CNH-CNY immediately. In the short term, carry trade can diminish the deviation and spread, but the existence of capital controls and the PBoC’s intervention retain the deviation and spread. Carry trade imposes appreciation or depreciation pressure on CNY, but the PBoC is not willing to let depreciation or appreciation go beyond their control. Though the original intention of the PBoC’s intervention is to suppress volatility, the battle with arbitrageur will increase volatility. The scale of false international trading or carry trade is tremendous. It imposes significant challenges on China’s capital control. When the capital control cannot be hold, the adjustment of policy combination becomes necessary. As a result, it is demonstrated that in the impossible trinity, the stability of exchange rate is decreasing, while capital mobility is increasing. Monetary independence is relatively strong. In the future, it seems predictable that CNY exchange rate will be inevitably more volatile.