RMB and CEPA Stephen YanLeung Cheung Professor Chair

RMB and CEPA Stephen Yan-Leung Cheung Professor (Chair) of Finance City University of Hong Kong Stephen Cheung City University of Hong Kong

Contents • Current debates on RMB • CEPA’s impacts on Hong Kong • Others Stephen Cheung City University of Hong Kong 2

Variable 1. The spot exchange rate, S, is the rate of exchange of 2 currencies for immediate delivery. 2. The forward exchange rate, F, is the rate of exchange rate of 2 currencies on one date for delivery at a future specified date. For example, the Euro/US dollars forward exchange rate for delivery in one year is 1. 3 US$ for 1 Euro Stephen Cheung City University of Hong Kong 3

• The objective is to examine several key international parity relationships, such as interest rate parity and purchasing power parity. Stephen Cheung City University of Hong Kong 4

Outline • • Interest Rate Parity Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates Stephen Cheung City University of Hong Kong 5

Interest Rate Parity • Interest Rate Parity Defined • Covered Interest Arbitrage • Interest Rate Parity & Exchange Rate Determination • Reasons for Deviations from Interest Rate Parity Stephen Cheung City University of Hong Kong 6

Interest Rate Parity Defined Suppose you have $100, 000 to invest for one year. You can do one of two things: 1. Invest in the U. S. at interest rate i$. After one year you will receive Face Value + Interest = $100, 000 + $100, 000 * ius = $100, 000(1 + ius) Stephen Cheung City University of Hong Kong 7

Interest Rate Parity Defined 2. Trade your dollars for yen at the spot rate. You will receive $100, 000 / S($/¥) in ¥. Then, invest this sum in Japan at i¥. After one year you expect to receive [$100, 000 / S($/¥)] * (1 + i¥) Hedge your exchange rate risk by selling the future value of the Japanese investment forward. You will receive now [$100, 000 / S($/¥)](1 + i¥) * F($/¥) = $100, 000[F($/¥)/S($/¥)](1 + i¥) Stephen Cheung City University of Hong Kong 8

Interest Rate Parity Defined Since both of these investments (1) and (2) have the same risk, they must have the same future value—otherwise an arbitrage would exist. Therefore, Investing in U. S. = Investing in Japan $100, 000[F($/¥)/S($/¥)](1 + i¥) = $100, 000(1 + ius) [F($/¥)/S($/¥)](1 + i¥) = (1 + ius) Stephen Cheung City University of Hong Kong 9

Interest Rate Parity Defined Formally, [ F($/¥) / S($/¥) ] (1 + i¥) = (1 + ius) or IRP is sometimes approximated as Stephen Cheung City University of Hong Kong 10

Interest Rate Parity Defined • IRP is an arbitrage condition. • If IRP did not hold, then it would be possible for a smart trader to make unlimited amounts of money exploiting the arbitrage opportunity. • This would change F, S, and i until the condition is restored. • Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds. Stephen Cheung City University of Hong Kong 11

Example If IRP failed to hold, an arbitrage opportunity would exist. A trader could engage in “Covered Interest Arbitrage”. It’s easiest to see this in the form of an example. Stephen Cheung City University of Hong Kong 12

Example Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. Spot exchange rate S($/£) = $1. 25/£ 360 -day forward rate F 360($/£) = $1. 20/£ U. S. interest rate i$ = 7. 10% British interest rate i£ = 11. 56% Stephen Cheung City University of Hong Kong 13

Example (continued) A trader with $1, 000 to invest could invest in the U. S. In one year his investment will be worth $1, 000 (1+ i$) = $1, 000 (1+0. 071) = $1, 000 (1. 071) = $1, 071 Stephen Cheung City University of Hong Kong 14

Example (continued) Alternatively, this trader could exchange $1, 000 for £ at the prevailing spot rate, receiving $1, 000 ÷ $1. 25/£ = £ 800 Invest this amount in Britain at i£ = 11. 56% for one year, expecting to receive £ 800 (1+ i£) = £ 800 (1+0. 1156) = £ 800 (1. 1156) = £ 892. 48 Stephen Cheung City University of Hong Kong 15

Example (continued) Sell forward now the £ 892. 48 that he expects to receive in one year. He will receive now £ 892. 48 x F 360($/£) = £ 892. 48 x $1. 20/£ = $1, 071 This is the same as what he would expect to receive if he invested the money in the U. S. Stephen Cheung City University of Hong Kong 16

Reasons for Deviations from IRP • Transactions Costs – The interest rate available to an arbitrageur for borrowing, ib, may exceed the rate he can lend at, i l. – There may be bid-ask spreads to overcome • Capital Controls – Governments sometimes restrict import and export of money through taxes or outright bans. Stephen Cheung City University of Hong Kong 17

Purchasing Power Parity • Purchasing Power Parity and Exchange Rate Determination • Evidence on PPP Stephen Cheung City University of Hong Kong 18

Purchasing Power Parity and Exchange Rate Determination • The exchange rate between two currencies should equal the ratio of the countries’ price levels. S($/£) = P$ P£ • If U. S. inflation is 5% and U. K. inflation is 8%, the pound should depreciate by 3%. Stephen Cheung City University of Hong Kong 19

Evidence on PPP • PPP probably doesn’t hold precisely in the real world, because commodity arbitrage is difficult – Transactions costs (e. g. shipping costs) – Controls (e. g. tariffs and quotas). – Non-tradable goods. • Also, PPP ignores capital flows, which nowadays seem to be more important than trade flows. • PPP-determined exchange rates still provide a valuable benchmark. Stephen Cheung City University of Hong Kong 20

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Fundamental Approach • Involves econometrics to develop models that use a variety of explanatory variables. This involves three steps: – step 1: Estimate the structural model. – step 2: Estimate future parameter values. – step 3: Use the model to develop forecasts. • The downside is that fundamental models do not work any better than the forward rate model or the random walk model. Stephen Cheung City University of Hong Kong 22

Technical Approach • Technical analysis looks for patterns in the past behavior of exchange rates. • Clearly it is based upon the premise that history repeats itself. • Thus it is at odds with the Efficient Markets Hypothesis. Stephen Cheung City University of Hong Kong 23

Performance of the Forecasters • Forecasting is difficult, especially with regard to the future. • As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate. • The founder of Forbes Magazine once said: “You can make more money selling advice than following it. ” Stephen Cheung City University of Hong Kong 24

Current Debates on RMB • Should RMB appreciate? • What are the impact on China if RMB appreciates? • What to be done? Stephen Cheung City University of Hong Kong 25

One year RMB NDF premium/discount to the spot Stephen Cheung City University of Hong Kong 26

1. Should RMB appreciate? • Global economy is not doing well, US dollar depreciated, Chinese foreign reserves increase. – In February, G 7 meeting Japanese FS claimed “ Chinese cheap products are the main reason for the slow down of Japan and global economy”, blame on RMB’S undervalue. – In May, G 8 meeting, US FS raised the issue of RMB’s appreciation. – US’s political pressure, next year, US presidential election, this will definitely be an issue. Stephen Cheung City University of Hong Kong 27

Changes of RMB cross rates in the past ten years Against 01/9301/9410/9701/0201/03 01/9301/03 01/9401/03 140/9701/03 Euro -28. 96% 2. 75% 33. 24% -20. 30% -22. 49% 9. 12% 6. 20% Yen -42. 50% 16. 18% 11. 88% -10. 93% -33. 42% 15. 78% -0. 34% Korean Won -32. 08% 24. 48% 35. 99% -10. 84% 2. 50% 50. 92% 21. 24% New TW Dollar -31. 10% 21. 34% 14. 08% -0. 58% -5. 17% 37. 63% 13. 42% Singapore Dollar -35. 82% 3. 50% 17. 10% - 5. 65% -26. 61% 14. 35% 10. 48% Malaysia Ringgit -30. 04% 26. 70% 13. 70% -0. 02% 0. 76% 44. 03% 13. 68% Philippine Peso -25. 79% 32. 96% 46. 68% 5. 08% 52. 08% 104. 94% 54. 13% Thai Baht -34. 04% 65. 08% 9. 92% -2. 89% 16. 22% 76. 21% 6. 74% Stephen Cheung City University of Hong Kong 28

External Reasons • Chinese deliberately undervalue RMB to maintain export’s competitiveness. • China’s trade surplus, foreign reserves up. • China exports deflation because of cheaper products. RMB’s appreciation will eliminate deflation. Stephen Cheung City University of Hong Kong 29

External Arguments A. China’s export increase is NOT because of the low exchange rate. There is a continued improvement on product quality, low cost and skilled labor force, technological transfer from MNCs. – China’s product’s elasticity on exchange rate is 0. 2. If RMB rate depreciates 1%, export will increase by 0. 2% – RMB’s undervalue will not increase export MUCH. Stephen Cheung City University of Hong Kong 30

• Account Werner International Consultancy Limited – In 2000, hourly wage of textile industry in China is 0. 69 US$, 1/37 of Japan, 1/20 of US and Europe and 1/8 of Korea. For automobile industry, the China’s labor/cost per hour is 1. 7% of Japan and US Stephen Cheung City University of Hong Kong 31

2002 U. S. Goods Exports, Imports and Trade Balance, by Region Millions of dollars, on a Census basis not seasonally adjusted Total North America Western Europe Eastern Europe, Former Soviet Reps. Pacific Rim South/Central America OPEC Other countries -470, 104 -86, 962 -89, 218 -8, 283 -215, 005 -17, 902 -34, 482 -36, 367 Source: U. S. Commerce Department, February 2003 Stephen Cheung City University of Hong Kong 32

External B. Chinese cheap products export “deflation”; the main reason for global economy’s slowdown. – China’s trade, 5% of the global trade – China’s export to Japan, accounts for 2% of the Japan’s GDP – Mostly low-end products – Imported materials – Should not be responsible for the global economy’s slowdown Stephen Cheung City University of Hong Kong 33

Imports and exports of China by main countries in 2003 quarter 1 Country (Region) Dollars (billion USD) % change when compare with 2002 Quarter 1 Trade Balance Export Import Export-Import Japan 12. 70 15. 74 2. 39 5. 55 -3. 04 US 17. 66 7. 93 3. 40 3. 99 9. 73 Europe 14. 14 11. 08 4. 19 3. 84 3. 06 Hong Kong 14. 89 2. 48 2. 91 1. 50 12. 41 South East Asia 6. 14 9. 70 3. 02 6. 43 -3. 56 Korea 4. 02 9. 16 2. 80 3. 77 51. 4 Taiwan 1. 84 10. 28 4. 50 2. 18 -8. 44 Russia 1. 08 2. 18 6. 75 2. 11 -1. 10 Australia 1. 25 1. 50 3. 67 2. 19 -0. 25 Canada 1. 14 1. 02 3. 22 21. 9 1. 2 Source: Customs General Administration People’s Republic of China Stephen Cheung City University of Hong Kong 34

US productivity and related data in manufacturing, percentage changes, 1949 -2000 (percent per year) 19492000 194919731979199019952000 19992000 Productivity Multifactor productivity 1 1. 2 1. 5 -0. 6 1. 1 1. 3 2. 1 1. 9 Output per hour of all persons 2. 8 2. 6 2. 2 2. 6 3. 3 4. 0 -0. 4 0. 0 -2. 1 -0. 8 0. 6 0. 1 -1. 2 3. 3 4. 0 2. 5 2. 0 3. 1 4. 1 2. 5 Hours 2 0. 5 1. 4 0. 3 -0. 7 -0. 1 -0. 2 -1. 4 Capital services 3. 7 4. 0 4. 7 2. 8 2. 5 4. 0 3. 8 Energy 2. 7 4. 9 0. 8 0. 3 1. 8 0. 5 2. 8 Non-energy 3. 0 2. 3 6. 2 1. 7 3. 5 4. 5 0. 9 Purchased business services 2. 8 5. 1 5. 4 1. 7 3. 5 1. 0 Combined inputs 3 2. 1 2. 4 3. 1 0. 9 1. 8 2. 0 0. 7 Output per unit of capital services Sectoral output Inputs Materials Source: The Bureau of Labor Statistics of the U. S. Department of Labor Stephen Cheung City University of Hong Kong 35

Internal Reasons • Despite high economic growth, banking system is fragile, income gap, and SOEs reform a) Unemployment problem. despite high economic growth, unemployment is stills a big problem because of the population growth and surplus labor form the rural areas. The fast growth in export-related industries ease part of the problem Stephen Cheung City University of Hong Kong 36

Internal Reasons b) Fragile banking system, NPL problem, capital adequacy ratio low (international level). In 2 years, according to WTO, China will have to open the bank industry, more competition. RMB’s appreciation will worsen the problem. c) SOEs reform, in 2002, more than 30% SOEs record profit, the total was 260 billion RMB. If RMB appreciates, this will worsen the SOEs profitability Stephen Cheung City University of Hong Kong 37

2. Impacts on Chinese Economy a) Worsen the investment environment, slow down the inflow of FDI. This will encourage the inflow of hot money to speculate on the RMB’s further appreciation b) Negative impacts on under-privileged sectors, such as agricultural, mining (steel) business. Stephen Cheung City University of Hong Kong 38

2. Impacts on Chinese Economy c) Increase deflation pressure. RMB’s appreciation may increase import and decrease export. This may worsen the oversupply problem in China. d) More importantly, RMB appreciates will leads to the RMB’s exchange rate instability and expectation of further appreciation, which may cause more inflow of funds for more speculation. Stephen Cheung City University of Hong Kong 39

2. Impacts on Chinese Economy e) RMB’s appreciation may not be advantages fro US & Japan. – China’s GDP accounts for 3. 5% of global economy. – China trade accounts for 5% of global trade – During the past decade, China’s cheap products contribute to the US’s high growth rate and low inflation rate, RMS’s appreciates may increase cost of US import and inflation will return Stephen Cheung City University of Hong Kong 40

– China has been the most important US treasury securities investor. Up to June 2003, China has bought 122. 5 billion US government bonds, accounts for 1/3 of China’s reserves – China contributes to the US’s refinancing activities – Maintaining the US’s low interest rate environment – RMB’s appreciates demand for US’s securities declines Stephen Cheung City University of Hong Kong 41

2. Impacts on Chinese Economy • RMB appreciates may ease the pressure for US SMEs (manufacturing). – Bad for MNCs accounts for 54% of the China’s export. – RMB appreciates may have negative impacts on investment, purchasing and production, e. g. Walmart, China’s products accounts for 70% of its products. Stephen Cheung City University of Hong Kong 42

Short-term measures (current account) • Encourage more imports; raw materials and oil. Reduce subsidies for export industries. • Allow enterprise to keep more foreign reserves. Stephen Cheung City University of Hong Kong 43

Short-term measures (capital account) • 480 billion US$ of FDI during the past 2 decades. – For strategic areas, such as Western part of China – Encourage more hi-tech or more value-added related • QFII, restriction on short-term portfolio investment. Tobin case may be used. • Regulatory control on hot money. Stephen Cheung City University of Hong Kong 44

Conclusions • In 2003, China’s export is 38 billion US$, ranked after US & Germany. Foreign reserves exceeded 365 billion US$. How to use this reserve efficiently. • Encourage Mainland enterprises for overseas expansions. • QDII Stephen Cheung City University of Hong Kong 45

International (regional) Integration 1. Economic integration enhance cooperation in economic and trade activities among different economies. E. g. Europe, Latin America, North America and South-Ease Asia. a. Free Trade Area – Remove (most) trade barriers, e. g. tariff to promote trade among member economies, such as NAFTA, ASEAN Stephen Cheung City University of Hong Kong 46

International (regional) Integration b. Customs Union – c. Member economies are required to remove all tariff, have a unified trade policy, e. g. EC and Caribbean EC Common Market – – – No trade barriers among member economies Unified trade policy Factors of Production can move freely among members economies , e. g. EU before Euro d. Economic Union – Common market features and a single currency (EU) Stephen Cheung City University of Hong Kong 47

International (regional) Integration e. Political Union – One step further the economic integration, having one single government, e. g. U. S. A. Step-by-step Lower tariff → eliminated trade barriers → Free-flow of factors of production → Unified tariff and external trade policies → Unified currency, fiscal policy, tax, exchange, form of economic union → One single government Stephen Cheung City University of Hong Kong 48

International (regional) Integration Experiences • Win-win situation • Create more opportunities for member economies • Mobility of factor of productions, comparative advantages • Resources allocation becomes more efficient. • Better over whole economic performance Stephen Cheung City University of Hong Kong 49

HK & Mainland economic cooperation • Before CEPA – Private sector – Barriers; tariffs; bounder; little mobility on factors of production Stephen Cheung City University of Hong Kong 50

HK & Mainland economic cooperation • CEPA – No tariffs on selected products made in HK – Market access fro HK services industries – Plus telecommunication, definition of ‘HK company’ and ‘made in HK’ – Long-term goal is to open up the mainland market and to enhance free flow of factors of production • CEPA is considered to be more than NAFTA but less than EU. Stephen Cheung City University of Hong Kong 51

HK & Mainland economic cooperation • CEPA will bring long-term impacts on the Pearl Delta region 1. Individual Travel will enhance human and capital flow 2. Further infrastructure project cooperation in the region, e. g. 西部通道, 港珠澳大橋及�港澳高速 鐵路 3. RMB business 4. Macro-economic policy cooperation – Cooperation between HK & provincial governments 5. Enhance cooperation on industries – Stephen Cheung HK servicing industries, such as financial industries, high value-added manufacturing industries City University of Hong Kong 52

Hong Kong’s advantages • • • Legal System Intellectual property right protection Information system English International network Stephen Cheung City University of Hong Kong 53

Industrial structure of Hong Kong (%) Year 1980 1985 1990 1995 2000 2001 Manufacturing Industry 23. 6 22 17. 5 8. 3 5. 8 5. 2 Services industry 67. 3 69. 5 74. 4 83. 7 85. 7 86. 5 Others 9. 1 8. 5 8. 1 8 8. 5 8. 3 Source: Hong Kong Census and Statistical Department Stephen Cheung City University of Hong Kong 54

Division of Labor 1. Between Hong Kong and Pearl Delta Region a. Hong Kong – – – Stephen Cheung Product development Design Trading Logistic Management Supply chain management City University of Hong Kong 55

Division of Labor b. Pearl Delta Region – Manufacturing process – Some R&D – Purchasing Stephen Cheung City University of Hong Kong 56

Division of Labor 1. Between Hong Kong and Shanghai a. Hong Kong – – Stephen Cheung Private banking services Funds management Funds raising for enterprise Derivative instruments City University of Hong Kong 57

Comparison of economic structure in small and medium economy Primary Production Secondary Production Tertiary Production Hong Kong (2001) 0% 14% 86% Singapore (2001) 0% 33% 67% Taiwan (2000) 2% 32% 66% South Korea (2002) 4% 42% 54% Switzerland (2002) 2% 34% 64% New Zealand (1999) 9% 23% 69% Ireland (2001) 4% 36% 60% Sweden (2001) 2% 29% 69% Norway (2000) 2% 31% 67% Source: The world fact book 2002, CIA, United States Stephen Cheung City University of Hong Kong 58

Division of Labor b. Shanghai – Trade finance – Retail banking – Consumer banking Stephen Cheung City University of Hong Kong 59

• CEPA aims at promoting more mobility of FPs between Hong Kong and Mainland, to enable Hong Kong to become ‘part of Chinese economic system’. Stephen Cheung City University of Hong Kong 60

Conclusion • • • Further mobility of FPs Cross-border infrastructural projects Legal system integration Financial regulation Recognition of professional qualification Environmental and security issues Stephen Cheung City University of Hong Kong 61