The relationship between stock returns and the foreign exchange rate: the ARDL approach

Abstract

This study employs the ARDL cointegration approach in order to examine the impact of financial liberalization on the relationships between the exchange rate and share market performance in China. We discovered that cointegration has existed between the Shanghai A Share Index and the exchange rate of the renminbi against the US dollar and Hong Kong dollar since 2005, when the Chinese exchange rate regime became a flexible, managed, floating system. We found that both the exchange rate and the money supply influenced stock price, with a positive correlation. We further show that the money supply increase was largely caused by a huge ‘hot money’ inflow from other countries in recent years. After local currency appreciation, hot money, followed by the money supply increase, pushed the market into a high level, based on expectations regarding the local currency's further appreciation.

Keywords:

• share market index
• exchange rate
• ARDL cointegration
• causality
• China

JEL classifications:

• F31
• F41
• G20
• N27

Acknowledgements

We are grateful to two anonymous reviewers for constructive criticism and suggestions, which improved the paper. We are also indebted to Robert Bianchi, who helped with an early version of this paper presented at the Asian Finance Association International Conference, Brisbane, from 30 June to 3 July 2009.

Notes

1. Contrary to the public pronouncement of the Chinese authorities that the currency is a based on a currency basket, recent empirical studies suggest that the de facto regime appears to be a soft peg to the US dollar with the IMF classifies China under ‘other conventional fixed peg arrangements’. See Shah et al. (2006) and Ogawa and Sakane (2006) for empirical validation.

2. The ARDL bounds testing approach has the advantage that the critical values produced by Pesaran et al. (2001) allow for the inclusion of a mix of I(0) and I(1) variables in the cointegrating relationship. Although the Johansen ML approach can also be used with a mixture of I(0) and I(1) variables, Rahbek and Mosconi (1999) suggest that including I(0) series in a VECM can produce nuisance parameters in the asymptotic distribution of the trace for the cointegration rank. See Wickens (1996) for further concerns over the Johansen ML procedure, and Tawadros (2001) for a discussion of the difficulties in interpreting the results from this technique for the monetary model.

3. Even firms that are not internationally integrated (that is, they have a low ratio of exports and imports to total sales and a low proportion of foreign currency-denominated assets and liabilities) may be indirectly affected.

4. Fama and French (1993) found that three stock-market factors affect stock prices in the US, including an overall market factor and factors related to firm size and book-to-market equity. Using four factors (three factors in Fama and French 1993, plus a one-year return momentum factor), Carhart (1997) found that these common factors in stock returns and investment expenses almost completely explain persistence in equity mutual funds’ mean and risk-adjusted returns.

5. We are indebted to an anonymous reviewer for constructive suggestions regarding this issue.

6. However, the Chinese official foreign exchange rate uses the indirect quotation system, in which the price of the foreign currency (for example, the US dollar) is measured in units of the local currency. In this case, the exchange rate of the RMB against the US dollar is expressed as 7 yuan/US dollar. In the text, we use the Chinese official quotation system when we discuss Chinese currency appreciation.