Hot Money Inflows and Renminbi Revaluation Pressure

Abstract

Despite a series of revaluations, which started in July 2005, hot money has been sporadically sneaking into China in anticipation of further revaluations of the renminbi. In this paper we build a monetary model to show how anticipated revaluations lead to the instability of a pegged exchange rate regime. This model assumes current account convertibility and some degree of capital control, and fundamentally sound domestic policies and economy, as is the case in China. The model demonstrates that market-oriented interest rates can act as an automatic stabilizer to ease revaluation pressures, but cannot resolve them completely because the nominal interest rate has a zero nominal bound. Therefore, the official parity is difficult to defend and the revaluation expectations can be self-fulfilling, in the absence of external intervention. The empirical results of Granger causality tests are consistent with the main findings of our theoretical model. There are a number of policy intervention measures that can extend the life of a pegged exchange rate regime.

Keywords:

• Hot money
• renminbi revaluation
• pegged exchange rate regime
• government intervention

Keywords:

• JEL CLASSIFICATION: E58
• F31

Acknowledgements

The authors are grateful for the useful suggestions and comments from Zhichao Zhang, Xiaming Liu, Haiyan Song, Wensheng Peng, Shu-ki Tsang, Joseph Fung, Yingqi Wei, Liping He, Yi Yuan, Kangda Rao, and workshop and conference participants of Hong Kong Monetary Authority, Xiamen University, East China Normal University, Shanghai, and Central University of Finance and Economics, Beijing. This research was supported in part by a Competitive Earmarked Research Grant (No. LU3409/06H) from the RGC of Hong Kong SAR Government, a research grant from Lingnan University, Hong Kong (No. DR06A3), and the National Philosophy and Social Science Research Foundation of China (05BJL056). However, the authors are responsible for any remaining errors.

Notes

Note

¹In the first-generation model of currency crisis (Flood & Garber, 1984; Krugman, 1979), it assumes that domestic credit increases with the rise of fiscal deficits; currency crisis is triggered by improper domestic policies. The model in this paper is different from the first generation model in this point.