*Corresponding author Keywords: CNH, Currency Intervention Index, Central Bank Reaction Function, Exchange Rate Intervention.

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1 016 3rd Inernaional Conference on Advanced Educaion and Managemen (ICAEM 016) ISBN: Exchange Rae Inervenion by Cenral Bank: Based on he Influence of he Hong Kong Offshore RMB Exchange Rae Jia-Jia YAN 1,a, Yi-Hong SU 1,b,*, Wen-Ting XIN 1,c and Jin-Le LIN,d 1 School of Economics and Managemen, Fuzhou Universiy, Fujian Province, China Fylde College, Lancaser Universiy, Lancashire, England a @qq.com, b @qq.com, c @qq.com, d Lin @gmali.com *Corresponding auhor Keywords: CNH, Currency Inervenion Index, Cenral Bank Reacion Funcion, Exchange Rae Inervenion. Absrac. We calculae exchange inervenion index o reflec he open marke operaion of cenral bank, inroduce he Hong Kong's offshore RMB exchange rae (CNH) o esablish Cenral bank reacion funcion and furher analyze he influence ha CNH has on he exchange inervenion aciviies of China's Cenral Bank. We discover ha he influence is no quie eviden due o he insufficien developmen of financial marke. Thus, we sudy he relaionship beween offshore Deusche Mark rae and he exchange inervenion of Deusche Bundesbank on he basis ha Mark has been compleed he whole developmen of inernaional currency offshore marke. Inroducion In he early 1s cenury, China has promoed RMB inernaionalizaion o relieve he negaive influence of excessive reliance on USD. Inroducing Hong Kong offshore RMB exchange rae (CNH) is a criical sep of revoluion. Based on he experience of inernaional currency, he offshore RMB exchange rae mus have a srong co-movemen effec on onshore RMB exchange rae (CNY) so ha he exchange rae inervenion by China's Cenral Bank will be more difficul o be carried ou due o weaker effeciveness. However, mos exising researches only analyze he co-movemen beween CNH and CNY from he perspecive of he pricing of exchange rae in he spor marke and he resuls are differen. Depending on he previous researches, i can be discovered ha he offshore RMB exchange rae will generae a more eviden influence on he onshore rae and will evenually make a huge influence on he exchange rae policy by cenral bank. Alhough he exchange rae inervenion is a criical mehod used by cenral bank, lieraure seldom focused on he influence ha CHN could bring. The Model Wih he developmen of economic inegraion, he connecion beween differen foreign exchange markes becomes increasingly igher. Accordingly, we buil up he cenral bank's reacion funcion which includes onshore and offshore exchange raes o analyze he influence of offshore exchange rae on inervenion. In addiion, since cenral bank's exchange rae inervenion is normally disurbed by he former behavior so he exchange rae inervenion from he former period is also considered ino he reacion funcion. The reacion funcion model is as Eq. (1). I measures he open marke on operaion. 0 is a consan. e is he flucuaion of he onshore exchange rae. off e is he flucuaion of he offshore exchange rae. I -1 is he lagged exchange rae inervenion. is he disurbing erm. on off I e e I (1)

2 Empirical Tes Monhly daa from Augus, 010 o December, 013 are used o build he reacion funcion o sudy he influence from CNH on he exchange rae inervenion policy of Chinese cenral bank. The esimaing Eq. is as Eq. (). C cny C C absi c c * abse c * abse absi () cny abs e, abse are absolue values of log reurn of onshore, offshore exchange raes. CNH exchange rae is from Bloomberg and calculaed by he mean value o ransform daily daa ino C C monhly daa. absi is absolue value of exchange rae inervenion index. absi is he lagged absolue value of exchange rae inervenion index. We refer o Weymark's exchange rae pressure index module (1995, 1997) by esing exchange rae inervenion index o reflec he cenral bank's operaions in he open marke. Exchange rae inervenion rae index regards foreign exchange marke pressure as he cenral concep. The definiion of EMP was firs published by Giron and Roper (1977). They defined EMP (he Eq. (3)) as unbalance in he foreign exchange marke which mus be eliminaed by foreign reserves or he change of exchange rae. Weymark (1995, 1997) believes his definiion depends on a highly resriced currency module and herefore menions ha he pressure in he foreign exchange marke should generally represen as he excessive demand of one currency in he inernaional marke under he paricipaion of curren exchange rae policy. EMP e r (3) e is he change raio of he exchange rae by direc quoaion, e e e r ( r r ) / B *100. B ln( / ). r is he change raio of foreign reserves, 1 1 is he moneary base lagged for one period of ime. r is foreign reserves. e / r is he elasic coefficien of exchange rae on foreign reserves. Weymark defined exchange rae inervenion index as Eq. (4). r r (4) EMP 1 e r We assume ha foreign ineres rae, price level and inernal producion are all exogenesis. PPP makes sense in he long erm. The freedom of capial flows is prohibied and here is incomplee subsiue of inernal and exernal capials, which ensures he inervenion by cenral bank. Accordingly, China s macro-economy model is buil up as Eq. (5)- (10). m y i p (5) d m 1 p a p e (6) * p 0 1 i i E[ e ]-e (7) * 1 m d r (8) s r e (9) s d m m (10) d m Eq. (5) is he money demand funcion, which represens ha he nominal money demand is deermined by he domesic oupu y, he domesic ineres rae i and he domesic price level m p. is he random erm. Real money demand is divided ino wo caegories, including ransacional and speculaive demand, in which he former one is he increasing funcion of income and he laer one is a decreasing funcion of ineres rae.

3 Eq. (6) is he price equaion, in which he exchange rae is deermined by he domesic price * and he curren foreign price p according o PPP. Since China applies he managed floaing exchange rae sysem, in he shor erm domesic price level is influenced by he curren exchange rae level e and he curren foreign price. PPP holds in he long run, ha is, a0 0,, a1 a 1 p bu in he shor run PPP does no necessarily hold. is he random erm. Eq. (7) is ineres rae equaion. Currenly, he domesic capial marke is no compleely opened and here is raher sric conrol over shor-erm capial flows, which lead o difference in he domesic and foreign ineres raes. Therefore, o a cerain exen, he increase in he domesic ineres rae i * aracs foreign capial inflows, and hus make currency appreciaed. i is foreign ineres raes. indicaes an exogenous risk premium. s Eq. (8) reflecs he change in money supply m is deermined by he changes of ne domesic credi d and foreign reserves r. Define d ( d d 1) / B 1, in which d is he curren domesic credi amoun and B is lag of basic money. Eq. (9) is he response funcion of he cenral bank o exchange rae changes. The greaer he coefficien is, he higher he degree of inervenion is. Eq. (10) shows ha he change of money demand and money supply are he same. All above variables are in logarihmic form. Based on he above equaions, we assume ha he risk premium kr k e, in which k is he coefficien of serilizaion and hen we ge he exchange rae inervenion index as Eq. (11). r r (11) 1 e r e r (1 k) From he above model, o esimae exchange rae inervenion index is o esimae which depends on he parameers k,,. According o Eq. (5) and (6), and are 0.43 and 0.983, respecively. Because =-1.64 and k 0.8 (Tang, 01), he exchange rae inervenion index can be obained. In order o eliminae he effec of ouliers, he exchange rae inervenion index is limied in he range of (-1, 1.5), shown in Figure 1. The mean value before he exchange rae reform was 1 and afer he reform he mean value became , which indicaes ha he degree of inervenion afer he reform has declined. However, affeced by he 008 subprime crisis, he cenral bank once again srenghened inervenion in he foreign exchange marke. Wih he improvemen of he economic siuaion and he promoion of he second exchange rae reform, he cenral bank reduced inervenion o some exen and RMB appreciaed a lile bi. Afer 011, he cenral bank inervenion showed differen characerisics. From Sepember 011 o Ocober 01, here were eigh overshooing, 6 of which were under he depreciaion pressure and semmed from he negaive growh of foreign reserves. p Figure 1. Exchange Rae Inervenion Index.

4 abse abs e The influence of CNH on China's cenral bank exchange rae inervenion. The resuls of saionary es show ha all variables are I(0). The olerance coefficiens of onshore and offshore cny exchange raes e and e is We firs se up he response funcion of he cenral bank o he onshore foreign exchange marke, and hen inroduce he offshore exchange rae o sudy he inervenion behavior. The lagged exchange rae inervenion index in each case had no significan effec on he curren inervenion index, so i was removed from he reacion funcion. In he sample, cny he coefficien of abse is significan, and ha of CNH is no. Furhermore, we inroduce he onshore exchange rae hreshold model and CNH o es he inervenion behavior under appreciaion and depreciaion respecively. The resuls show ha he exchange rae flucuaion causes he cenral bank o inervene in he onshore marke, and he reacion mechanism is no he same under appreciaion and depreciaion. In he case of appreciaion, he exchange rae flucuaion increases he negaive impac on he cenral bank's inervenion, and i does no significanly affec inervenion under depreciaion. The response coefficiens of he offshore exchange rae are no significan in all cases, which shows ha here is no significan relaionship beween he curren offshore exchange rae flucuaion and he cenral bank's exchange rae inervenion behavior. Experience from German Cenral Bank As we menioned above, he influence of he offshore RMB exchange rae marke on he onshore marke has no ye been evidenly shown. In addiion, because of lack of daa, we fail o furher analyze he dynamic changes in he cenral bank's exchange rae inervenion. Therefore, we use Deusch Mark for example which wen hrough complee developmen of he inernaional currency, in order o observe he differen influences from he offshore exchange marke on he cenral bank s inervenion in each developmen sage. Because he Eurodollar marke and he German domesic foreign exchange marke are highly synchronized, we use he New York foreign exchange marke as he Mark exchange rae. We use daily daa of exchange rae inervenion from December 1, 1981 o December 31, 1995 and he onshore and offshore exchange rae daa are from Frankfur and New York markes respecively. The German cenral bank's inervenion funcion is as Eq. (1). NY US absi 0 1absr 1 abs5 1 3absr 1 4absI 1 5absI 1 (1) In order o compare wih China, we also ake he absolue value of he variables in he German US cenral bank's reacion funcion. Among hem, absi ( absi ) are he absolue values of he open NY marke operaions of German and USA cenral banks. absr ( absr ) are he onshore (offshore) GM exchange reurn raes, which represen he shor-erm goal of cenral bank's inervenion. 4 1 abs5 abs s s i is he 5-day moving average in he Frankfur exchange marke, 5 i0 which presens he mid-erm goal of cenral bank's inervenion. Table 1 shows ha all explanaory variables are significanly less han 0.8, consisen wih he modeling requiremens of muliple linear regression models. Variable absr Table 1. Tolerance Coefficiens. NY absr abs 5 I Coeffici en We divide he whole sample ino wo sages, he iniial sage ( ~ ) and he prosper sage ( ~ ). Table shows ha in he iniial sage of he offshore marke, he offshore exchange rae flucuaion does no affec he behavior of he cenral bank's inervenion, US I

5 bu wih he growh of he offshore marke, he influence will become more significan. Table. German's cenral bank. Variables Sample 1 Sample ~ ~ (Inercep) 5.14 ** (.375) (-0.5) 1 ( absr ) -419 *** (-3.14) (-1.041) ( abs5 ) *** 47.6 *** (4.089) (5.710) NY 3 ( absr ) * (0.411) (1.867) 4 ( absi ) *** *** (1.514) (8.131) US 5 ( absi ) *** 0.3 *** (.401) (7.581) Sample Number R F 51.7 *** 60.6 *** Noe: *, **, *** mean being significan a 10%, 5% and 1% significan level, respecively. German experience and China's fuure. Germany began o accelerae he process of inernaionalizaion in he 1980s and he economic siuaion in ha period was similar o China, which is of grea imporance for RMB inernaionalizaion. Firs of all, he naure of he offshore marke - IBF is he same as he offshore RMB marke - Hong Kong, which ensures he consisency of he naure of he wo markes. In order o faciliae he non-residens o carry ou financial ransacions in he offshore currency, moneary auhoriies can choose o develop offshore financial markes in own counry or overseas. For, IBF is buil overseas and he naure is similar o he offshore RMB marke in Hong Kong. Secondly, in order o promoe he currency inernaionalizaion and he developmen of he offshore marke, Germany and China have ime synchronizaion. Thirdly, in he iniial sage of inernaionalizaion, Germany ranked highly according o inernaional rade, which is similar o he curren siuaion in China. I is an imporan approach o promoe inernaionalizaion by using currency in inernaional rade in he iniial sage. From 1980 o 1998 Germany ranked second in expor and China ranked second afer 009. Lasly, he offshore is he only currency which has experienced a complee process of he inernaional currency offshore marke and has made grea achievemen. In summary, i can be prediced ha in he iniial sage of he offshore RMB marke, he impac on he cenral bank's inervenion only comes from he onshore raher han offshore exchange rae flucuaion. However, wih he furher developmen of he offshore marke, he offshore exchange rae flucuaion will have a subsanial impac on he cenral bank's inervenion which may be even more remarkable han he impac from he onshore flucuaion. Conclusion We build up a cenral bank reacion funcion o sudy he effec ha CNH has on he exchange rae inervenion. Exchange rae inervenion index shows ha China's cenral bank carries ou a mighy inervenion policy on he exchange marke. Using monhly daa from Augus 010 o December 013, we find ou ha CNY raher han CNH has a significan influence on he exchange rae inervenion. Because he offshore RMB marke in Hong Kong has jus begun, we refer o he

6 experience from Germany o predic he fuure in China. We conclude ha i is advisable o furher expand RMB ouflow o large he scale of offshore RMB. Wih he furher developmen of he offshore RMB marke, CNH will have a subsanial influence on he cenral bank's inervenion. References [1] Weymark D N. Esimaing exchange marke pressure and he degree of exchange marke inervenion for Canada[J]. Journal of Inernaional Economics, 1995, 39(3): [] Weymark D N. Measuring he degree of exchange marke inervenion in a small open economy[j]. Journal of Inernaional Money and Finance, 1997, 16(1): [3] Giron L, Roper D. A moneary model of exchange marke pressure applied o he poswar Canadian experience[j]. The American Economic Review, 1977:

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