A Simple Explanation of Biased Movements of Renminbi Exchange Rate
International Journal of Financial Engineering, Vol. 05, No. 04, 1850040 (2018)
18 Pages Posted: 8 Jan 2019 Last revised: 20 Jan 2019
Date Written: December 26, 2018
The central parity of the renminbi is determined by the closing rate on the previous day according to the central parity formation mechanism following the August 2015 reform. This paper develops a simple model to study how this mechanism affects the currency’s exchange rate dynamics. The central parity is shown to be under monotonic decay or growth conditional on its rate relative to the expected exchange rate determined by a generic stochastic process. Such dynamics requires the central bank to engage in vigorous intra-marginal intervention to halt currency depreciation (or appreciation). Such upward (or downward) bias will disappear if a randomizing factor subject to market conditions is incorporated into the mechanism. The analysis is consistent with the observations in the renminbi foreign exchange market, and the theories and results in the previous studies on target zones.
Keywords: China’s exchange rate policy, renminbi, target zones, stochastics
JEL Classification: F31, G13
Suggested Citation: Suggested Citation