Capital Controls and the Volatility of the Renminbi Covered Interest Deviation
48 Pages Posted: 3 Dec 2019
Date Written: November 18, 2019
Abstract: We examine how China’s capital controls affect the volatility of the renminbi (RMB) covered interest deviation (CID). We find that capital controls not only drive up the level of the RMB CID, but also cause the CID to be more volatile, highlighting the tradeoff between the role of capital controls in maintaining financial stability and hindering financial market efficiency. We also find that capital controls result in greater CID volatility in more liberalized RMB exchange regimes. Furthermore, we decompose CID into the interest rate differential (IRD) and forward premium (FP) and find that capital controls normally amplify the volatility of both. However, during the Federal Reserve Bank’s quantitative ease era, capital controls mitigated the volatility of the IRD. Finally, using an error correction model, which enables us to study the association of capital controls with both long-run and short-run volatility simultaneously, we find that, while capital controls increase both the long- and short-run volatility of the IRD and the CID overall, they do not affect FP volatility.
Keywords: Capital controls, Covered interest deviation, CID volatility, Interest rate differential, RMB forward premium
JEL Classification: E43, F31, G15
Suggested Citation: Suggested Citation