The Theory Of Exchange Rates

Published Date: 02 Nov 2017

The theory of exchange rates has evolved rapidly in the last fifteen years, it affects the economy and our daily lives, when the U.S. dollar becomes more valuable relative to foreign currencies. The research about the foreign exchange reserve began earlier in foreign countries, and prevailed in the 1960s and 1979s. As time goes on, china has taken an important role in the Asian foreign exchange market. Recent years, its significantly huge foreign-exchange reserves attract many researchers’ attention.

In terms of factors effecting foreign exchange reserves which is from the global view, Kenen Yudin, in earlier 1965, considered several factors’ influence on the amount of foreign exchange reserves, the method used to select the variable lacks of empirical support but also hold in logic.

Heinz Robert Heller (1966) constructed the demand of reserves. Heller’s model is the beginning of cost revenue. After that period, many scholars have developed Heller’s pattern and obtained their results. He said that holding the reserves exist opportunity cost. The expression is the loss of investment benefit owing to holding reserves. When marginal cost equals to marginal proceeds, international reserve achieved the proper scope. Clark (1970) has extended Heller’s method and developed a random model considered the opportunity cost for holding foreign exchange reserves, then constructed the government utility function. He reached three aspects: first, the random error item of standard error has positive correlated between foreign exchange reserves and optimal foreign exchange reserves. Second, it has negative correlated between optimal foreign exchange reserves and marginal propensity to import. Third, the more opportunity cost for holding foreign exchange reserves, the less optimal foreign exchange reserves are.

Frenkel (1974) used cobb-douglas function to build a mathematical model of foreign exchange reserves, researched the relationship between the variables such as one country’s Import-export, the fluctuation of International payment and the requirements of foreign exchange reserves. Next, Parkin (1977) and Khan (1979) re-examine the issue and provide similar results. Giavazzi and Pagano (1988) argue that fixing the exchange rate to a hard currency will have the benefit of another country’s reputation to fight inflation through the evidence from France and Italy. Bahmani-Oskooee and Alse (1997) reveal that there is a positive relationship between foreign exchange reserves and inflation and the causal relationship between the two is bidirectional. Ho and McCauley (2006) conclude that the inflation target would be difficult to achieve due to the large scale reserve accumulation in Asian countries which may affect their monetary policy independence. Lin and Wang (2009) point out that inflation rate will rise when foreign exchange reserves increase. More recently, Haselmann and Herwartz (2010) found that the introduction of the euro made German investors invest less in national assets, but more in European and Monetary Union (EMU) and rest-of-the-world assets.

There is a wealth of research about foreign exchange reserves on developed countries, until relatively recently there have been few studies on the Chinese renminbi (RMB), although this situation has started to change because of the accession to the World Trade Organization in 2001. Through the review, some research on the same topic of the impact of swift growth of China’s foreign exchange reserves has not reached the unanimous conclusion. Based on Kelly, Michael G. (1970), consider the China government buy part foreign exchange as foreign exchange reserves if company earn foreign exchange, it indicates that the Chinese government will increase supply of RMB, and it will cause inflation. In 1995, Guobo Huang has collected the economic data about China during 1980 to 1990, He researched the international reserve scale of China by using of ECM and discovered that three interesting stuffs: first, the Chinese foreign exchange reserve has the negative correlation with import, that is when the import increased the foreign exchange reserves will reduce. Second, it has negative correlation with average propensity to import that is when the average propensity to import increased the foreign exchange reserves will reduce. Third, the Chinese government has an ability to adjust the foreign exchange reserves, but the ability will reduce without considering the Bank of China’s net foreign exchange reserves. Wu Jian (1998) combined the ratio analysis method and the factor analysis method to study the determinant of reasonable Chinese foreign exchange reserves. He assumed that the Chinese demand foreign exchange reserve consists of four aspects: foreign exchange demanded for imports, foreign exchange demanded for repaying the total foreign debt balance, exchange demanded for profits return from foreign direct investment and foreign exchange reserves demand for the country’s intervention in the foreign exchange currency market. He also established a linear equation model. The purpose of his thesis was to determine reasonable foreign exchange reserves for China, so he did not determine the equation’s parameters with time serial data or test the equation. As noted by Flood and Marion (2001), China’s reserve hoardings cannot be compared through time unless they are scaled in some way, since the economy has also been developing rapidly during the same period. Xu pointed out in 2001 that the amount of currency in circulation imposes a more notable impact on the foreign exchange reserve in the short-term than does money and quasi-money. In addition, he also found that a long-term equilibrium relationship between the average propensity to import does not exist, yet the variation of a short-term average propensity to import exerts comparatively notable negative impacts on foreign exchange reserves. The reason is that under the current foreign exchange supervision system, an increase in imports means that a country would have to sell more foreign exchange, which would result in a decrease in the volume of foreign exchange reserves that are held. Frankel (2004) has emphasized the opportunity cost of huge foreign exchange reserves and argued that China would pay foreign investors with a higher return than it earns from its investment in foreign exchange reserves. Narayan and Smyth (2004) examined the relationship between the RMB and China’s foreign exchange reserves within a cointegration and Granger causality model. This study found that in the long-term foreign exchange reserves, Granger causes the real exchange rate, while in the short run, there is no directional Granger causality to the real exchange rate. Using multiple regression analysis, Liu Yumin and Ouyang Qiuzhen(2008) concluded that the actual size of China's foreign exchange reserve had been more than modest size since 2001. Based on the Agarwal model, Yuan Fang (2009) said that China’s foreign exchange reserve was insufficient from 1990 to 1996, and it was appropriate from 1997 to 2001, and it had become excessive after 2002.

Based on the previous researches, We proceed in three stages. The next section considers the choice of the variables, which is essential for implementing the regression. We choice the six factors( import, gaps between import and export, FDI used, current account, foreign debt balance, foreign exchange rate)based on exchange rate, international trade and fund utilization rate. Then we make hypothesis and run regressions of the six factors, uses t-ratio to examine whether the variables are significant and have the right signs. At last, we remain three factors-import, foreign debt balance and foreign exchange rate.

We can see that China's foreign exchange reserve is mainly allocated in dollar assets, the proportions o f Euro and other currencies are relatively small. The continuing weakness of dollar leads to a direct devaluation of dollar assets. Under this background, it’s necessary to improve our structure of reserve currencies. From above research achievements about foreign exchange reserves structure in domestic and abroad, we choose six of the main factors according to three aspects. This would be introduced in the following part.