CURRENCY CONVERTIBILITY AND LINKAGE BETWEEN CHINESE OFFICIAL AND SWAP MARKET EXCHANGE RATES

DAVID J. LEATHAM [*] This article investigates the impact of currency convertibility under the current account on the informational linkage between official and swap market exchange rates for Chinese currency (renminbi). Findings indicate that currency convertibility increased the informational connection between the government's official exchange rate and the swap market exchange rate, exclusively traded by foreign investors, and thus improved the information content of renminbi exchange rates. Moreover, the results also suggest that more complete currency convertibility was needed for more informed renminbi exchange rates. (JEL F31, F32, G14, G15) I. INTRODUCTION After unifying the dual exchange rates of the Chinese currency renminbi (RMB) and implementing a managed-float system on January 1, 1994, China formally committed itself to partial currency convertibility, that is, currency convertibility under the current account, in December 1996. Partial currency convertibility means that any domestic or foreign agent in China has the right to convert freely the domestic currency into a foreign currency at the official exchange rate to complete a current account transaction. A current account transaction is typically the purchase of goods or services from abroad, including the remittance of profits earned on direct investment. Partial currency convertibility is partial in its nature in that it does not permit conversion of the domestic currency into a foreign currency for the purpose of a capital account transaction, such as capital exporting. However, partial currency convertibility was an unprecedented step in the liberalization of China's foreign exchange system. It sh ould have significant effects on China's foreign exchange market performance. Little empirical work has been done previously to examine how currency convertibility affects performance of financial markets in developing countries. This article addresses the impact of partial currency convertibility on the informational efficiency of Chinese foreign exchange markets. Specifically, this article empirically investigates the informational linkage between official and swap market exchange rates in China before and after partial currency convertibility was implemented. The RMB official exchange rates were based on rates of the interbank market where Chinese firms made their foreign exchange transactions during the study period. Hence, official exchange rates over the sample period depended primarily on domestic transactions. In contrast, swap markets were foreign exchange markets traded exclusively by foreign-invested enterprises (FIEs) in China during the study period, though FIEs could also get access to the interbank market after China allowed partial currency convertibility. Thus, swap m arket exchange rates reflect information provided by foreign investors. The underlying assumption is that Chinese domestic investors and foreign investors on the foreign exchange markets may have differential access to information if they are legally separated in two completely segmented markets. The existence of information asymmetry (i.e., different information sets) on values of domestic assets between foreign investors and domestic investors has been well recognized in finance literature (Kang and Stulz, 1996; Brennan and Cao, 1997). However, the issue of whether foreign investors have more information than domestic investors is controversial. The controversy also applies to studies on Chinese stock markets (i.e., A shares and B shares markets), which was characteristic of complete market segmentation, and similar to the Chinese foreign exchange markets before partial currency convertibility. Chui and Kwok (1998) argue that foreign investors may be better informed than Chinese domestic investors about the value of financial assets, because of the Chinese government's control of mass media and the more advanced technology for processing and analyzing information by foreign investors. …