Convertibility Restriction Determination in China’s Foreign Exchange Market and its Impact on Forward Pricing
Different from the well established markets such as the dollar-Euro market, recent CIP
deviations observed in the onshore dollar-RMB forward market were caused by
conversion restrictions in the spot market rather than changes in credit risk and/or
liquidity constraint. This paper proposes a theoretical framework under which the
Chinese authorities impose conversion restrictions in the spot market in an attempt to
achieve capital flow balance, but faces the tradeoff between achieving such balance and
disturbing current account transactions when determining the level of conversion
restriction. Such conversion restriction in turn places a binding constraint on forward
traders’ ability to cover their forward positions, resulting in the observed CIP deviation.
More particularly, the model predicts that onshore forward rate is equal to a weighted
average of CIP-implied forward rate and the market’s expectation of future spot rate,
with the weight determined by the level of conversion restriction. As a secondary result,
the model also implies that offshore non-deliverable forwards reflect to the market’s
expectation of future spot rate. Empirical results are consistent with these predictions.