PROOF COVER SHEET Journal acronym: Author(s): Article title: Article no: Enclosures: RAEL Jie Li A monetary approach to the exchange market pressure index under capital control 624079 1) Query sheet 2) Article proofs Dear Author, 1. Please check these proofs carefully. It is the responsibility of the corresponding author to check these and approve or amend them. A second proof is not normally provided. Taylor & Francis cannot be held responsible for uncorrected errors, even if introduced during the production process. Once your corrections have been added to the article, it will be considered ready for publication. For detailed guidance on how to check your proofs, please see http://journalauthors.tandf.co.uk/production/checkingproofs.asp. 2. Please review the table of contributors below and confirm that the first and last names are structured correctly and that the authors are listed in the correct order of contribution. 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AQ4 Please provide the working paper number for ‘‘Aizenman et al. 2010’’. AQ5 Please provide the page number for ‘‘Eichengreen et al. 1994’’. AQ6 Please provide the volume number for the reference ‘‘Liu (2004)’’. AQ7 Please provide the volume & page number for the reference ‘‘Spolander 1999’’ if applicable AQ8 Please specify the University name and the place for ‘‘Tijmen et al. 2008’’. C/e: AA C/e QA: SM Applied Economics Letters, 2011, 00, 1–5 A monetary approach to the exchange market pressure index under capital control Jie Li AQ2 AQ1 5 10 15 20 Chinese Academy of Finance and Development, Central University of Finance and Economics, 39, Xueyuan Nan Lu Road, Haidian, Beijing 100081, PR China E-mail: [email protected] The conventional Exchange Market Pressure Index (EMPI), originated from Girton and Roper (1977) and popularized by Eichengreen et al. (1994, 1995) and Weymark (1995), uses weighted average of loss of foreign reserves and depreciation of local currency to capture foreign exchange market pressure. However, it does not take into account the effect of capital control on foreign exchange market pressure. With effective capital control, the conventional EMPI tends to under- or overestimate the actual foreign exchange market pressure, depending on the magnitude of capital control. We adopt a monetary approach to derive a formula for new EMPI under capital control. Then we test the difference between the old and the new EMPI with China’s data. The result shows that the conventional EMPI overestimates the actual foreign exchange market pressure by 91% in average. Keywords: exchange market pressure; capital control; monetary model JEL Classification: F31; F32; G15 I. Introduction 25 30 35 With the rapid progress of globalization and financial liberalization, currency crises hit the world often. To empirically investigate the causes of crises, we need to measure them well. In their pioneering study, Girton and Roper (1977) proposed the definition of foreign exchange market pressure, combining the changes in exchange rates and foreign exchange reserves. Weymark (1995) revised the Girton and Roper’s definition of the exchange market pressures and proposed a general definition of exchange market pressure, a country’s excess money demand under the current exchange rate policy. Eichengreen et al. (1994, 1995) popularized the practical use of Exchange Market Pressure Index (EMPI) by introducing precisionweighting scheme to average loss of foreign reserves and depreciation of domestic currency. They successfully avoided the use of structural parameters of economy when calculating EMPI, which makes possible the computation of EMPI for a large set of countries. Since then, EMPI becomes the standard index for measuring the severity of foreign exchange market pressure. However, EMPI does not take into account the effect of capital control on foreign exchange market pressure. Without doing so, EMPI tends to under- or overestimate the actual market pressure. For an example, during financial market turmoil, a monetary authority may close down its foreign exchange market for the time being, which eliminates possibility of losing more reserve holdings and depreciation. EMPI, averaging the loss of reserves and depreciation, cannot capture the actual magnitude how the market would have reacted without capital control. Applied Economics Letters ISSN 1350–4851 print/ISSN 1466–4291 online # 2011 Taylor & Francis http://www.tandfonline.com http://dx.doi.org/10.1080/13504851.2011.624079 1 40 45 50 55 J. Li 2 60 65 70 We try to fill the gap by incorporating capital control into a simple monetary model setting and derive a new EMPI which better reflects the actual magnitude of foreign exchange market pressure. We test our new EMPI with simulated data and confirm that the introduction of capital control does improve the accuracy of estimating exchange market pressure. In addition, we experiment the application of new EMPI with China’s data and find that the old EMPI overestimates the actual exchange market pressure by 91% in average. The rest of the article is organized as follows: Section II reviews some related literature. Section III lays out a simple monetary model and derives a formula for the new EMPI, then we run an experiment with China’s data. Section IV concludes. II. Related Literature 75 80 85 90 95 100 105 Girton and Roper (1977) first used the monetary approach to analyse the Canadian exchange market pressure and focused on the question that how much pressure Canadian authority will suffer, keeping the fixed exchange rate regime. Connolly and Dantas da Silveira (1979) applied the theoretical model of Girton and Roper for the case in Brazil during the period of 1955 to 1975. Modeste (1981) adopted a similar monetary model to test Argentina exchange market pressure in 1970s. Kim (1985) derived the theoretical model of exchange market pressure in South Korea, featured by managed floating exchange rate system and small open export-oriented economic characteristics. Weymark (1995) established an EMPI based on rational expectation and small open economy monetary model with the intervention of the central bank. Through this model, she measured the bi-and multilateral intervention for the Canadian Central Bank during 1975–1990. Based on Weymark (1995), Spolander (1999) estimated the exchange market pressure and the intervention of the Finland Central Bank during the period of implementing managed-float regime. Stavarek (2007) applied Spolander’s methodology to four European countries (Czech Republic, Hungary, Slovakia and Poland) during the period of 1993 to 2005. Pentecost et al. (2001) used the principal component analysis to construct a measure of the exchange market pressure. They estimated the exchange market pressure of German Mark in five members in the European exchange rate mechanism. Tijmen et al. (2008) argued that the traditional measure of 1 exchange market pressures has defects that their measurement does not include the definition of exchange market pressures under different conditions.1 III. A Simple Monetary Model The model used in this section is built on a simple monetary setting for a small open economy with capital control. Domestic output and the foreign price level are assumed to be exogenous. 110 The model This model is extended from Waymark (1995). 115 mdt ¼ pt þ b1 yt b2 it þ vt ð1Þ pt ¼ a0 þ a1 pt þ a2 et ð2Þ mst ¼ dt þ rt ð3Þ rt ¼ rt et ð4Þ it it ¼ lt ðEst etþ1 et Þ ð5Þ where asterisks denote the variables in foreign countries and Et is the rational expectation operator at time t. mt is the logarithm of the money stock in period t with the superscript s and d denoting supply and demand, respectively. pt is the logarithm of the domestic price level in period t. yt is the logarithm of real domestic output in period t. it is the logarithm of the domestic interest rate level in period t. vt is the stochastic money demand disturbance in period t. et is the logarithm of the period t exchange rate expressed as the domestic currency cost of one unit of foreign currency. t1 Dt1 dt ¼ ht Dt h , where ht is the money multiplier Mt1 in period t and Dt is the stock of the domestic credit. t1 Rt1 rt ¼ ht Rt h , where Rt is the stock of foreign Mt1 exchange reserves in period t. t is the policy authority’s time-variant response r coefficient. lt is the measure for capital control. lt is greater than 0. If there is no capital control, lt equals 1 and Uncovered Interest Parity (UIP) holds. Another large strand of the literature focuses on the relationship between the authority reaction and exchange market pressure; see Aizenman and Hutchison (2010) among others for different applications. 120 125 130 135 140 AQ3 EMPI under capital control 145 150 155 3 Equation 1 is the standard money demand function for a small open economy. The money demand is positively related with domestic price (pt) and domestic output (yt), negatively related with domestic interest rate (it). Equation 2 characterizes the movement of domestic price that is determined by foreign price ðpt Þ and exchange rates (et). This characterization allows the domestic economy to deviate from Purchasing Power Parity (PPP). Nevertheless, it reduces to PPP when a0 ¼ 0, and a1 ¼ a2 ¼ 1. Equation 3 is the usual representation of changes of monetary base, consisting of changes in domestic credit and foreign reserves. Equation 4 is the monetary authority’s policy response function, reflecting its preference in exchange market intervention. Under a pure float exchange rate regime with rt ¼ 0, the monetary authority refrains from intervention, letting exchange rate (et) to fluctuate while keeping constant foreign reserves ðrt ¼ 0Þ. too small), or on future capital inflows (domestic currency is expected to be overdepreciated or Et etþ1 is too large). When lt ¼ 1, the interest rate spread is exactly offset by expected future depreciation, leading to UIP. With UIP, the model condenses to Weymark (1995). Combining Equations 1, 2 and 5 yields mdt ¼ a0 þ a1 pt þ a2 et þ b1 yt b2 ½lt ðEt etþ1 et Þ þ it þ vt ð6Þ In money market equilibrium, we have mdt ¼ mst 195 200 ð7Þ From Equation 3, 4, 6 and 7, we can get the following: 160 et ¼ rt b2 lt ðEt etþ1 Þ dt þ a1 pt þ b1 yt b2 it þ vt a2 þ b2 lt ð8Þ 165 170 175 180 185 190 With rt ¼ 1, the monetary authority intervenes exchange market at all times keeping exchange rate constant. rt falls between 0 and 1, indicating that the small open economy adopts an intermediate exchange rate regime. The introduction of lt in Equation 5 allows us to incorporate capital control,2 the common practice of an emerging/developing country in the real world, into consideration of capital flows across borders. When lt >1, the positive interest rate spread between domestic and foreign country cannot be fully explained by expected depreciation of domestic currency. This may be due to the existence of two kinds of capital controls. First, current capital inflows are restricted to the extent that the current domestic exchange rate (et) does not appreciate enough. In another word, et is greater than it would have been without capital controls. Second, due to restrictions on capital outflows in the future, the expected future depreciation ðEt etþ1 Þ is not big enough. The combination of controls in current inflows and future outflows may aggravate the deviation from UIP, leading to a higher value of lt. When 0<lt <1, the positive interest rate spread is overcompensated by expected depreciation of domestic currency, indicating restrictions on current capital outflows (domestic currency is overappreciated or et is 2 In Equation 8, the exogenous disturbances to the economy are changes in the foreign price level pt , changes in the level of domestic output yt , changes in the foreign interest rate level it and changes in the domestic credit dt and random money demand shock vt . Rewrite Equation 7 as et ¼ rt þ Wt 205 ð9Þ where ¼ ða2 þ b2 lt Þ1 and Wt ¼ b2 lt ðEt etþ1 Þ þ dt a1 pt b1 yt b2 it vt : ¼ @et =@ rt ¼ ða2 þ b2 lt Þ1 is the elasticity that converts observed reserve changes into equivalent exchange rate units while keeping money market equilibrium. And Wt represents the combination of factors other than reserves that influence the change of exchange rates in money market equilibrium. 210 215 Definition of EMPI According to Weymark (1995), Exchange market pressure measures the total excess demand for a currency in international markets as the exchange rate change that Instead of the multiplicative form of right-hand side of Equation 5, some interpret it as risk premium using additive form. See Chinn and Meredith (2005) for applications. 220 J. Li 4 8.00 Old EMPI New EMPI 6.00 4.00 2.00 Feb-08 Aug-08 Feb-07 Aug-07 Feb-06 Aug-06 Feb-05 Aug-05 Aug-04 Feb-04 Feb-03 Aug-03 Aug-02 Feb-02 Aug-01 Feb-01 −4.00 Aug-00 −2.00 Feb-00 − −6.00 −8.00 −10.00 −12.00 Fig. 1. Comparison of the old and new EMPI for China from January 2000 to December 2008 would have been required to remove this excess demand in the absence of exchange market intervention, given the expectations generated by the exchange rate policy actually implemented. 225 EMPI is thus defined as EMPIt ¼ et þ Rt 230 235 240 ð10Þ The first part of right-hand side of Equation 10 captures the magnitude of exchange rate changes and the second part measures the foreign exchange market intervention by a monetary authority. While this general formula is the same with Weymark (1995), the derivation of differentiates our model from her’s. The following are the EMPI in Weymark (1995) without capital control and our new EMPI with capital control. EMPIt ¼ et ða2 þ b2 Þ1 rt ð11Þ EMPIt ¼ et ða2 þ b2 lt Þ1 rt ð12Þ A simple comparison of Equations 11 and 12 tells us that in a world of capital control, particularly in emerging/developing countries, the traditional EMPI tends to overestimate actual exchange market pressure when lt >1 and underestimate it when 0<lt <1. An experiment of the new EMPI in China 245 To test for the difference between the new EMPI and the old one, we apply our method to China’s data from year 2000 to 2008.3 For simulating the new EMPI, we need structural parameters of China’s money demand function and PPP. Dai (2000) estimated China’s money demand function. The empirical results show that estimated 3 b2 ¼ 0:179, while Liu (2004) obtained a2 ¼ 0:781 by estimating China’s PPP. As shown in Fig. 1 in the presence of capital controls, the old EMPI may not reflect the actual pressure in the foreign exchange market. The simulation above shows that, without taking into account capital control, the old EMPI overestimates China’s exchange market pressure from January 2001 to December 2008 by 91% in average. 250 255 IV. Conclusion In this article, we construct a new EMPI through a simple monetary model, taking into account capital control. We find that the old EMPI overestimates China’s exchange market pressure by 91% in average from year 2000 to year 2008. Our new index better reflects the actual exchange market pressure with capital control. 260 265 Acknowledgements Excellent research assistance by Zhongyuan Yuan and Shuzhan Zhou is greatly appreciated. The author would like to thank Thomas Willett, Barry Eichengreen, Ramkishen Rajan, Alice Ouyang and Liqing Zhang for sharing their insights. The author is also grateful for the comments from the participants of the fifth and sixth annual conferences of Asia–Pacific Economic Association, and the 84th annual conference of Western Economic Association. Financial support from the China National Social Science Fund (11CJL037) is greatly acknowledged. All errors remain the author’s. The capital control index from Chinn and Ito (2008) is updated until year 2008. 270 275 EMPI under capital control References AQ4 280 285 290 295 AQ5 300 305 Aizenman, J. and Hutchison, M. (2010) Exchange market pressure and absorption by international reserves: emerging markets and fear of reserve loss during the 2008–09 crisis, Department Working Paper, SCIIE, Santa Cruz, CA. Chinn, M. D. and Ito, H. (2008) A new measure of financial openness, Journal of Comparative Policy Analysis, 10, 309–22. Chinn, M. D. and Meredith, G. (2005) Testing uncovered interest parity at short and long horizons during the post-Bretton Woods Era, NBER Working Paper No. 11077, NBER, Cambridge, MA. Connolly, M. and Dantas da Silveira, J. (1979) Exchange market pressure in post war Brazil: an application of the Girton-Rtoper monetary model, American Economic Review, 69, 448–54. 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