The Interrelationship between Exchange Rates and Stock Prices: Evidence from China

Abstract

For more than 30 years, the relationship between stock prices and foreign exchange rates has drawn attention of economists, because they both play crucial roles in influencing the development of a country's economy. Many studies have been conducted both theoretically and empirically. So far, the research thus far has extended the inquiry into the stock market and exchange rate relations across developed and emerging economies to bring a broadly-based insight into the issue and to fill the gap in the literature. However, the China's market is rarely included in the existing literature. The main objective of this study is to examine the relationship between stock prices and RMB exchange rates in China. The sample period for this study is from Jan 1, 2002 to Jul 31,2009, and the weekly data of Shanghai and Shenzhen A share stock index and RMB exchange rate against U.S. dollar, Euro and Japanese Yen were gathered from Datastream. During the data period, the range of Shanghai A share is from 1066 to 6396 points, and the range of Shenzhen A share is from 246 to 1660 points during the data period. And at the same time, the RMB exchange rates also changed dramatically, especially before and after the reform of RMB exchange rate formation mechanism on Jul 21, 2005. According to this, the data are divided and examined by two parts, that is before and after the China's exchange rate reform. The models applied in this study includes Augmented Dickey-Fuller Test, Engle and Granger Two-step Test and Granger Causality Test. The results show that, first, in terms of the broad relationship the relationship between the exchange rate and stock price are either positive or negative, and the relationships are opposite before and after the reform. Second, there is no sign indicating that the Chinese exchanges rates and stock prices become more connected after the reform. What's more, before the reform, Shenzhen A share stock index is more connected with RMB exchange rates and their relationships are negative. While, after the reform, Shanghai A share stock index is comparatively more connected with RMB exchange rates and their relationships become positive. Finally, the Granger causal order is found between some pairs of variables, that is the RMB exchange rate with Japanese Yen is the Granger Cause of Shanghai stock price before the exchange rate reform and is Granger Cause of both Shanghai stock price and Shenzhen Stock price after the reform. While, for another direction, before the reform, Shenzhen A share stock index is the Granger cause for RMB exchange rate with U.S. dollar. However, after the reform, there is no causal relationship between these two variables

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