Fluctuation and Reform: A Tale of Two RMB Markets

The fluctuations of exchange rates under different regimes have been studied extensively in the literature. Despite Meese and Rogoff (1983) suggesting that the movements of exchange rates are largely unpredictable, since the pioneering work of Mussa (1986), an extensive literature indicates that exchange rate volatility is greater under a more flexible regime than under a fixed one. However, the empirical literature on the linkage between the onshore and offshore exchange rate markets under different regimes is not rich. In particular, when the onshore market moves from a managed floating regime towards a more flexible one, the fluctuations of this linkage have seldom been studied.

The coexistence of the Renminbi (RMB) onshore and offshore markets in China provides an invaluable case to study the linkage between a managed floating onshore market and a free-floating offshore market. China has only one fiat currency, but has two segmented currency markets, the onshore RMB (CNY) market and the offshore RMB (CNH) market.

The framework of “one currency, two markets” makes China’s currency market quite unique compared to its Western counterparts. In this study, we characterize the linkage between the onshore and offshore Renminbi exchange rates, and estimate the effect of the recent Renminbi market reforms against the backdrop of Renminbi internationalization. Using GARCH-type models, we find robust evidence of the volatility clustering phenomenon and the leverage effect in the pricing differential between the onshore and offshore exchange rates. We also find that the recent Renminbi currency market reforms all increase the volatility of the pricing differential between the two Renminbi markets, while these reforms are proved to either enlarge or shrink the pricing differential.