The Forward Exchange Rate and False Trade: Analysis from a Currency Arbitrage Perspective
LU Bing, WANG Yaqi, HONG Shengjie
PBC School of Finance, Tsinghua University;School of Finance, Central University of Finance and Economics;School of Economics and Management, Tsinghua University
Summary:
Since the exchange rate reform was implemented in 2005, the RMB exchange rate has continually appreciated. Following the reform, especially during the long period after the financial crisis, the market formed strong expectations of the appreciation of the RMB (Yao, 2008; Zhang, 2010). In this context, many firms hope to convert overseas currencies into RMB to enjoy the gains from the continuing appreciation of the RMB. This type of trading is called currency arbitrage (Zhang, 2010). However, due to China's capital controls (Ma & Mccauley, 2008), hot money cannot flow into China through legal channels. Thus, firms need to engage in a series of activities to evade the tight capital controls. One of the most commonly used channels is false trade, whereby firms manipulate the value of imports or exports, or even completely falsify their transactions (Gunter, 2004; Ferrantino et al., 2012; Kellenberg & Levinson, 2014; Lin et al., 2018). Although false trade has aroused significant attention at the policy level in China, few studies have quantitatively examined false trade, especially in terms of the traders' motivations, because false trades are difficult to detect and measure. In this paper, we examine the false trade activity of Chinese exporters from a currency arbitrage perspective. In this paper, based on the HS six-digit product level export data from mainland China to Hong Kong during 2010-2012, we examine the false trade behavior of exporters seeking to evade the capital controls and profit from the appreciating RMB, and provide evidence for the motivation to engage in currency arbitrage. We find that the expected appreciation of the RMB significantly promotes the increase in the export value of products. For products with a higher value to weight ratio, we find that the exports are more sensitive to the appreciation of the RMB forward exchange rate. This finding strongly supports the false trade hypothesis. Firms do not randomly select products to export when they engage in abnormal trade to bypass capital control. Rather, to save transportation costs, they try to make their goods as valuable as possible given a fixed weight. Therefore, firms are likely to choose products with a high value to weight ratio when they engage in false trades. Our heterogeneous tests indicate that false trades are more likely to occur among products with a higher share of processing trade. In addition, we use the 2012 exchange rate reform as an exogenous shock to further verify the currency arbitrage hypothesis. The exchange rate reform in 2012 increased the volatility of the RMB exchange rate and thus increased the cost of cross-border currency arbitrage. We find that the false trade practices of firms are significantly reduced after the exchange rate reform. Our paper makes three main contributions to the literature. First, studies have pointed out that the appreciation of the RMB exchange rate depresses exports. However, we find that when Chinese exporters expect the RMB exchange rate to appreciate, they increase the value of their exports to Hong Kong to transfer hot money to mainland China through false trades and engage in speculative arbitrage. Thus, this paper provides a new perspective for explaining that the surge in mainland China's exports to Hong Kong against the background of the continued appreciation of the RMB exchange rate following the exchange rate reform in 2005. Second, we further quantify the increase in the share of false trade in relation to the total exports as a result of currency arbitrage, and find that currency arbitrage is an important driver of the increase in the share of false trade. Third, to identify false trade behavior, we calculate the value to weight ratio of HS six products and find that when the forward exchange rate appreciates, the export value of products with a high value-to-weight ratio increases. Our findings have several policy implications. First, customs supervision departments should continue to detect false trade activity, strengthen the customs audit mechanism, and pay more attention to products with a high value to weight ratio, such as electrical products and precious metals. Second, our heterogeneous tests show that false trades are more likely to occur in products with a higher share of processing trade. Therefore, the customs department should impose stricter regulations on the transactions of processing trade. Lastly, China should further promote the marketization reform of the RMB exchange rate to increase the cross-border arbitrage costs for firms, and restrict the false trade activities of exporting firms.
卢冰, 王雅琦, 洪圣杰. 人民币预期汇率变动与虚假贸易——基于套汇视角的分析[J]. 金融研究, 2020, 475(1): 9-27.
LU Bing, WANG Yaqi, HONG Shengjie. The Forward Exchange Rate and False Trade: Analysis from a Currency Arbitrage Perspective. Journal of Financial Research, 2020, 475(1): 9-27.
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