Economic Uncertainty and Exchange Market Pressure: Evidence From China

This paper evaluates the impact of local and external economic uncertainty shocks on China's exchange market pressure from a time-varying perspective. We first construct a simple behavioral model to provide some economic background for our empirical analysis. The model identifies two channels, namely market sentiment and market demand, through which economic uncertainty has a time-varying impact on exchange market pressure. Notably, we calculate a new exchange market pressure index for China by considering China's practice. Using the economic policy uncertainty index as a proxy for economic uncertainty and our new estimates of China's exchange market pressure, we employ a novel TVP-VAR model controlling for over-parameterization to a monthly dataset from January 2001 to October 2020 to analyze the impact of China's and U.S. economic policy uncertainties on China's exchange market pressure. Our empirical findings robustly show that an upsurge in U.S. EPU is followed by appreciation pressure of the RMB against the dollar, while a hike in China's EPU triggers devaluation pressure on the RMB. In addition, the impact of economic policy uncertainty has considerable time variation in magnitude, especially after mid-2011, showing a trade-off mechanism between the effects of domestic and foreign economic uncertainties on China's exchange market pressure. Moreover, we attribute the time-varying features to the changes in China's dependence on the U.S. and in the exchange rate flexibility. Finally, China should further improve the exchange rate flexibility, reduce its dependence on the U.S. and develop a more diversified currency basket in the exchange rate formation mechanism.