Liberalization of the financial system in China : impact on foreign exchange and monetary policy.

Summary We study the impact of the gradual liberalization process of the Chinese financial system on the foreign exchange market and the conduct of monetary policy in China. Our work focuses on four main reforms. In particular, two measures to liberalize cross-border financial flows, namely the launch of the Shanghai Free Trade Zone in 2013 and the creation of the Shanghai-Hong Kong Stock Connect in 2014. In addition, we are exploring the creation of a new channel for inbound flows with the opening of China's interbank bond market to a wide range of foreign investors in 2016. We also include the reform of the monetary regime in 2015. The novelty of our general approach lies in the granularity of the data used, as well as in the introduction of financial indicators to account for the increasing role of financial markets in the country's economic environment. We show that the new channels allowing the acceleration of two-way flows have not reduced the fragmentation between the onshore and offshore renminbi markets. On the contrary, they have led to increased tensions in the foreign exchange market. The results also suggest that only the Shanghai-Hong Kong Stock Connect and the opening of the bond market have had a significant impact on China's integration into the global financial system. Finally, we find that the Chinese central bank became more restrictive in adjusting the monetary base after the introduction of the Shanghai-Hong Kong Stock Connect. As the Chinese authorities have indicated that domestic economic objectives will remain their top priority, these results suggest that the reform process will remain gradual and cautious.