Parallel exchange market as a transition mechanism for foreign exchange reform: China's experiment

In the process of China's foreign exchange reform, the so-called swap market was a key element. Despite the problems it caused, notably those associated with a dual exchange rate, the paper argues that the swap market proved to be a useful transition mechanism for China's foreign exchange liberalisation. It is shown that the swap market caused exchange controls to wither and introduced market forces into incentive structure. Furthermore, statistical evidence has been found that the Chinese official exchange rate and the swap rate are cointegrated and there existed long- and short-run causal relationship in the sense of Granger in the direction from the swap to the official rate. It is evident from these findings that the swap market facilitated the reform of the mechanism of China's exchange rate by its services of information extraction and of introducing market forces into China's exchange rate decisions.