The relationship between stock returns and the foreign exchange rate: the ARDL approach

Abstract

This study employs the ARDL cointegration approach in order to examine the impact of financial liberalization on the relationships between the exchange rate and share market performance in China. We discovered that cointegration has existed between the Shanghai A Share Index and the exchange rate of the renminbi against the US dollar and Hong Kong dollar since 2005, when the Chinese exchange rate regime became a flexible, managed, floating system. We found that both the exchange rate and the money supply influenced stock price, with a positive correlation. We further show that the money supply increase was largely caused by a huge ‘hot money’ inflow from other countries in recent years. After local currency appreciation, hot money, followed by the money supply increase, pushed the market into a high level, based on expectations regarding the local currency's further appreciation.

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