DOES HOT MONEY IMPACT STOCK AND EXCHANGE RATE MARKETS ON CHINA?

This study investigates the impact of hot money on stock and exchange rate markets and the returns and volatility spillover between the stock and exchange rate market in China by using the monthly data covering the period from July 2005 to June 2013. This paper also uses the quantile approach to determine whether the hot money influences the stock and exchange rate markets. The results first reveal the long-run equilibrium relationship that is exhibited between the stock and exchange rate market. Second, hot money has an impact on the stock market but has no effect on the exchange rate market, according to the VECMBEKK model. Third, regarding the volatility spillover effects on the stock and exchange rate markets, there is a spillover effect on the Shanghai stock and exchange rate markets. Hot money has an impact on the stock and exchange rate markets. Finally, we apply the quantile regression to determine the impact of hot money on low quantiles of the exchange rate and high quantiles of the Shanghai and Shenzhen stock market.


INTRODUCTION
As the financial markets have become liberalised and international, the relationship between the stock market and the exchange rate market has become a popular issue for the economic literature to investigate and discuss. Currently, the analysis of the relationship between the stock market and the exchange rate market is more interesting and important in emerging markets such as the Chinese market. The Chinese government implemented the fixed peg exchange rate policy before 2005. As the financial markets were liberalised, the Chinese government released the exchange rate policy reform in July 2005, abolishing the fixed nominal exchange rate system for the U.S. dollar. Foreign governments had pressured the Chinese government to make their exchange rate more flexible and floating. As a result, the Chinese government shifted their system to a version of a currency basket system.
Over the past several decades, numerous studies have investigated the relationship between the stock market and the exchange rate market. These two markets are essential to the financial market. Prior studies often used the Johansen cointegration test to identify the relationship between the stock and exchange rate markets. Pan, Fok and Liu (2007) utilised the Johansen cointegration test to find the long-run equilibrium relationship between exchange rates and stock prices for the East Asian markets and found the long-run relationship between the markets was at least at a 10% level for Hong Kong, in the two sub-periods before the Asian financial crisis. Some studies have indicated that the linkage between the stock and exchange rates is a short-run relationship; Zhao (2010) used the Johansen cointegration method to determine the relationship between the stock and exchange rate market and used the GARCH method to study a shortterm dynamic relationship between stock prices and exchange rates in China. Nevertheless, few studies have explored the relationship between Chinese stock prices and the exchange rates. One of the aims of our study is to investigate this relation in the Chinese market. Our finding is that there is a long-run equilibrium relationship between the markets.
To investigate the relationship between stock prices and exchange rates, there are two models for examining the casualty relationship of both markets. The international trading effect theory was formulated by Dornbusch and Fisher (1980), in reference to the goods market. The fluctuations of exchange rates have a direct influence on the profitability of a business and a firm's international competitiveness. The appreciation of exchange rates will decrease the exporters' sales, earnings, and stock prices, and vice versa. The portfolio balance effect (Frankel, 1983) was necessary for investors for hedging and the diversification of portfolios. Because the previous relationship was changed, it provided a unidirectional causality from stock prices to exchange rates.
The hot money issue is quite an interesting topic in the financial market currently (Kim & Iwasawa, 2017;Fuertes, Phylaktis, & Yan, 2016;Tsai, Chiang, Tsai, & Liou, 2014). Because of globalisation, hot money 1 can spread around the world, especially in emerging markets. This study focused on the Chinese market, which is the biggest emerging market, and investigated their flow of hot money. After 2005, the Chinese government began the exchange rate policy reform, and the inflow and outflow of hot money became more frequent, as shown in Figure 1. Few papers have investigated how hot money has affected the stock and real estate markets (Guo & Huang, 2010;Xu & Chen, 2012). This paper investigates the impact on the stock and exchange rate markets as hot money flows into the Chinese market. A few studies have investigated the impact of hot money on the exchange rate and stock market. This study further examines the influence of hot money on the stock and exchange rate market after China implemented financial liberalisation in 2005. The quantile regression model is used to estimate the relation of these two markets under different market conditions (different quantiles of exchange rates, stock prices, and hot money). In this research, using the quantile regression method, we observe the impact of hot money on markets under various conditions. This study tests the impact of hot money on both the stock and exchange rate markets under different quantiles to determine the effect of hot money on both markets in declining or in rising markets.
This study has three objectives. First, this paper uses the cointegration method based on the Johansen cointegration model to identify the long-run relationship between the stock and exchange rate markets. Second, this study further examines the influence of hot money on the return and volatility on the stock and exchange rate markets. Finally, there is a lack of literature on the use of quantile regression methods; therefore, this paper is intended to provide evidence of the impact of hot money on two markets in different quantiles.

DATA AND METHODOLOGY
This research mainly examines the impact of hot money on the stock and exchange rate markets in China. Our empirical data are from the monthly frequency time series dataset of the stock and foreign exchange markets in China covering the period from July 2005 to June 2013. 2 The information is collected from several resources: Following the studies from Zhang and Fung (2006) and Guo and Huang (2010), this paper defines the calculation of hot money (HM) as follows: where FER, TSB and FDI denote the change in foreign exchange reserves, trade and service balance and foreign direct investment. The rates of change of the data series are calculated as: where P i,t is the price level of the market i (i = e for exchange rate, i = s for stock price) at the time, t. R e,t denotes the change of exchange rate; R s,t denotes the return on stock prices. Johansen (1988) noted that the cointegration procedure is based on an unrestricted vector autoregressive (VAR) model for the ( n × 1) vector Y t : 3 where Y t explores the vectors of all the economic variables, the model (~I(1)) includes n variables, the Π, Γ, and Φ are parameter matrices to be estimated, D t contains deterministic terms (constant, trend, seasonal dummy) and ε t denotes the white noise, which is the variable of I(0). There are two tests for the reduced rank of Π, which are the trace test and the maximum eigenvalue test and are shown as follows: where λ i denotes the characteristic estimation values, and T is the number of the effective observations after the lag adjustment. The trace test illustrates the existence of any vector of cointegration, r = 0, implies that λ 1 = λ 2 = … = λ n = 0 , that is, λ trace = 0 ; if there are a number of distinct cointegrating vectors (r),λ 1 ≠ 0, λ 2 ≠ 0, …, λ r ≠ 0, but λ r+1 = λ r+2 = … = λ n = 0, then the value of is nearly equal to zero. The maximum eigenvalue tests the null hypothesis that the cointegration vector is r, against the alternative of r +1 cointegrating vectors.
This section introduces the VECM-BEKK model that incorporates spillover volatility effects and enables us to examine the relationship between stock indices and exchange rates. This research utilises a bivariate conditional mean equation of the VECM-BEKK model, i.e., the VECM process: where R e,t is the change of exchange rates and R s,t is the return on stock index.
is error correction term. S t−1 and EX t−1 are the prices of the stock index and the exchange rate, respectively. ε t = [ε e,t , ε s,t ] represents a vector of the random error at time t, which indicates that the market has been affected at that time, ε t |I t −1~N(0, H t ), H t is a 2 × 2 variance-covariance matrix, and I t−1 is the information collection of time t-1. The 2 × 1 vectors α = [α e,0 , α s,0 ] are the long-run float coefficients. The parameter α e,n + j and α s,n + j denote the mean spillovers effect, α e,i (α s,i ) indicates the exchange rate (stock return) is affected by its lag value, α e,n + j is the mean of the spillovers from the stock indices to the RMB exchange rate, α s,n + j is the mean of the spillovers from the RMB exchange rate to the stock indices, and hm t denotes the influence of hot money between the stock and the exchange rate. According to the MGARCH model by Engle and Kroner (1995), the conditional variance equation of VECM-BEKK model is where v t denotes the white noise process and A and D represent the 2 × 2 triangular matrix. B ij is the 2 × 2 matrix B and reveals the ARCH effect of volatility, which is the volatility impact of market i on market j; the element C ij indicates the impact of volatility persistent between market i and market j.
The Equation (10) for H t , further expanded by matrix multiplication, takes the following form: h ee,t = a 2 11 + b 2 11 ε 2 e,t−1 + 2b 11 b 21 ε e,t−1 ε s,t−1 + b 2 21 ε 2 s,t−1 + c 2 11 h ee,t−1 + 2c 2 11 c 21 h es,t−1 + c 2 21 h ss,t−1 + d 2 11 hm t (11) h es,t = a 11 a 21 + b 11 b 12 ε 2 e,t−1 + (b 21 b 12 + b 11 b 22 )ε e,t−1 ε s,t−1 + b 21 b 22 ε 2 s,t−1 + c 11 c 12 h ee,t−1 + (c 21 c 12 + c 11 c 22 )h es,t−1 + c 21 c 22 h ss,t−1 + d 11 d 21 hm t (12) h ss,t = a 2 21 + a 2 22 + b 2 12 ε 2 e,t−1 + 2b 12 b 22 ε e,t−1 ε s,t−1 + b 2 22 ε 2 s,t−1 + c 2 12 h ee,t−1 + 2c 12 c 22 h es,t−1 + c 2 22 h ss,t−1 + (d 2 11 + d 2 22 )hm t (13) where the h ee,t variable symbolises the change of RMB's exchange rate; h es,t represents the covariance combined with the change rate of the RMB exchange rate and the stock price return; and h ss,t stands for the variance of the stock return. This study tests the coefficients b 12 and c 12 to determine if there are significant effects based on the volatility of spillover from the exchange rate market to the stock market ( Several studies have used the quantile approach to analyse the conduct of dependent variables, given the information contained in a set of explanatory variables. In this section, this paper use quantile regression approach to investigate the impact of hot money on the stock market and exchange rate markets, from different quantiles. First, this paper use the quantile regressions of R s,t and R e,t , R e,t,τ = α e,τ + β e,τ hm t,τ + ε e,t,τ where R e,t,τ is the change of the RMB exchange rate at the τ quantile and R s,t,τ is the stock return at the τ quantile on the Shanghai and the Shenzhen composite indices. β e,τ and β s,τ are the coefficients of the model that this paper estimated. The model estimates β e,τ and β s,τ for different conditional quantile functions, and ε s,t and ε e,t are error terms. The variable HM t denotes the impact of hot money on the stock and the exchange rate markets. Then, this paper assumes the conditional mean of R is μ(X) = X'β, and the ordinary least squares approach suggests the mean, Table 1 presents the summary statistics of the returns on the stock indices and the change of foreign exchange rates and hot money for the sample period from July 2005 to June 2013. The means of the returns on the stock indices and hot money are greater than 0. The means of the returns on R SH,t and R SZ,t are 0.6347 and 1.3152, and the standard deviation of R SH,t and R SZ,t are 9.4459 and 10.3365, respectively. A higher return on stock indices indicates a higher risk, which suggests that the Shenzhen composite index has a higher risk in the market. The average change of exchange rates is negative, which means that the currency depreciates during the sample period. The exchange rates and SH stock returns of Jarque-Bera statistic show the significant results for the null hypothesis of normal distribution.

EMPIRICAL RESULTS
To examine the degree of the integration of the variables, this paper applied the unit root test to ensure the stationarity of the time-series data. The variables should be conducted for each level and for the first difference if the variables are significant by using the unit root test. The Phillips-Perron (PP) test is used to search for the existence of unit roots. The results for the Phillip-Perron test, as shown in Table 2, illustrates that the change of the foreign exchange rate and the returns on the stock market are non-stationary, with the exception of hot money. The variables that are non-stationary data become stationary in the first difference at the 1% level. After the first difference degree, this paper found that all of the variables are significant. Then, this paper is going to test the cointegration method to investigate the long-run equilibrium.  The result of the Johansen trace and maximum eigenvalue cointegration tests in Table 3 display evidence of a cointegration system. 4 The test results show that the exchange rates and the stock prices are cointegrated. At the 5% confidence level, the results show that cointegration exists between the prices of the stock indices and the exchange rates, as the trace and maximum eigenvalue tests are statistically significant. Consequently, based on the evidence in Table 3, this paper concludes that there exists a cointegration relationship between the stock prices and the exchange rates.  This section applies the VECM-BEKK model to explore the dynamic relationship between the RMB foreign exchange rates and stock prices, as shown in Table 4. On panel A in Table 4, the coefficients of the stock return, α s,1 and α s,2 , are not significant on the SH and the SZ stock markets, but the coefficients of the change of the exchange rate α e,2 are significant. This finding shows that the stock market is an efficient market, but the exchange rate market is not an efficient market. In term of the return spillover effect between the stock and exchange rate markets, we can find the results of β e,1 , β e,2 , β s,1 and β s,2 are not significant. Table 4 investigates the monthly return and volatility spillover effects between stock and exchange rate markets and hot money effect on two markets. The statistics show H 0 : β e,1 , = β e,2 = β s,1 = β s,2 = 0 is 4.110 (5.6680) between the SH (SZ) stock and exchange rate markets and the insignificant return spillovers.

The results of Panel D in
The error correction coefficients of π e and π s measure the speed of adjustment in response to deviations from the long-run equilibrium, and we found that the two coefficients are significant negatively on panel A of Table 4. We generally expect π e < 0 and π s > 0, but it is also possible that the error correction coefficient of the two markets have the same negative sign (Bohl, Salm and Schuppli, 2011). Bohl, Salm and Schuppli (2011) suggest that |π e | > |π s | is only required to restore the long-run equilibrium, and our result is |π e | > |π s | Table 4, the results of φ e and φ s are significant for the effect of hot money on the stock and exchange rate markets, indicating the hot money impact on the stock return and the change of exchange rate markets in China.

On Panel A of
In Panel B of Table 4, a  The results in Panel D of Table 4 investigate the monthly volatility spillover effects between the stock and the exchange rate markets. The value of H 0 : b 21 = c 21 = b 12 = c 12 = 0 is 30.2700 (26.0900) between the SH (SZ) stock and the exchange rate markets and the significant volatility spillovers. We further test the volatility spillovers from the stock market to the exchange market (H 0 : b 12 = c 12 = 0) and the volatility spillovers from the exchange market to the stock market (H 0 : b 21 = c 21 = 0). The values of H 0 : b 12 = c 12 = 0 and (H 0 : b 21 = c 21 = 0) are 10.9550 and 17.8400, respectively, and they are significant on the SH stock and exchange rate markets, indicating the volatility spillover shows a bi-causality effect between the Shanghai stock and exchange rate markets. However, the value of H 0 : b 21 = c 21 = 0 is 20.3610 and significant for the SZ stock market, indicating the volatility spillovers from exchange market to Shenzhen stock market.
Finally, we investigate hot money impact on the stock and exchange rate markets on the mean of H 0 : φ e = φ s = 0 and the volatility equation H 0 : d 11 = d 21 = 0 by the VECM-BEK model in Panel D of Table 4. The values of H 0 : φ e = φ s = 0 and H 0 : d 11 = d 21 = 0) are 98.4610 and 13.5000 (17.0980 and 32.1660) and are significant on the SH (SZ) and exchange rate markets, indicating that hot money has a significant impact on the change of exchange rates and stock returns.
Examining the standardised residuals and square standardized residuals using the Ljung-Box Q statistic as shown in Table 4 on Panel C, the Ljung-Box Q statistics of the standardised residuals of the SH and the SZ are 3.5310 and 3.8390, respectively, denoting that there is no autocorrelation to the standardised residuals in the SH and the SZ; the Ljung-Box Q statistics of the standardised residuals exchange rate is 8.6320, denoting that there is no significant autocorrelation with the standardised residuals in the exchange rate. Consequently, the Ljung-Box Q 2 statistic shows no evidence of linear and non-linear dependence in the square standardises residuals; thus, the VECM-BEKK models can sufficiently describe the dynamic relationship.
The quantile regression method is used to examine the influence of hot money on the exchange rate and the Shanghai and Shenzhen composite stock markets. The result illustrates the impact of hot money on the SH and SZ markets under different quantile regressions, as shown in Table 5. The coefficients acquired from the different quantiles are clearly shown. The coefficients of the impact of hot money on the exchange rate market are negative and are significantly evident in the higher quantiles. In other words, the estimated statistics suggest statistical / β e,i R s,t−i + φ e hm t + π e Z t−1 + ε e,t and R s,t = α s,0 + i 1 n = / α s,i R s,t−i + i 1 n = / β s,i R e,t−i + φ s hm t + π s Z t−1 + ε s,t .

CONCLUSIONS
There have been enormous inflows and outflows of "hot money" to the Chinese market in recent years. As the biggest emerging country, China has become an interesting issue to investigate. Using our sample period from July 2005 to June 2013, this paper utilises monthly frequency data to explore the impact of hot money on the stock and exchange rate market. First, using the cointegration method, this paper explores a long-run equilibrium relationship between the stock and exchange rate markets. Second, the paper applies the VECM-BEKK model to identify the impact of hot money on the stock and exchange rate markets and examines the volatility of the spillover between the stock and the exchange rate market. Finally, this study uses the quantile approach to determine the influence of hot money on the stock and exchange rate markets.
To summarise the results, first this paper finds a long-run equilibrium relationship between the stock and exchange rate market based on the cointegration model. Second, hot money has an impact on the stock and exchange rate markets. Finally, the results of the quantile regression showed that hot money has an impact on the exchange rate market in the low quantiles and on the Shanghai and Shenzhen stock markets in the high quantiles. The quantile regression clarifies the impact of hot money on stock and exchange rate markets in the difference quantile regions. This finding could be very useful in investment decisions and policymaking.

ACKNOwLEDGEMENTS
The authors acknowledge editor and anonymous reviewers for their constructive and thorough comments that greatly improved the quality of this paper.

NOTES
1. Hot money is defined as the flow of funds (or capital) from one country to another in order to earn a short-term profit. 2. RMB exchange rate has changed its regime in 2005 after china release the financial liberalisation. China implemented a managed floating exchange rate regime in July 2005. Because of the monthly data of foreign direct investment, this study takes the same frequency data for all variables. 3. Because the non-stationary time-series data is uncertainly, this paper firstly examines the stationary by using the time-series data at the level and at their first differences to test the significant evidence of the relationship. If there is a significant relationship between the non-stationary variables, it will imply that the variables have the characteristics of the equilibrium in the long-run after the first differences adjustment. In other words, because of non-stationary time-series data of the stock indices and exchange rate in our data, cointegration method identifies the variables become the stationary variables after using the first difference. Consequently, after the cointegration test of the time-series data, this study can apply the time series data to examine. 4. This study utilises Johansen cointegration method to examine the cointegration between stock prices and exchange rates. Johansen (1988) suggested that the cointegration analysis and the consistent the causal relationship are analysed by estimating a vector error-correction model (VECM). Seeing as the time series data are integrated on the same order, cointegration methods can be used to clarify whether a stable long-run relationship exists between each variable.