Demand for Money in China with Currency Substitution: Evidence from the Recent Data

China has undertaken numerous economic reforms since 1978, including the abolishment of the fixed exchange rate system and adoption of a “managed floating exchange rate” regime in 2005. In the present study, we examined money demand in China by employing quarterly data after China adopted the new exchange rate system (from 2006Q1 to 2016Q1). To consider currency substitution, demand for money that includes exchange rate in addition to income and inflation is estimated. By incorporating the CUSUM and CUSUMSQ tests for stability in conjunction with cointegration analysis, we find M2 is a better measurement of monetary aggregate because it is cointegrated with its determinants and it is also stable. We also find strong evidence of currency substitution for M2.


Introduction
Money demand is a crucial macro topic because it forms the link between the monetary aggregates and some important macro variables. Money demand in many countries has been extensively studied. Following other countries, money demand in China also attracts a lot of attention, especially after 1980's. This is because China has undergone dramatic economic reforms since 1978, resulting in rapid growth of the economy. Currently, China has become the world's second largest economy in terms of nominal gross domestic product (GDP).
The literature on money demand in China includes but is not limited to [1] [2] [3] [4] [5]. In general, the previous literature has employed standard estimation technique or cointegration techniques to estimate money demand in China from different aspects such as the definition of monetary aggregate, the variables that should be included in the money demand function, the effects of economic reform on money demand, and the causal relationship between monetary aggregate and some other macroeconomic variables. In the study [1], they use quarterly data over the period of 1983Q1-2002Q4 and employ CUSUM and CUSUMSQ stability tests in bounds testing approach for cointegration to analyze money demand in China. In addition to income and domestic interest rate, foreign interest rate and exchange rate are incorporated into the model. The coefficients for both foreign interest rate and exchange rate are not significant, indicating the foreign sector does not play a significant role in money demand in China during the period of 1983 to 2002. They find that M1 monetary aggregate in China is stable, while the stability of M2 monetary aggregate is somewhat questionable. Interestingly, in [3], annual data from 1997 to 2006 were used and they find both M1 and M2 are stable.
These studies have helped us understand money demand in China. However, there are several limitations. First, there is almost no paper reporting effects of possible currency substitution on money demand in China. Currency substitution occurs if the domestic people hold foreign currencies in place of the domestic currency. Typically, when a currency either depreciates or appreciates, domestic people will try to protect their wealth by currency substitution. The depreciation of domestic currency may increase demand for money if the depreciation increases the wealth since the value of foreign assets measured in domestic currency will be higher. But depreciation may lower the demand for money if the public try to increase the value of assets by increasing the holdings of foreign currencies to avoid further domestic currency depreciation. China has gradually opened up to the world since 1978 and currency substitution may have important effects on money demand in China, which has been ignored in most previous studies. This is probably because China was under fixed exchange rate before 2005. Second, the stability of money demand is vital for effective monetary policies and for the economy. As demonstrated by [6], cointegration does not imply stability. The CUSUM and CUSUMQ stability test can be used to test the stability of demand for money. Moreover, it has been suggested that money demand would be less stable if currency substitution exists since domestic monetary policy will be affected by foreign economic variables. This argument makes it even more important to test the long-run stability of money demand, especially when the exchange rate is included into the model. Third, the data used in most of the previous studies cover from 1980 and up to 2000s. However, Chinese reform has been undertaken for more than 40 years now and major changes have continued to take place in Chinese economy after 2000. The properties of money demand in China based on the most recent data might be different.
Thus, the purpose of the present study is to examine the possible effects of currency substitution on demand for money in China based on the most recent data and to test its stability. To this end, Section 2 provides a brief overview of the recent banking system reform and exchange rate reform. Section 3 formulates the model of demand for money and introduces the bound testing ap-proach to cointegration technique. Section 4 presents the empirical results and Section 5 concludes.

The Reform of Banking System and Exchange Rate
Since 1978, China has gradually undergone a transition from regulation over financial instruments to liberalization of its financial markets. According to [7], the reform of banking system in China has gone through 3 stages so far. During

Model Specification and the Bound Testing Approach
Following the previous literatures, money demand of a country depends on transaction demand for money, which is usually measured by the domestic income. Despite the reforms, Chinese interest rate is still not completely marketoriented and it is not a good measurement of opportunity costs of holding money.
Previous studies such as [4] argue that inflation rate is a better measurement of opportunity costs of holding money in China. Hence, inflation rate is chosen to measure the opportunity costs of holding money in present study. In order to consider the possible currency substitution, exchange rate is included into the model. The modified money demand model is outlined by Equation (1) (1) in order to carry out the testing procedure. Following [9], it takes following form: The null hypothesis of no cointegration ( 0     pointed out by [10], the above results may be considered preliminary since lags are selected arbitrarily. We decide to overcome the arbitrary nature of lag selection and employ a selection procedure to select the appropriate number of lags on each variable. The selection procedure employed in this study is Akaike Information Criterion (AIC). That means we employ AIC to select the optimum number of lags for each variable in Equation (2) after imposing maximum of 2, 4, and 6 lags on each first differenced variable in (2).

Empirical Results and Stability Tests
The optimal lags, F-test with optimal lags, and the values of error correction terms for M1 are reported in Table 1. The optimal lags, F-test with optimal lags, and the values of error correction terms for M2 are reported in Table 2. From the results of F-test with optimal lags in Table 1, the values of F-test with optimal lags are greater than 95% upper bound value for M1 with 2 lags and with 4 lags, while the error correction term is only negative and significant for M1 with 2 lags. From the Table 2, the F-test with optimal lags for M2 are all greater than the 95% upper bound, and the error correction terms are all negative and significant, supporting cointegration. It seems that there is stronger evidence of cointegration when M2 money aggregate is used.
Since one of the main objectives of this paper is to test the long-run stability, we only report the long-run estimation here. Table 3 reports the long-run coefficient estimates for M1 aggregate, while Table 4 reports the long-run estimates for M2 aggregate.
From   After the long run estimates, we examine the stability by applying CUSUM and CUSUMSQ tests for both M1 and M2. The stability results are reported in Figure 1 and Figure 2. It seems it is stable for all cases we tested.
These results are quite interesting since they are different from the results in [1]. First, M2 is cointergated with its determinants in all cases and M1 is only cointegrated in some cases in present study, while both M1 and M2 are cointegrated in [1]. Second, M2 is stable in the current study, while the stability of M2 is questionable in [1]. Third, we detect strong currency substitution for M2 money aggregate in present study, while the coefficient for exchange rate is insignificant in [1].

Conclusions
In the present study, we employ the quarterly data after China's exchange rate reform in 2005 to study demand for money in China. We include the exchange rate into the equation in order to examine possible currency substitution given the ongoing financial reform and the exchange rate reform in 2005. We show that the cointegration of M1 monetary aggregate with domestic income, inflation rate as well as exchange rate is doubtful, while M2 money aggregate is cointegrated with these determinants. Moreover, for M2 monetary aggregate, the coefficients of domestic income are positive and significant in all cases while the coefficients of exchange rate are all negative and significant, suggesting strong currency substitution. The CUSUM and CUSUMQ test with cointegration analysis revealed that M2 aggregate is stable in all cases. Based on the cointegration results, M2 serves as better money aggregate for China. This result is different from the finding in [3]. One Policy implication is: the monetary authority should target M2 rather than M1 now and should also pay attention to the currency substitution in order to carry out an effective monetary policy in China.
We use inflation rate, rather than interest rate to measure the opportunity costs of holding money in China in current study. Further research may investigate if interest rate is appropriate measurement using recent data. However, one may have to wait a little longer to study it for two reasons. 1) The interest rate is not completely market-oriented yet. 2) Compared to the interest rate, the inflation rate is still quite high in China, which makes inflation rate a better measurement of opportunity costs of holding money in China. It may take some time for the Chinese government to control the inflation rate. Further research could use different cointegration method to estimate the model in order to see if the findings are robust. Further research could also test the effect of exchange rate on other macro variable using the data after China adopted the managed floating exchange rate regime and discuss if China should move to completely floating exchange rate regime.