TECHNISCHE UNIVERSITÄT DRESDEN Fakultät Wirtschaftswissenschaften EXCHANGE RATE EXPECTATIONS, CURRENCY CRISES, AND THE PRICING OF AMERICAN DEPOSITARY RECEIPTS Dissertation zur Erlangung des akademischen Grades Dr. rer. pol. vorgelegt von Stefan Eichler Diplom-Volkswirt geboren am 14. Mai 1982 in Borna Gutachter: Prof. Dr. Alexander Karmann Prof. Dr. Marcel Thum verteidigt am 9. Januar 2012 To Mareike Acknowledgements My greatest thanks are reserved for Professor Alexander Karmann for giving me the opportunity to do my Ph.D at his chair. Without his enduring encouragement, education, support, and constructive criticism over the last five years I could not have completed this dissertation. I am deeply indebted to Professor Marcel Thum (my second referee) for his valuable comments and his interest in my dissertation. I also want to thank the remaining members of my thesis committee, Professor Udo Broll and Professor Udo Buscher, for their time and critical comments. I greatly benefited from the help of many people. I owe a debt of gratitude to Professor Andreas Bühn and Professor Dominik Maltritz. We wrote many papers together and their education in writing academic papers enabled me to write this dissertation. Special thanks go to Professor Andreas Bühn, Professor Rodrigo Herrera, and Karol Sobanski for their helpful comments on earlier drafts of this thesis. I want to thank Sunshine Moore and Ayla Rockliff for proof reading several versions of the papers. I am indebted to Dr. Andreas Werblow for his enduring efforts in teaching me econometrics. I also benefitted from discussions with many current and former colleagues including Dr. Gunnar Dittrich, Matthias Göthel, Andrea Jurack, Dr. Ekatherina Shteyn, Kai Hielscher, Michael Hofmann, Dr. Mohammad Farzanegan, Dr. Christian Lessmann, and Dr. Gunther Markwardt. I appreciate the comments of several editors and anonymous referees whose critical remarks significantly contributed to the papers included in this thesis. I also want to thank the participants of the colloquium and the Brown Bag Seminar at Technische Universität Dresden as well as participants of several conferences for their helpful comments on the papers of this dissertation. I also want to thank my parents for always believing in me and enabling me to study. Their love and support made this dissertation possible. Last and most of all, I want to thank Mareike, my beloved and wise wife, for your unconditional love and patience, which always supported me during the whole endeavor of writing this dissertation. Stefan Eichler Contents I. Introduction………………………………………………………………………….. I.1 I.1 Motivation………………………………………………………………………… I.1 I.2 Deriving exchange rate expectations from prices of American Depositary Receipts…………………………………………………………………………… I.4 I.3 Contribution to the literature……………………………………………………… I.6 I.4 Main findings and policy implications…………………………………………… I.8 II. Exchange rate expectations and the pricing of Chinese cross-listed stocks………...... II.1 II.1 Introduction……………………………………………………………………….. II.2 II.2 Exchange rate expectations and the Chinese ADR and H-share discounts……...... II.5 II.2.1 The ADR discount…………………………………………………………….. II.5 II.2.2 The H-share discount…………………………………………………………..II.8 II.3 ADR and H-share discounts in China 1998-2009………………………………… II.9 II.4 Forecasting performance of ADR and H-share investors’ exchange rate expectations……………………………………………………………………….. II.11 II.5 Determinants of ADR and H-share investors’ exchange rate expectations………. II.21 II.5.1 Hypotheses…………………………………………………………………..... II.21 II.5.1.1 The incentive to devaluate competitively………………………………… II.21 II.5.1.2 Relative purchasing power parity (PPP)………………………………….. II.22 II.5.1.3 Harrod-Balassa-Samuelson (HBS) effect……………………………........ II.22 II.5.1.4 Uncovered interest rate parity (UIP)……………………………………... II.23 II.5.1.5 Foreign exchange reserves growth……………………………………….. II.24 II.5.1.6 Export growth…………………………………………………………….. II.24 II.5.1.7 Risk of twin banking and currency crisis………………………………… II.25 II.5.1.8 Risk of twin sovereign debt and currency crisis………………………….. II.25 II.5.2 Panel regression analysis……………………………………………………… II.26 II.6 Conclusions……………………………………………………………………….. II.36 II. Appendix.………………………………………………………………………… II.44 III. The ADR shadow exchange rate as an early warning indicator for currency crises…. III.1 III.1 Introduction……………………………………………………………………….. III.2 III.2 Measuring currency crisis expectations using ADR market data………………… III.6 III.3 ADR spread and shadow exchange rate in times of currency crisis ……………... III.9 III.4 Currency crisis-related variables that drive the ADR spread…………………….. III.15 III.4.1 Discussion of hypotheses…………………………………………………….. III.15 III.4.2 Empirical identification of the currency crisis risk drivers…………………... III.17 III.5 Empirical analysis………………………………………………………………… III.20 III.5.1 Panel analysis of the determinants of currency crisis expectations………….. III.22 III.5.2 Regime switches in the determination of currency crisis expectations……… III.28 III.6 Conclusion………………………………………………………………………... III.35 III. Appendix.………………………………………………………………………….. III.42 IV. What can currency crisis models tell us about the risk of withdrawal from the the EMU? Evidence from ADR data………………………………………….. …....... IV.1 IV.1 Introduction…………………………………………………………………… …. IV.2 IV.2 Alternatives to, legal aspects of, and consequences of leaving the EMU………... IV.7 IV.2.1 Alternatives to leaving the EMU…………………………………………….. IV.7 IV.2.2 Legal aspects of leaving the EMU………………………………………........ IV.9 IV.2.3 Consequences of leaving the EMU…………………………………………... IV.11 IV.3 Indicators of currency crisis risk…………………………………………………. IV.12 IV.3.1 Twin banking and currency crises…………………………………………… IV.13 IV.3.2 Twin sovereign debt and currency crises…………………………………….. IV.14 IV.3.3 The incentive of competitive devaluations…………………………………... IV.15 IV.4 Empirical analysis…………………………………………………………………IV.17 IV.5 Conclusions………………………………………………………………………. IV.24 IV. Appendix…………………………………………………………………………... IV.30 V. Overview of panel unit root tests…………………………………………………....... V.1 Tables Table II.1: Direction of change statistics of out-of-sample forecasts…………………….. II.15 Table II.2: MSE ratios and Diebold-Mariano statistics of out-of-sample forecasts……… II.18 Table II.3: Panel estimation results: ADR discounts……………………………………... II.30 Table II.4: Panel estimation results: H-share discounts………………………………….. II.32 Table II.A1: Stock pairs included in the sample…………………………………………. II.44 Table II.A2: Summary statistics for the variables of the ADR and H-share samples……. II.45 Table II.A3: Results of the panel unit root tests………………………………………….. II.46 Table III.1: Panel estimation results for Argentina………………………………………. III.24 Table III.2: Panel estimation results for Malaysia………………………………………... III.25 Table III.3: Panel estimation results for Venezuela (1994-1996)………………………... III.26 Table III.4: Regime switches in currency crisis expectations……………………………. III.32 Table III.5: Results of the regime switching regressions………………………………… III.33 Table III.A1: List of included ADR/underlying stock pairs……………………………… III.42 Table III.A2: Index weights for the commodity price indices…………………………… III.43 Table III.A3: Index weights for the export destinations’ exchange rate indices…………. III.44 Table III.A4: Results of the panel unit root tests…………………………………………. III.45 Table III.A5: Results of the time series unit root tests…………………………………… III.47 Table IV.1: Regression results…………………………………………………………….IV.20 Table IV.A1: Domestic banks included in the national CDS premiums indices………… IV.30 Table IV.A2: List of included ADR/underlying stock pairs……………………………... IV.31 Table IV.A3: Summary statistics………………………………………………………….IV.32 Table IV.A4: Results of the panel unit root tests………………………………………… IV.33 Figures Figure II.1: Average ADR and H-share discounts of Chinese cross-listed companies…………………………………………………………………. II.10 Figure III.1: ADR shadow exchange rate and official exchange rate Argentina (2001-2002)………………………………………………………………. III.11 Figure III.2: ADR shadow exchange rate and official exchange rate Malaysia (1998-1999)………………………………………………………………. III.12 Figure III.3: ADR shadow exchange rate and official exchange rate Venezuela (1994-1996)……………………………………………………………….. III.13 Figure III.4: ADR shadow exchange rate and official exchange rate Venezuela (2003-2007)………………………………………………………………...III.14 Chapter I Introduction I.1 Motivation Exchange rates are a key issue in international economics and politics.1 While the determinants of exchange rates have been extensively studied in previous works, this dissertation contributes to the literature by deriving exchange rate expectations from stock market (ADR) data and analyzing their determinants. This exercise is done for three cases where one has to resort to exchange rate expectations since the national exchange rate is either manipulated by the central bank (the first paper in Chapter II), fixed in pegged exchange rate regimes (the second paper in Chapter III), or not existent as the considered country is part of a currency union and therefore has no national currency (the third paper in Chapter IV).2 The first paper presented in Chapter II analyzes exchange rate expectations for the case of China in the period 1998-2009 in order to test standard exchange rate theories.3 American officials repeatedly accused China of systematically undervaluing its currency against the U.S. dollar4, which produces political tensions between both countries. A recent climax in this dispute