1) In the last year, China’s economic growth has slowed substantially, but is st

Question

1) In the last year, China’s economic growth has slowed substantially, but is still faster than that of the U.S. or Europe. Based on this information, what impact has that had on China’s currency?

2) “For an investment in a foreign-currency denominated financial asset, part of the return comes from the asset itself and part from the foreign currency”. Explain why that statement is true or false.

3) Relative purchasing power parity expands on the theory to suggest that it is the difference in inflation rates that explains changes in exchange rates between two countries. Why is this a better predictor than absolute purchasing power parity ?

Explanation / Answer

(1) As China's growth rate remains higher than that in US or in Europe, its domestic demand is not entirely fulfilled by internal production, therefore demand for imports increase. As China imports more from abroad, Chinese demand for foreign currency rises (to pay for imports) and demand for Chinese currency (Yuan) falls. This leads to a devaluation of Yuan vis-a-vis other currencies.

(2) A part of the total returns from such an asset comes from the incomes from the asset (e.g. Coupon interest for bonds or dividends for stocks) and asset appreciation/depreciation, but another part comes from foreign currency appreciation/depreciation, since the first component of return is paid in foreign currency. A rise/fall in value of foreign currency will increase/decrease the core financial return.

Note: First 2 questions are answered.

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