Modern Economy, 2012, 3, 563-566
http://dx.doi.org/10.4236/me.2012.35074 Published Online September 2012 (http://www.SciRP.org/journal/me)
A Study of the Causal Relationship between Real Exchange
Rate of Renminbi and Hong Kong Stock Market Index
Wai-Choi Lee1,2
1Department of Economics and Finance, Hang Seng Management College, Hong Kong, China
2School of Finance, Shanghai University of Finance and Economics, Shanghai, China
Received May 23, 2012; revised June 20, 2012; accepted June 28, 2012
ABSTRACT
This paper attempts to study whether the real exchange rate of Renminbi and stock market index in Hong Kong are re-
lated to each other or not. The study uses cointegration and Granger causality tests on the monthly data of the real ex-
change rate of Renmnibi (RMB) in terms of Hong Kong dollars (REX) and Hang Seng Index (HSI) since the foreign
exchange reform of China in July 2005. The major findings of the study are a) the cointegration test shows that there
exists a long-run equilibrium relationship between REX and HSI; b) the error correction mechanism further evidences
that there is an error correction between REX and HSI in the short run; c) the Granger causality test indicates that there
is causal direction from RMB to HSI but not vice versa.
Keywords: Cointegration Test; Error Correction Mechanism; Granger Causality Test; Renminbi; Hang Seng Index
1. Introduction
In July 2005, the People’s Bank of China (PBoC) aban-
doned the 11-year-old peg of the Renminbi (RMB) against
the American dollar (USD) and replaced it with a man-
aged floating exchange rate based on market supply and
demand with reference to a basket of foreign currencies.
Not surprisingly, currencies in the basket included the
currencies of three trading partners—i.e., the USD, the
euro, and the Japanese yen. Under the new system, ad-
justments in the rate of exchange fluctuation will not only
govern the relationship between RMB and USD, but also
the relationship between RMB and other main currencies
such as the euro and the Japanese yen.
At the same time, the RMB was revalued by 2.1%—
from 8.28 RMB per USD to 8.11 per USD. In September
2005, the PBoC decided to adopt a narrow band of 0.3%
on either side of the central rate within which RMB can
fluctuate against USD. Since then, the RMB has gradu-
ally been revalued against USD. As of 22 May, 2012, the
exchange rate of RMB is raised to 6.33 per USD.
Since 1983, the monetary authority of Hong Kong has
maintained currency stability, defined as a stable external
exchange value of the currency of Hong Kong, in terms
of its exchange rate in the foreign exchange market against
the USD, at around HK$7.80 to US$1. As a result, the
exchange rates of Hong Kong dollar (HKD) in terms of
foreign currencies, such as RMB, follow the exchange
rates of USD in the same direction. As the USD depreciates
against RMB, the HKD depreciates against it accordingly.
The Hong Kong Stock Exchange is Asia’s third largest
stock exchange by market capitalization, behind the To-
kyo Stock Exchange and Shanghai Stock Exchange. Hang
Seng Index (HSI), the most widely quoted gauge of the
Hong Kong stock market, includes the largest and most
liquid stocks listed on Main Board of the Stock Exchange
of Hong Kong. It is a market capitalization weighted index
and comprises 48 constituent stocks of Hong Kong and
Mainland China enterprises. The aggregate market capi-
talization of these stocks accounts for over 65 percentage
of the total market capitalization in the Hong Kong Stock
Exchange.
Classical economic theory suggests a relationship be-
tween the stock market performance and the exchange
rate behaviour. Dornbusch and Fisher [1] and Aggarwal
[2] affirm that currency movements affect international
competitiveness and the balance of trade position, and
consequently the real output of the economy, which in
turn affects current and future cash flows of companies
and their stock prices.
Granger, Huang and Yang [3] find that currency de-
preciation could either raise or lower the value of Asian
companies during the Asian Crisis of 1997, depending on
whether the company mainly imports or mainly exports.
When the stock market index is considered, the net effect
cannot be predicted.
Yue, Cheng, Lee and Man [4] perform a panel data
analysis across four small export-oriented economies,
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564
namely, Hong Kong, Singapore, South Korea, and Taiwan.
The empirical results suggest that for small export-orie-
nted economies, a drop in the external of local currency
will result in an increase in exports and a rise in stock
market index.
Hong Kong is famous for being a small open economy,
allowing unrestricted flows of international goods and
funds. It is believed that the revaluation of the RMB
against the USD dampens the competitiveness of China’s
exports to the United States. Thus, the present and future
cash flows of Hong Kong and mainland export-oriented
enterprises are adversely affected. The stock market index
of Hong Kong is expected to decline in response to the
revaluation of the RMB against the USD/HKD. However,
the revaluation of the RMB against the HKD leads to
more capital flows from China to goods and assets markets
in Hong Kong. The stock market index of Hong Kong is
therefore expected to rise. The overall effect on Hong
Kong Stock Market Index is indeterminate without an
empirical study.
This paper attempts to examine whether the exchange
rate of RMB and HSI are related to each other since the
foreign exchange reform of China in July 2005 by using
cointegration and Granger causality tests. It is structured
as follows: Section 2 describes the data; the results of
cointegration test, error correction mechanism, and Granger
causality test are discussed in Sections 3, 4 and 5 respec-
tively; Section 6 concludes the paper.
2. Data Description
The monthly data of the nominal exchange rate of RMB
in terms of Hong Kong dollars (NEX), the composite
consumer price index of Hong Kong (CPIHK), the total
consumer price index of China (CPIChina), and Hang Seng
Index (HSI) are collected from Datastream for the time
period from August 2005 to March 2012. The real ex-
change rate of RMB in terms of HK dollars (REX) is
equal to NEX times CPIChina to CPIHK, i.e.,
China
HK
CPI
XCPI REX NE (1)
There are 80 observations to be used in this study. Ta-
ble 1 shows the descriptive statistics of REX and HSI.
Table 1. Descriptive Statistics of real exchange rate of RMB
in terms of HKD and Hang Seng Index.
Series REX HSI
Mean 1.155538 19947.90
Median 1.161332 20397.06
Maximum 1.243363 29540.78
Minimum 1.065253 12976.71
Standard deviation 0.052004 3604.71
Skewness –0.330679 0.097631
Kurtosis 2.113493 2.718397
Since the data used in this study are time-series data, if
they are non-stationary, regression will result in exagger-
ated results and spurious regression problem [5]. It is
essential to test the stationarity nature of the data before
the regression analysis.
REX and HSI are plotted in Figures 1 and 2. Both
time-series are not stationary because visually the mean,
variance, and autocovariances of the individual series do
not seem to be time-invariant. The Augumented Dickey-
Fuller (ADF) test for unit root [6] is used to test the sta-
tionarity of these time series.
Table 2 shows the results of ADF unit root test. The
ADF statistics of InHSI and InREX cannot reject the null
hypothesis of a unit root at 1% and 5% MacKinnon
critical value (–3.5188 and –2.9001 respectively). On the
other hand, the ADF statistics of InHSI and InREX
reject the null hypothesis at 1% and 5% significant levels
respectively. It is concluded that InHSI and InREX
are stationary and InHSI and InREX are of integrated
order of 1, in short, I(1).
3. Cointegration Test
According to the cointegration idea put forward by Engle
and Granger [7], although individual time-series variables
are non-stationary, there may still be a linear combina-
tion among the variables such that their stochastic trends
can be cancelled out. An Augmented Engle-Granger (AEG)
test is used to check for the stationarity of the term ut in
the following regression equation. The regression results
are shown in Table 3.
Real Exchange Rate of RMB in terms of HKD
0.95
1
1.05
1.1
1.15
1.2
1.25
1.3
8/1/05 2/1/06 8/1/06 2/1/07 8/1/07 2/1/08 8/1/08 2/1/09 8/1/09 2/1/10 8/1/10 2/1/11 8/1/11 2/1/12
Figure 1. Real exchange rate of RMB in terms of HKD,
August 2005-March 2012.
Hang Seng Index
0
5000
10000
15000
20000
25000
30000
35000
8/1/05 2/1/06 8/1/06 2/1/07 8/1/07 2/1/08 8/1/08 2/1/09 8/1/09 2/1/10 8/1/10 2/1/11 8/1/11 2/1/12
Figure 2. Hang Seng Index, August 2005-March 2012.

W.-C. LEE 565
Table 2. Results of ADF test.
Series ADF Test Statistic
InHSI –2.709003
InREX –1.064461
InHSI –3.709665
InREX –3.456199
Table 3. Regression results of Equation (2).
α β
Regression coefficients 9.528219 2.480117
Standard deviations 0.055285 0.367391
t-statistic 172.3472 6.750621
Probability (t-statistic) 0.0000 0.0000
Adjusted R-squared: 0.360691.
lnHSIt = α+ βlnREXt + ut (2)
Applying ADF unit root test on ut, the ADF test statis-
tic of the residual is –2.390807. The null hypothesis of a
unit root is rejected at 5% MacKinnon critical value
(–1.9443). It is concluded that HSI and REX are cointe-
grated. That is, there is a long-run equilibrium relation-
ship between HSI and REX. The regression on the two
variables in (2) is meaningful, not spurious; and there
exists a positive relationship between them as β, in Table
3, is positive.
4. Error Correction Mechanism
The error-correction mechanism (ECM) developed by
Engle and Granger [7] is used to test whether a disequi-
librium state will be adjusted to equilibrium in the short
run. The ECM in this study is as follows.
lnHSIt = α + β1lnREXt + β2ut – 1 +

t (3)
The regression results are shown in Table 4. The es-
timate of regression coefficient of ut – 1 is of correct sign
and found statistically significant at 1%. It is concluded
that there is error correction between REX and HSI in the
short run.
5. Granger Causality Test
The Granger Causality Test [8] is used to detect if there
is the cause-and- effect relationship between HSI and REX.
The test involves estimating the following regressions:
44
tit-i j
i=1 j=1
InHSI ΔInREX Δ   

t-j 1t
InHSI u  
j t-j2t
InREX +u
(4)
44
ti t-i
i=1 j=1
ΔInREX =ΔInHSI +Δ 
 (5)
where it is assumed that the disturbances u1t and u2t are
uncorrelated.
The null hypotheses of the test and the regression results
by using 4 lags of each variable are shown in Table 5.
Table 4. Results of Equation (3).
α β1 β2
Regression coefficients–0.00403 –0.14138 –0.19262
Standard deviations0.00770 0.647329 0.05408
t-statistic –0.52314 –0.21841 –3.56184
Probability (t-statistic)0.60240 0.82770 0.00060
Adjusted R-squared: 0.125743.
Table 5. Results of Granger causality test.
Null Hypothesis F-Statistic Probability
(F-Statistic)
lnREXdoes not Granger
cause lnHSI 3.11554 0.02072
lnHSI does not Granger
cause lnREX 0.83532 0.50763
By using 4 lags, the null hypothesis of REX does not
Granger cause HSI is rejected as the probability value of
F-Statistic are close to 0. Another way of saying is that
REX Granger-causes HSI. However, HSI does not Gran-
ger-cause REX.
6. Conclusions
This paper attempts to examine whether the real exchange
rate of RMB and Hong Kong stock market index are re-
lated to each other. The result of cointegration test shows
that they are cointegrated. The regression result indicates
that there exists a positive relationship between them. In
addition, the result of error correction mechanism further
evidences that there is error correction between them in
the short run. The Granger causality test indicates that the
real exchange rate of RMB Granger-causes Hang Seng
Index.
To conclude, the movement of the real exchange rate
of RMB will lead to a movement of Hang Seng Index to
a certain extent. When RMB appreciates against HK dol-
lars, Hang Seng Index will rise. It might imply that the
positive effect of capital flows to goods and assets mar-
kets in Hong Kong on Hong Kong stock market is domi-
nant due to the revaluation of the RMB against the HKD.
On the other hand, Hang Seng Index does not Gran-
ger-cause the real exchange rate of RMB in terms of HK
dollars. It reflects the fact that since the HK dollar is
linked to the US dollar at a fixed rate, any economic and
financial changes in Hong Kong, such as a change in HSI,
does not have any impact on the exchange rates of other
foreign currencies in terms of US and HK dollars.
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