Two-Way Capital Flows Model Based on Multi-Market Arbitrage: Empirical Analysis on Short-Term Capital Flows in China

As small-country two-asset model, the portfolio balance theory could not explain why the low interest rate policy in China could not avoid speculative foreign capital influx, but stimulates greater bubble in financial market. This paper proposes a two-way capital flow model based on multiple-assets arbitrage, where bilateral capital flow between two countries depends on investors´ portfolio adjustment among bonds, stocks, real estate and the foreign exchange market in both countries. Empirical analysis shows that net international capital flow from 1990 to 2006 in China is positively correlated with the interest rate and rate of return of stock market in China and exchange rate of RMB against USD, negatively correlated with that in USA. This paper suggests that exchange rate and interest rate marketization will be effective in keeping the independence of domestic monetary policy under speculative capital flows.