Abstract
Currency carry trade disguised as goods trade can potentially channel external financial shocks to domestic economic environment, despite capital controls. We identify this channel in the context of post-GFC China using variations in product characteristics and a policy shock. We show that trade volumes of cost-efficient products responded significantly more to carry returns. However, such differential responses to carry returns vanished after the government’s clampdown on illicit capital flows. At the aggregate level, we demonstrate further that the surge in disguised carry trades led to a significant expansion of China’s shadow banking credit but not its traditional bank lending credit.
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