8 Economists' Investment Tips
Guan Tao: “Understanding the RMB” -- Basic Concepts of Exchange Rates (Part 2)
Summary of this issue
The relationship between market exchange rates and equilibrium exchange rates.
The relationship between overvaluation and undervaluation of exchange rates and appreciation and depreciation of exchange rates.
The definition of value laws in the foreign exchange market, market meaning, and policy implications.
Purchasing power parity and currency overpayment, who should I write to?
Understand the exchange rate policy between China and the US under the theory of the ternary paradox and the duality paradox.
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Another basic concept of exchange rates that has been discussed a lot is the equilibrium exchange rate. As soon as we talk about the RMB exchange rate issue, the government often says that we should maintain the basic stability of the RMB exchange rate at a balanced and reasonable level. What is an equilibrium exchange rate? It is relatively well defined in theory. It means the exchange rate level corresponding to a country's economy reaching a balanced state both internally and externally at the same time.
Although the characterization of the equilibrium exchange rate is quite clear, we found that there is no uniform standard for its quantification, and there are many calculation methods. This question is quite specialized. In my book “The Exchange Rate Game,” my colleague, Mr. Zhang Bin, made a special appendix introducing the main calculation methods and basic concepts of an equilibrium exchange rate. If you are interested, you can read it.
Corresponding to the equilibrium exchange rate is the market exchange rate. What is the relationship between the market exchange rate and the equilibrium exchange rate? If the market exchange rate appreciates excessively compared to the equilibrium exchange rate, then exchange rate overvaluation will occur. In other words, an appreciation of the exchange rate does not mean that the exchange rate is overvalued. Many people simply equate appreciation with an overvaluation of the exchange rate; this is wrong. Only when the market exchange rate appreciates excessively compared to the equilibrium exchange rate is called an overvaluation of the exchange rate. Similarly, if the market exchange rate depreciates excessively compared to the equilibrium exchange rate, the exchange rate will be undervalued, but depreciation is not simply tantamount to undervaluation.
Based on this concept, we can introduce another concept - the foreign exchange market also has a so-called law of value. If we want to implement a market-based exchange rate, we must respect basic economic laws. One of the important rules is the law of value. The law of value means that value determines the price, and the price fluctuates up and down around value. So what does the value law in the foreign exchange market refer to? The value law of the foreign exchange market means that the market exchange rate cannot deviate too far from the equilibrium exchange rate. In other words, there is no currency that only rises or falls, and there is no currency that does not rise or fall. In the dark, there is a balanced exchange rate that drives changes in the market exchange rate. However, we just mentioned that the equilibrium exchange rate is unspeakable. It has qualitative standards, but there is no uniform quantitative method, so the equilibrium exchange rate is usually not calculated, but tested by trial and error during the transaction process.
Historically, neither the government nor the market had an innate information advantage over the equilibrium exchange rate. China is an example of this. The RMB exchange rate was in line in 1994. At the time, the RMB exchange rate against the US dollar was 8.7. At the same time, there were strong expectations that the RMB depreciation was strong. Market participants generally believed that the 8.7 exchange rate could not be maintained; the RMB would fall below 9 or even 10. However, the reality is that after 1994, not only did the RMB not fall below 9, but instead appreciated, rising to 8.49. Foreign exchange reserves doubled that year, from 212 billion yuan at the beginning of the year to 51.6 billion. Since then, the RMB has gradually become an emerging strong currency. The exchange rate merger in 1994 established the strong position of the RMB. The successful counterattack on the RMB exchange rate proved that those in the market who expected the RMB to continue to depreciate were wrong.
The “7.21” foreign exchange reform in 2005 also proved that in advance, the government may not have absolute certainty about the balance level of the RMB. What is an important part of the “7.21” foreign exchange reform? This is a one-time 2% appreciation of the RMB exchange rate against the US dollar. At the time, the official response to reporters' questions clearly stated that after a 2% appreciation, our trade surplus will decrease, trade balance will tend to balance, and RMB will also become balanced and reasonable. However, the reality is that after the “7.21” foreign exchange reform, our trade surplus grew larger and the RMB continued to appreciate until 2013, when it appreciated by 340 percent. In hindsight, this shows that the government probably doesn't have an innate information advantage over the so-called equilibrium exchange rate level. Therefore, the equilibrium exchange rate was not calculated in advance; it was a trial and error test of market transactions.
The second element of the law of value is that prices fluctuate up and down around value. In other words, even if you know what level the equilibrium exchange rate is at, the market exchange rate cannot automatically stabilize at the equilibrium level; it must fluctuate up and down around the equilibrium level. As a result, when the market is generally bullish, people selectively believe in good news, the exchange rate will appreciate excessively; when the market is generally bearish, everyone selectively believes in bad news, and the exchange rate will depreciate excessively. This is the market meaning of the law of value. So what's its policy implications? If the government wants to keep the exchange rate basically stable, it can only regulate it; without regulating the market exchange rate, it is impossible to automatically stabilize at an equilibrium level. Therefore, the logic of the market is that the market exchange rate cannot be stabilized at an equilibrium level, and the logic of the policy is that if it is to be stable, it must be regulated.
The “8.11” foreign exchange reform in 2015 can explain the relationship between the market exchange rate and the equilibrium exchange rate. After the “8.11” foreign exchange reform, China experienced a decline in reserves, capital outflow, and exchange rate depreciation. The government has repeatedly emphasized that the RMB exchange rate should remain basically stable at a balanced and reasonable level, but we can actually see that the main reason for China's declining reserves and exchange rate depreciation in 2015 and 2016 was the concentrated outflow of short-term capital. Over the past two years, the size of our short-term capital outflows was two and four times the current account and direct investment surpluses, respectively. The concentrated outflow of short-term capital is an important characteristic. Theoretically speaking, short-term capital flows are driven by market sentiment and often deviate from economic fundamentals, leading to excessive exchange rates. Exchange rate overregulation also has a theoretical basis. The American economist Don Bush proposed the theory of exchange rate overregulation. He believes that the rate of adjustment in the commodity market is different. The price level in the commodity market is sticky, and commodity price adjustments are relatively slow, but market price adjustments in the financial market are very fast. Prices change as soon as market expectations change, so asset price adjustments in the financial market are faster than adjustments in the commodity market, which will lead to exchange rate overregulation. In other words, adjustments in the virtual economy sector are faster than physical transactions. This is a situation that often occurs when exchange rates fluctuate or market exchange rates. Exchange rate overregulation theory is an important branch of exchange rate determination theory. The example of the “8.11” foreign exchange reform shows that simply relying on the market to adjust the exchange rate level can easily occur.
In fact, there is no uniform standard for an equilibrium exchange rate. Regarding the equilibrium exchange rate, there is a very important theory called purchasing power parity.
According to purchasing power parity, the RMB exchange rate to the US dollar should have been 3.5 so far, but the current actual exchange rate level of the RMB is around 6.9, which means that the RMB exchange rate is now undervalued, and the RMB will appreciate. This is actually what people believed before 2014, and it was also something the market believed in. According to purchasing power parity, the long-term appreciation of the RMB is inevitable. However, now everyone believes that China's currency has surpassed that of the US. If we look at the share of M2 in GDP, China far surpasses the US. Under such circumstances, the RMB will definitely fall. If the share of M2 in GDP of China and the US is to reach the same level, the RMB exchange rate against the US dollar should be around 20, but now the RMB exchange rate is 6.9. The RMB exchange rate is clearly overvalued, so it must be depreciated. But let alone whether this theory can predict the future, and can the past be explained using the same theory and methods? According to the same method, we can calculate that the RMB exchange rate has always been overvalued since the exchange rate was merged in 1994. Even after the “7.21” foreign exchange reform in 2005, the RMB exchange rate was at its highest level, reaching more than 200 percent. This means that after the “7.21” foreign exchange reform, the RMB appreciated by 340 percent, which is simply wrong. But why can the yuan appreciate? Because current account surpluses accounted for too much of GDP at the time, the RMB was undervalued, and the relationship between supply and demand contributed to the appreciation of the RMB. This theory does not explain why the RMB will appreciate after 2005; on the contrary, it shows that the appreciation of the RMB since 2005 was wrong. It can be seen from this that the so-called monetary overrun theory cannot necessarily explain the exchange rate. Under these circumstances, the current market is bearish on the RMB; it first has an opinion and then looks for arguments. It first bears the RMB, says that the RMB will depreciate, and then uses various methods to prove what level the RMB will depreciate to.
Speaking of exchange rate theory, there are two important exchange rate theories that cannot be avoided. One is the ternary paradox, and the other is the dualistic paradox. The ternary paradox, also known as Krugman or Mondale's impossible triangle, talks about the three goals of independence of monetary policy, exchange rate stability, and free capital flow, that cannot be achieved simultaneously; at most, only two can be achieved; at most, at least one must be abandoned. From a macro perspective, this theory discusses what monetary policy should prioritize when the two goals of steady internal growth and stable external exchange rates clash. How did China do it? During the Asian financial crisis, China chose a monetary policy to maintain growth, and at the same time promised to the outside world that the RMB would not depreciate, so it used foreign exchange management policies to support a stable exchange rate. We have abandoned the free flow of capital and taken the two goals of exchange rate stability and monetary policy independence. Moreover, President Zhou Xiaochuan and President Yi Gang have repeatedly emphasized that China is a large country, and that monetary policy should prioritize domestic economic policy goals. This is the ternary paradox.
But in 2013, Elena Rey, an economist at the London Business School, proposed that there is no ternary paradox, but rather a dualistic one. What is the duality paradox? In the case of free flow of capital, whether the exchange rate policy is floating or fixed, monetary policy is not completely independent. After 2014, the Federal Reserve withdrew from quantitative easing, and monetary policy was normalized. The Federal Reserve was expected to raise interest rates aggressively in 2015, but it wasn't until the end of 2015 that it raised interest rates for the first time. why? One important reason is that China implemented the “8.11” foreign exchange reform in August 2015, which had a major impact on overseas markets. Drastic fluctuations in overseas markets also affected the Federal Reserve's interest rate hike agenda in September, causing interest rate hikes to be postponed until December. On November 28, 2018, while attending an event, current Federal Reserve Chairman Powell also mentioned that the Federal Reserve's monetary policy is now focusing on the global economic slowdown, so some changes in overseas markets also have an impact on the Federal Reserve's monetary policy. The US dollar exchange rate is freely floating. This also just validates Rey's statement. Currently, there is no ternary paradox, but a dualistic paradox. It is also on this basis that the International Monetary Fund put forward a proposition that in order to strengthen the independence of monetary policy, so-called countercyclical macroprudential measures can be adopted to control capital flows when necessary, thereby increasing the independence of monetary policy.
The above is the content of our section. I'm Guan Tao, thank you all.
Explanation of terms
Equilibrium exchange rate: Theoretically, it refers to the exchange rate level corresponding to a country's economy reaching an equilibrium state internally and externally at the same time. However, there is no uniform standard for quantification, and there are many calculation methods.
Exchange rate overregulation theory: The American economist Don Bush proposed that the adjustment speed in the commodity market is different. The price level in the commodity market is sticky, and commodity price adjustments are relatively slow, but market price adjustments in the financial market are very fast. Prices change as soon as the market expects prices to change, so asset price adjustments in the financial market are faster than adjustments in the commodity market, which will cause the exchange rate to be overadjusted.
The ternary paradox: The three-yuan paradox, also known as Krugman or Mondale's impossible triangle, talks about the three goals of monetary policy independence, exchange rate stability, and free capital flow cannot be achieved simultaneously; at most, two can only be achieved; at most, at least one must be abandoned. From a macro perspective, this theory discusses what monetary policy should prioritize when the two goals of steady internal growth and stable external exchange rates clash.
The dualistic paradox: In the case of free flow of capital, whether the exchange rate policy is floating or fixed, monetary policy is not completely independent.
That is the content of this course, thank you all.
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