Guan Tao: “Understanding the RMB” — The Basic Concept of Exchange Rates (Part 1)

Summary of this issue

How do Greenspan and Rogoff view the “exchange rate”?

Why should investors understand the market logic and policy logic of exchange rates at the same time?

From a micro and mesoscopic perspective, what is an exchange rate? And what are the exchange rate pricing methods?

What economic and policy implications do these basic concepts reflect?

What's in this issue

Usually, when talking about the RMB exchange rate, listeners want experts to directly explain whether the exchange rate appreciates or depreciates. Preferably, they can also explain what range the exchange rate is in. But I want to remind everyone that if someone simply tells you a conclusion, be very careful. Former Federal Reserve Chairman Greenspan once said that he had been making exchange rate predictions for half a century before he discovered that he should always establish a humble attitude on this issue. Meanwhile, Rogoff, the former chief economist of the International Monetary Fund, also said that it is very difficult to even explain the exchange rate changes of major currencies after the fact, not to make predictions in advance. Rogoff published a very famous book in China called “This Time Is Not the Same: 800 Years of Financial Absurdity”.Experienced experts like Rogoff and Greenspan all have a humble attitude on exchange rate issues, so we need to be more careful. So to understand the exchange rate issue, logic is more important than conclusion.

I used to work within the system. Since I left the system in 2015, I have mainly been engaged in research work. The fields I have studied are the same fields I have worked in in the past; they are all foreign exchange policies. After coming out of the system, as I wrote in the preface of the book “The Essence of Exchange Rates” published in 2016, I now stand between the government and the market, and I think I can be the third eye between the government and the market. Why is that? Because after leaving the government department, I am closer to the market and can get more first-hand market information and data, market people will also report more realistic situations to me. But I'm not a complete marketer. I used to work in the government department.I have a very important experience with government decisions. It's a trade-off issue. The government doesn't know what the best outcome is, but sometimes it has to make some compromises. Therefore, from the perspective of the government and the market, I can provide everyone with a more neutral, objective, and balanced view.

I thinkWhen the logic of the policy is consistent with the logic of the market, doing more with less; if the logic of the policy is not consistent with the logic of the market, then the effect of the policy will be greatly reduced; if the logic of the market is not consistent with the logic of the policy, then investors may also suffer huge losses. The best results are possible only when these two things work together.

Today, let's start with the first part — the ABC exchange rate and the evolution of the RMB exchange rate formation mechanism. Let's first talk about some basic concepts. However, the basic concepts I want to talk about here are not taken from books, but rather some exchange rate policies and market implications.

i.eWhat is the exchange rate?

Microscopically speaking, the exchange rate is a comparative relationship between one currency and another. From a Chinese perspective, that is, from a national level, the exchange rate policy is the country's arrangement of the exchange rate system and the choice of exchange rate policy. I like to make a distinction between the exchange rate system and the exchange rate policy. Exchange rate policy in the broad sense includes both the exchange rate system and the exchange rate policy; but in the narrow sense, the system is the system, and the policy is the policy, so we need to make a distinction.

As we all know, there is a monetary policy framework called an inflation target system, that is, the monetary policy of a country's central bank is aimed at price stability. This is an institutional arrangement; it is relatively stable and will not be easily changed. However, as the economic situation changes, under the inflation target system, monetary policy may sometimes be neutral, sometimes it may be tight, and sometimes it may be loose. For example, after the 2008 crisis, all countries adopted unconventional monetary policies. So the system may be stable, but the policies are changing. The exchange rate issue is the same. The exchange rate system is divided into a fixed exchange rate system, a floating exchange rate system, and a managed floating exchange rate system, but under the management floating exchange rate system, if the exchange rate is more flexible over a certain period of time, the exchange rate policy emphasizes flexibility. At some point, the exchange rate policy will emphasize the goal of stability in stages. This is the exchange rate from a national level.

From an international perspective, the exchange rate has been upgraded to the international monetary system to meet the needs of international trade and international payments. It is the sum of several regulations for currencies to perform the world currency function worldwide, including countries' determination of exchange rates, currency convertibility, balance of payments, how to handle surpluses and deficits, the types of foreign exchange reserves, and how to manage gold and foreign exchange. These elements make up the international monetary system.

We just mentioned that the exchange rate is the comparative relationship between one currency and another. This involvesPricing method for exchange rates. The exchange rate has two pricing methods. One is called the direct pricing method, that is, a certain unit of foreign currency is equal to how many units of domestic currency. What China uses is the direct pricing method. The RMB exchange rate was previously announced by the People's Bank of China, but now the People's Bank of China authorizes the China Foreign Exchange Trading Center to publish it. It indicates how much is one dollar equal to RMB. However, there is also an international pricing method, called the indirect pricing method, which is a fixed unit of domestic currency equal to how many units of foreign currency. For example, using the indirect pricing method, the dollar exchange rate is how much of a foreign currency is one dollar equal to. So we can see that even in international practice, there isn't just one practice; both the direct pricing method and the indirect pricing method fall under international practice.

What economic and policy implications do these basic concepts reflect?

First, studying the exchange rate issue depends not only on the domestic but also on the international market, since it is a comparative price relationship between one currency and another, a relative price.

Second, exchange rate policies are part of a country's economic sovereignty and monetary sovereignty. However, from the basic concept of the exchange rate, we can see that exchange rate policies naturally have externalities. For some large countries in particular, the larger the economy and the larger the scale of trade and investment, the greater the spillover impact of exchange rate changes on other countries.

Third, from the pricing method, we can see that countries all emphasize that exchange rate policies are their own sovereignty. For example, using the direct pricing method, the current RMB exchange rate is equal to 6.90 yuan. This was determined by the People's Bank of China. Seems like China's sovereignty, but according to America's indirect pricing method, 1 US dollar equal to 6.90 yuan is actually US sovereignty. Who actually has the final say on how much the exchange rate is, I'm afraid, isn't that simple. In particular, the exchange rate issue is external, so in the field of international finance and diplomacy, it is impossible to consider and understand exchange rate policies only from the perspective of one's own country.

The above is the content of our section. I'm Guan Tao, thank you all.

Explanation of terms

exchange rate: Microscopically speaking, the exchange rate is a comparative relationship between one currency and another. From a Chinese perspective, that is, from a national level, the exchange rate policy is the country's arrangement of the exchange rate system and the choice of exchange rate policy.

Inflation target system: It indicates that the monetary policy of a country's central bank is aimed at price stability.

Direct exchange rate pricing method: A certain unit of foreign currency is equal to how many units of the national currency. What China uses is the direct pricing method.

Indirect exchange rate pricing method: A certain unit of national currency is equal to how many units of foreign currency. Both direct and indirect pricing methods are part of international practice.

This is the content of this course. Thank you all.