Hosted by: Hongru Financial Education Foundation, Shanghai Institute of Finance and Law
[Editor's Note]
December 9, in the 97th issue of "Hongru Discussion on the Tao", Lin Shu, professor of the School of Economics and director of the Department of International Finance of Fudan University, gave the following views on the exchange rate of the RMB: We have now formed relatively consistent expectations, and once the expectations are formed, if the market does not adjust in time, it will lead to unilateral expectations and trend depreciation. Previous appreciation experience has told us that once this trend is formed, it will be difficult to reverse in the short term.
The following is the transcript of Lin Shu's speech, first published on the WeChat public account Shanghai Institute of Finance and Law (WeChat ID: SIFL2002), and published with authorization by The Paper (www.thepaper.cn).
![Hosted by: Hongru Financial Education Foundation, Shanghai Institute of Finance and Law [Editor's Note] On December 9, in the 97th issue of](https://cdn-dd.lujuba.top/img/loading.gif)
Lin Shu, professor of the School of Economics and director of the Department of International Finance, Fudan University,
RMB exchange rate, capital controls and US monetary policy is indeed a very hot topic now. I have done a lot of research on this aspect, so I will share it with you here. My speech today mainly has three parts. First, I will briefly review some basic situations of the RMB exchange rate policy, that is, some basic characteristics and facts. This helps us to further analyze later. I will focus on the latter two parts: the relationship between RMB exchange rate policy and China's macro-financial issues, as well as the future trend of the RMB exchange rate, and what is the relationship with US monetary policy.
Basic Situation of RMB Exchange Rate Policy
First, let me introduce to you some basic facts of China's RMB Exchange Rate Policy. First of all, what is the most important basic fact I think? It has been more than 20 years since the exchange rate reform began in 1994. China's monetary policy system has two pillars - fixed exchange rate and capital controls. Therefore, China's monetary policy framework is actually a so-called "exchange rate pegging system combined with capital controls." This is the most basic fact.
Regarding monetary policy systems, the commonly used definition method is the International Monetary Fund method. IMF publishes an annual report on exchange rate arrangements and controls every year. In this report, the monetary policy system of each country will be announced. It has a very long table that lists the situations of each country. To sum up, there are four types of monetary policy systems in a country.
The first type is the so-called exchange rate target system, which means that the monetary policy is to peg the bilateral nominal exchange rate . For example, the situation in China is to peg the US dollar. Use this nominal exchange rate level as a nominal anchor, or an intermediary target of monetary policy.
The second type is the so-called money supply target system. The country's monetary policy is to focus on the growth rate of Monetary Aggregates. The one that is usually used is M2, and some countries also use M3. A relatively typical example is Mexico .
Since the early 1990s, many developed countries have gradually adopted the so-called inflation target system. This inflation target is focused on a medium-term inflation forecast. Usually an inflation target (zone), such as 2%. Monetary policy will then be adjusted based on the predictions.
The last type is the other. In other words, there is no clear goal that clearly defines such a goal, at least the official has not announced it. This type of country is like Malaysia .
What is the situation in China?
From the exchange rate reform in 1994 to 2005, we have a strict fixed exchange rate system, that is, a strict exchange rate target system, which belongs to the first situation. After 2005, if you look at the IMF's annual report, you will find that we have a slight change. Where does this change be reflected? We are not a strict exchange rate target system, we have become a dual-track system, which is the so-called dual framework. On the one hand, we focus on the target of money supply, mainly the growth rate of M2 in China; on the other hand, our exchange rate has not completely floated and implemented the so-called craw-like pegging.
Why did China adopt a strict fixed exchange rate system after the exchange rate reform in 1994? There is not no reason. We had very strong reasons to implement a fixed exchange rate system at that time. So what is the most important reason? It was actually high inflation in the late 1980s and early 1990s. Many people think that China adopts a fixed exchange rate to promote trade is actually a misunderstanding. China adopted a strict fixed exchange rate system at that time, and its biggest goal was to control inflation.
We had very high inflation in the late 1980s and early 1990s. A big advantage of implementing a fixed exchange rate is that it can curb inflation expectations. If a fixed exchange rate is credible, it can act as a so-called "nominal anchor" to anchor inflation expectations. If the public feels that the exchange rate between the RMB and the US dollar is a reputable and strictly fixed exchange rate, then China's inflation rate and the US's inflation rate will not be much different. That is, if your reputable fixed exchange rate can convince the public and make them believe that China's inflation rate will not be too far from that of the United States, it can anchor the public's inflation expectations to a certain extent. Another reason for implementing a fixed exchange rate is that the stability of the exchange rate helps trade.
The second pillar of China's monetary policy system is capital account control. So why should strict capital account control be implemented? Because if a country adopts a fixed exchange rate and opens its capital account, it will have a very serious consequence, which is followed by the complete loss of independence of monetary policy. This is a very important conclusion in our international finance, which is the so-called "three-paragraph". What does this "three-paragraph" mean? There are three good things in this world that everyone wants. Stable exchange rates, free transnational flow of capital and independent monetary policy. But unfortunately, this theory tells us that we can only get two of these three good things. Therefore, each country will have different choices based on its own country's different situations. For example, China chose a fixed exchange rate plus capital account control. Because monetary policy independence is crucial to a big country like China, we cannot let the Federal Reserve help us formulate monetary policies, especially if our economic cycle is the opposite of the United States.
is also like the Hong Kong region of China. It is a small open economy and a trade and financial center. Therefore, exchange rate stability and the free flow of capital across the country are very important to it. Therefore, Hong Kong implements a fixed exchange rate plus free flow of capital. But what it abandons is monetary policy independence. Therefore, Hong Kong does not have an independent monetary policy, and its monetary policy is completely following the Federal Reserve. Let’s look at the United States again. It chose to abandon the fixed exchange rate, which freely floats the exchange rate and allows free flow of capital across the country. Because the United States has a very developed finance and is a global issuer for reserve currencies, the free flow of capital is of great significance to it. On the other hand, it is a big country and requires monetary policy independence.
Another reason why China implements capital controls is due to financial stability. Because large-scale transnational flows of capital in the short term will have a relatively large impact on a relatively fragile financial system. So for these two reasons, we have also implemented strict capital account control, which is some historical background. Such an institutional arrangement of
has had very good results in the 1990s and can be said to be very successful. The effect can be viewed from three aspects: First, inflation is effectively controlled. The second effect is that we have successfully escaped the Southeast Asian financial crisis. The countries around China have been hit hard, but our impact is relatively small. Why? Because at that time we had a fixed exchange rate with a high degree of credibility and capital account control, which played a very good role. The third effect is that the stability of the exchange rate has promoted China's trade.
But after the new century, especially after China joined the WTO, this institutional arrangement faces severe challenges. I think the fundamental problem is that there are problems with both pillars.There are problems with fixed exchange rates and capital controls. What is the problem with fixed exchange rates? Our exchange rate system is too rigid. From 1994 to 2005, the nominal exchange rate level has not been adjusted. This rigid exchange rate system will lead to misalignment. In China, the RMB exchange rate was first undervalued, and later it led to overvalued. Due to the rigid exchange rate system, the market has no way to clear expectations and no way to differentiate, which ultimately leads to a serious overvalued unilateral appreciation expectations and the RMB exchange rate. This is a question of exchange rate.
The problem facing capital controls is the opening of trade and FDI, which has led to the continuous decline in the effectiveness of capital controls and the cost of controls is increasing. Therefore, after problems arise between these two pillars, the unilateral appreciation of our exchange rate and the effectiveness of capital account control declined, resulting in a series of financial problems. Concentrate on the macro financial bubble brought about by the unilateral appreciation of the RMB exchange rate.
RMB exchange rate policy and China's macro-financial issues
The macro-financial bubble formed in the past 10 years is ultimately due to the fact that our fixed exchange rate is too rigid. Although our real exchange rate is adjusting, the adjustment of our actual exchange rate mainly depends on price adjustment rather than nominal exchange rate adjustment.
so the adjustment speed is too slow. One problem caused by slow adjustment of asset prices is that it will create unilateral expectations. The biggest difference between asset prices and commodity prices is that its adjustment speed is very fast. But if you artificially intervene and delay its adjustment speed, it is very likely to lead to a unilateral expectation. Asset prices will form a so-called multiple equilibrium. That is to say, the price of this asset is not entirely determined by fundamentals. People’s expectations may affect asset prices. If you let it adjust too slowly and form unilateral expectations, asset prices are likely to overshoot. In other words, it turns out that 10% of the RMB is enough. If you let it adjust quickly, it will cause unilateral appreciation expectations, which may increase by 30% at this time. I think this is indeed happening in China.
After China joined the WTO in 2002, we had a surplus of for the current account and a surplus of , and a surplus of capital accounts. And both of these surpluses are very large. Under these two surpluses, it is obvious that this nominal exchange rate has adjustment requirements and pressure to appreciate. Therefore, it is normal to have an appreciation expectation, and appreciation expectation will lead to capital inflows. But the method we deal with is that nominal exchange rate is not allowed to be adjusted, that is, artificially maintaining this level of 8.3. How to maintain it? The central bank must intervene in the foreign exchange market. To put it bluntly, if you use RMB to buy US dollars, you will release the liquidity of RMB, allowing the base currency to expand and the currency to passively relax. You may be familiar with this word. We have a term called "foreign exchange deposit".
What does this foreign exchange deposit mean? It is because we want to buy US dollars with RMB, maintaining this fixed exchange rate leads to the issuance of base currency. We call it foreign exchange deposits.
In order to maintain this fixed exchange rate, our passive currency is easing, which leads to an increase in capital prices. The rise in asset prices has led to the increase in the yield of RMB assets, and hot money from outside has more motivation to flow into China. On the one hand, it is betting on the appreciation of the RMB. On the other hand, the return on RMB assets is very high, so it further stimulates the expectation of capital inflows and appreciation. So it is always in such a cycle, which ultimately leads to excessive appreciation of the RMB.
If the central bank wants to control this liquidity, the usual method is to increase interest rates and adopt currency tightening. However, the problem of raising interest rates is that it will amplify the spread at home and abroad , and further stimulate inflows. What we have adopted is a seemingly clever method, which is to increase the deposit reserves of commercial banks. Our reserve ratio is very high globally. Why raise the reserve ratio? In fact, it is to restrict bank lending. However, increasing the reserve ratio is actually an invisible taxation for commercial banks. Because of increasing reserves, this part of the money cannot be used to lend.So it is equivalent to a tax on commercial banks. So how can commercial banks realize their own profits? In this case, how do you make money? We can only move the original on-balance sheet business to off-balance sheet business, and expand off-balance sheet business, so we have formed China's shadow banking system. Everyone is going to manage their finances because the yield rate is higher. So this seemingly clever approach actually only converts the on-balance sheet expansion of financial institutions into off-balance sheet expansion, so how effective it is, I think it is worth discussing, and may cause some mismatch and distortion of resources.
Looking back on the past ten years or so, especially after the financial crisis, the RMB has been in a period of appreciation, and it is also a major cycle of global RMB arbitration transactions. What ultimately led to? In fact, the currency crisis in China has already occurred, but it is the other way around, not the sharp depreciation or excessive depreciation of the Thai baht during the Southeast Asian crisis. We are just the other way around, and we expect to lead to a currency crisis like excessive appreciation of the RMB.
The reason for the optical system is not enough, or rather unfortunately, we have encountered a huge external impact, which is the global financial crisis in 2008. We know that after 2005, the RMB was forced to appreciate, but the time of appreciation was chosen very unfortunate, because shortly after the appreciation, a global financial crisis broke out. In order to deal with the financial crisis, major developed countries have adopted extremely loose monetary policies. The United States has lowered interest rates to zero, and some European countries and Japan have even adopted negative interest rates. Therefore, the external monetary environment is very loose, the liquidity is very loose, and the interest rate is very low. External stimulus further amplified the bubble of RMB exchange rate. For a long time, there is a very easy way to make money. As long as you can move your money to China at a very low cost abroad and buy financial products, you can get high returns. This income comes from two aspects. One is the continuous appreciation of the RMB, and the other is the huge interest rate spread at home and abroad, so you actually earn both the exchange rate spread and the interest rate spread. And it is a unilateral arbitrage behavior with almost no risk. The expectation of unilateral appreciation and the interest rate spreads at home and abroad have formed about ten years of RMB interest arbitration transactions, which will lead to a large amount of hot money flowing in.
Next I will talk about our own internal policy factors, which is also very important, which has further amplified the bubbles behind us and has played a huge stimulating role. This internal policy factor is the "4 trillion" we launched in 2009. "4 trillion" is usually understood as a fiscal stimulus. Why will fiscal stimulus eventually turn into large-scale monetary easing? This is also related to our fixed exchange rate. Because in fact, what is a basic law in our open macroeconomics? If your country adopts a fixed exchange rate, then fiscal stimulus must require the cooperation of monetary policy. If we look at China's history, expansionary fiscal policy is often an important reason for monetary easing. Here I will show you two best examples. One is that after Deng Xiaoping's speech in the Southern Tour in 1992, we had large-scale financial stimulus. Then, at this time, our money supply is also rising. Another example is the recent "4 trillion", and the monetary effect of their two large-scale fiscal stimulus was very strong. It can be seen from the growth rate of China's M2 since 1986 that the first peak was in 1992 and 1993, after the speech on the Southern Tour, there was a large-scale fiscal stimulus. Another peak was after 2008 and 2009, so when China's M2 growth peaked, it was usually when large-scale fiscal stimulus was launched. Therefore, under such a large-scale release of money, the domestic macro-financial bubble has been further stimulated.
The second challenge is the challenges facing capital controls. There are many studies in our academic circle that show that capital controls are very difficult if a country is open to trade and FDI. If a country is open to trade, investors will come up with many ways to bypass capital account control.So, the most basic fact is that although China claims to have "strict capital account control", China has a lot of illegal capital flows. The decline in capital control effects has left us in a very out of control over the inflow of hot money, which has also contributed to the exchange rate bubble. Another consequence is that the effectiveness of monetary policy cannot be guaranteed. So, for a long time, especially after the crisis, we followed the major developed countries to volatility loosely.
What is the cost of rigid exchange rate system and invalid capital controls? The ultimate result is passive easing and unilateral appreciation expectations of Chinese currency, asset bubbles and excessive appreciation of exchange rates. And these have seriously hit the real economy. Since 2005, we have allowed the RMB to appreciate in value by more than 35% against the US dollar. Because China's inflation is higher than that of the United States, the real exchange rate rises more. If we look at the exchange rate of the package currency , because other currencies appreciate more against the US dollar.
So the actual exchange rate level of a package of currencies also has a very large appreciation. Such a significant appreciation will have a huge impact on the competitiveness of Chinese products in the international market. It will not only affect export companies, but even if the products produced by your company are completely domestically sold, it will also be affected by the appreciation of the actual exchange rate due to competition. Therefore, China's macro-financial bubble has had a very negative impact on the real economy, but it has stimulated speculative financial transactions.
RMB exchange rate trend forward and US monetary policy
Starting in 2014, especially after "8.11", a new cycle of RMB appreciation began. Around 2014, as the growth rate of the real economy slowed down significantly, people began to doubt whether China's economy could achieve a soft landing, and expectations for the exchange rate have begun to diverge. And I personally think that the role of "8·11" is the so-called wake up call. It was before "8.11", everyone had expected differentiation. However, after the emergence of the "8.11" policy, everyone's expectations of
have basically been consistent. Why does 8.11 bring such a strong effect? It actually wakes everyone up like an alarm clock. Some people did not realize that the RMB was under pressure to depreciate, and after this incident, they also knew that there might be pressure to depreciate.
So what is the situation in the RMB exchange rate policy now? I think we are repeating the previous mistake now, which is to use a rigid mechanism to artificially delay the speed of asset price adjustment, and this strategy of trying to exchange time for space will lead to worse results. Because what I just said is that there may be multiple equilibrium in asset prices. If you allow the market to clear out faster, it may be enough to depreciate by 5% or 10%. But if you artificially delay such adjustments, it will lead to no differentiation in expectations and everyone is unanimously bearish. This may depreciate by 20%. So I think it is a very bad policy to artificially delay asset price adjustment. So our current monetary policy is actually in a new dilemma, because the trend of the real economy is slowing down and monetary easing is required, but we now have the requirement of a exchange rate stabilization.
From the medium and long term, is the RMB really not a derogatory basis? Here are four common reasons to support people without a derogatory basis. We have already seen this a lot. First, we still have a surplus in our current account, second, we have a lot of 3 trillion yuan reserves. Even if we use a little bit now, we still have 3 trillion yuan. What is the third? Although the growth has declined, it is still higher than other countries. This seems to be a very favorable factor, and there are still interest rate spreads at home and abroad. So from these four points, it seems that it makes sense for people to have no prejudice. But think about it the other way around, you can also say that it makes sense that people have a derogatory base.
Why? First, the current account income and expenditure of the exchange rate have become less and less important, especially in the short term, which is no longer the main factor in the exchange rate determination, because the exchange rate is becoming increasingly the price of an asset. And although our surplus is narrowing, this is the first factor.The second one is that we say that there are many reserves, and the determination is large, but if you do such arithmetic, you will find that we put the reserves/M2 below Thailand's level in 1996, and there was a crisis in Thailand in 1997; it was also lower than the level in Argentina in 2,000, and there was a crisis in Argentina in 2001. So we have a lot of reserves, and its meaning is to resist Soros. If Soros comes, I can defeat you. However, it cannot withstand the "Chinese aunties". In other words, if all domestic investors exchange foreign exchange, our reserves will definitely not be enough. So from the perspective of this reserve/M2, you say it is very high, but I don’t think it must be high. Third, from the perspective of growth prospects, although we are higher than the United States, we need to look at the trend. The United States is improving and China is declining. In addition, if you look at it from a long-term perspective, we have a very important theory in international finance called purchasing power parity. The prices of homogeneous commodities should be similar in both countries. Why do we go to Japan and Europe to buy? Because tradable goods of the same quality are obviously more expensive in China. From the most important perspective, from the perspective of asset prices, the security and liquidity of the US market are better than that of China, and our current asset prices are very high. Therefore, if the asset is reset, the depreciation pressure will be great on the effect of the RMB exchange rate. Finally, US monetary policy is also a very important factor. Among these factors, I think asset prices and US monetary policy are two particularly important factors.
From the current point of view, I personally think it is more reasonable for people to be derogatory. This is my basic judgment on the RMB exchange rate. Unfortunately, we have now formed relatively consistent expectations, and once the expectations are formed, if the market does not adjust in time, it will lead to unilateral expectations and trend depreciation. Previous appreciation experience has told us that once this trend is formed, it will be difficult to reverse in the short term. What we are doing now is strengthening controls. Strengthening control is right, but strengthening control cannot fundamentally solve the problem. Strengthening control can delay adjustment, but there is no way to reverse the trend. So in the short term, there will still be pressure to depreciate. In addition, external shocks such as US monetary policy and what Trump will do after he came to power in January are very important variables. As for the medium- and long-term trends, it depends on our macroeconomic situation between China and the United States, especially the progress of China's supply-side reform.
I would like to evaluate the current RMB exchange rate mechanism. Our current mechanism is to focus on a basket of currencies. This seems very clever. We can find an excuse to depreciate quietly. Because other currencies are depreciating with the US dollar, we can depreciate a little, and we can also say that we are still strong currencies. But in fact, this seemingly clever approach is actually a self-defeating strategy. Why? I don't think it can be maintained. Because under the strong dollar, it will form a mechanism of expected self-reinforcement. Because now the basket of currencies is weak against the US dollar, if we focus on the basket of currencies, the weakness of these currencies against the US dollar will automatically turn into expectations of RMB depreciation. But what is the position of the RMB in the world? China's current GDP ranking is second. Then if the RMB depreciates, it will definitely stimulate other currencies we are staring at will to further depreciate. We have seen this "8.11" very clearly. After "8.11", the RMB depreciated slightly, and neighboring countries will depreciate immediately. Therefore, if the RMB weakens further, it will further stimulate the depreciation of a package of currencies, so it may form a vicious cycle. I think this may have this problem if I focus on a mechanism like a basket of currencies. Actually, I personally think I prefer two extreme approaches. Either you go back to the previous central parity fixing and have complete control over the mid-price, and it will become very easy to maintain the exchange rate. Either you are taking a relatively wide fluctuation method, allowing the exchange rate to be promoted at a relatively fast speed, and allowing the market to be promoted. I think these two seemingly more extreme methods may work a little better.
Finally, let me talk about how the US rate hike affects China's economy. I think there are three channels:
is the first to pass through trade channels. I think this is a good thing for China, but this good thing is that there is a "Big if". What is this "Big if"? It is the Federal Reserve's judgment that the trend of the US economy is correct. Then in this case, the rate hike indicates that the clear recovery of the US economy will help the demand for Chinese products. So I think this channel may be beneficial to China's exports if the Federal Reserve judges correctly.
The second one will affect global liquidity, and the US dollar rate hike will lead to a shrinking global liquidity. For those countries with US dollar bonds, will make it more difficult to borrow new debts and will also increase the cost of borrowing new debts. I think this impact will be relatively smaller for China.
The third channel, I think the impact on China's exchange rate may be relatively large, mainly the substitution of US dollar assets on RMB assets. means that when the return on US dollar assets increases, investors will abandon RMB assets to seek US dollar assets. This has a great impact on us, and another is that it causes the depreciation of currencies in other countries to against the US dollar. Because if we focus on these currencies, that is, our capital will depreciate as they are, and ultimately further aggravate the pressure on capital flight.
Finally, the point I want to express is that the impact of US monetary policy on China's macroeconomics will eventually lag behind the RMB exchange rate policy. Here I will also give a basic conclusion of open macroeconomics that everyone is very familiar with, that is, the impact of external currency shocks on this country depends on your exchange rate system. If you have a fixed exchange rate, then raising interest rates abroad is not good for this country. Why? The reason is simple. In order to maintain the exchange rate level, the country must passively tighten the currency. So if we maintain a fixed exchange rate, like when the Federal Reserve raises interest rates, we will maintain a fixed exchange rate, and we have to follow the United States to tighten. This will add to the insult to our growth rate that is already downward and slowing. But if the other way around, our exchange rate has sufficient flexibility, if it is a floating exchange rate, then the rise in foreign interest rates is a good thing for the output of our country. Why? Because it can stimulate domestic output through the depreciation of its own currency.
