Hello everyone! Welcome to the session “RMB Exchange Rate and Globalization“. I am DI Dongsheng from the School of International Relations, Renmin University of China.

In the last lecture, I made a start. We talked about the factors that couldn’t determine the exchange rate. In this talk, we’re going to discuss what factors determine the exchange rate in the long run.

Why do we discuss this “in the long run”? Why is the period of time important? Because with different periods of time, the determinants of exchange rates vary. Short-term exchange rates are determined by market expectations. When a large number of funds flow across borders or a large number of people behave collectively, volatility can be created. Buffett always believes that the market is a lunatic. So short-term exchange rates are not predictable.

When it comes to medium-term exchange rate – more than one year, especially around 2 to 3 years, or at most 3 to 5 years – in such a period, you will see a pair of tangible hands playing a decisive role in the exchange rate, that being the government’s regulation. The exchange rate of a currency is different from the price of commodities. Commodities are produced at certain costs. From 1971, the currency is no longer an objective commodity, but a sign of sovereign credit. A country’s sovereign government is fully capable of defending or manipulating its own currency credit, because the currency credit is its creation, and costs almost nothing to create. But in a period of 5 to 10 years or even longer, you will find that in the long term, the power of the market is very strong, while the government’s power is limited, as the saying goes “an arm can’t twist the thigh”. Now we’ll talk about the internal forces of the market and how it shapes the long-term exchange rates of currencies.

[Title: Direct Factors Affecting Long-Term Exchange Rates]

Those who have studied finance have heard of the Balassa-Samuelson effect, which is mentioned in many papers and monographs on exchange rates. But many empirical studies have found that the Samuelson effect, or the Samuelson hypothesis, is ineffective in explaining the application of exchange rates in the contemporary world. This theory is a theoretical conjecture put forward by two noted American economists in 1962. It is just a theoretical assumption. But in 1971, the dollar was decoupled from gold, marking a qualitative change in the entire monetary world. From then on, the rules of the game changed. It is not the previous world anymore. What used to make sense in the past will not make sense in another time and space. Today, when we discuss the issue of currency exchange rates based on the Balassa-Samuelson effect, we often come to the wrong conclusions. What should we do? I suggest looking at the facts.

I sorted out the historical big data samples of global currency fluctuations in the past half century since 1971. We put forward dozens of hypotheses and tested these hypotheses and conjectures one by one with empirical data. The study found that the most direct and effective factor affecting the rate, in the long run, is the price of a country’s tradable goods. What are tradables? In layman’s terms, all products that can earn money from other countries are tradables. The weighted average price of tradables determines the exchange rate level of a country. If the price of a country’s tradable goods rises, its exchange rate will fall in the long run, and vice versa. The reason is simple. From a long-term perspective, the tradable goods of various countries generally conform to the Law of One Price. If the price gap of tradable goods between the two countries is too large, people will buy and resell at a profit. Eventually, a balance between the two countries would be achieved.

So what factors determine the price level of a country’s tradable goods?

[Title: The Relationship between Technology Level and Exchange Rate]

As is known, price depends on supply and demand. In terms of supply, with a higher technological level and competitiveness, the price of tradable goods will fall faster. If you manage to control the costs and improve efficiency, your exchange rate will be higher. However, when we try to verify the factor of technological progress, we find that although its contribution is positive, this can only explain 20% of the change in the exchange rate, but it’s not the key factor.

[Title: The Relationship between Aging and Exchange Rate]

Later, we found that demand weighs more than other factors. We should therefore focus on the influencing factors on the demand side. From the demand side, what determines the price fluctuation of tradable goods? By comparing the data, we found that the age structure of the population is the most explanatory factor. In our model, population aging can explain about 65% of exchange rate fluctuations. The faster a country ages, the more likely its exchange rate is to be high. It is very interesting.

Why is aging so closely related to exchange rates? Why does the exchange rate go up when people get older? Because as people get older, their desires diminish. Whether they have money or not, their consumption will shrink. How much beer could you drink per day in your twenties? How much can you drink now? For an aging society with a shrinking consumption, will its production capacity also decline proportionally? Not at all. The labor force in the factory will decrease, but its capacity will not. Because in industrialized countries, there’s no doubt that automated production lines and robots can take place of the disappearing labor. Society’s supply won’t reduce, while the demand is shrinking, resulting in a sharp decline in the price of tradable goods. Under such a mechanism, after the 1990s, despite a series of economic difficulties such as recession, asset prices plummeting, industries transferring, and the disappearance of core brands, Japan’s debt rate became higher and higher, but its exchange rate was still high. To what extent? It was so firm-standing that the government wanted to lower the rate but didn’t manage to. The key factor was aging. Japan was the fastest aging economy in the world.

Technological progress and aging can explain most of the long-term trends in exchange rate fluctuations, but these two factors are still superficial. As social science researchers, we need to think thoroughly, explore further, and dig to the bottom layer of these two superficial economic factors from an interdisciplinary perspective. What other factors have shaped the economic, social, and structural changes in society?

[Title: 6 Deep Factors Affecting Exchange Rates]

After sorting out over 200 economies’ social, economic, and political conditions, we found some amazing laws as follows.

[Title: The Relationship between National power and Exchange Rate]

The first factor is what I call national power – the so-called big or small governments. The larger the proportion of a government’s fiscal spending to its GDP, the better its exchange rate will be in the long run. Liberal economics regard government as a necessary “evil”. The so-called “evil” is a negative factor, a bad one. Although necessary, it is a bad factor. However, in my theory, especially in my book “Money, Power and People“, I explained that economic growth needs the cooperation of the public sector and the private sector, which requires the capacity and efficiency of the public sector. The so-called developed countries are the ones that can control and mobilize their people. The so-called developing countries are those in which the central government can’t appeal to anyone outside the Capital. No local governments respond to them. The central governments are not able to collect taxes, so they have little money to spend or to provide effective public service. But the problem is that if the government cannot provide public goods, like social security order, business order, integrated domestic market, international trade agreements, infrastructure, education, medical care, and so on, the country can’t be prosperous solely depending on the private sector. All the entrepreneurial success and enterprise development can’t be achieved with just the efforts of entrepreneurs. What’s supporting them? It’s the essential support from public services provided by the government. Just like air to people and water to fish, normally you don’t realize its existence and only feel pain when it’s gone.

From statistics that we can see, in general, the more powerful a government is and the higher the proportion of its fiscal expenditure to GDP, the better the exchange rate will be in the long run, and people will live a more decent life, which, by UN standards, means a higher HDI (Human Development Index).

[Title: The Relationship between Trade Opening and Exchange Rate]

The second point is the degree of trade opening. It means that a country that is more integrated into the international trade system and the economy which has a higher proportion of exports will have a higher exchange rate in general. Accordingly, what you export is more important than your export volume. The World Bank released a report “what makes a currency pro-cyclical”. In this report, they carried out quantitative research and found that if a country exports energy, raw materials, bulk commodities, and ores, its economy is characterized as pro-cyclical. That’s to say when the global economy is in recession, things you export will also depreciate and become worthless. As the saying goes, it never rains, but pours. Due to the falling prices of energy and commodities during the recession, your exchange rate will depreciate further, making things worse. So, your economy will fluctuate greatly. It will be subject to overheating in an economic boom and will fall to the ground during a recession. Conversely, if you rely on manufacturing and exporting manufactured goods, your pro-cyclical characteristics will be less obvious. Because your exchange rate will be high in the long run and your currency doesn’t tend to depreciate. We assume that the economy is in recession and your currency has been dumped and depreciates a little bit. Your exported industrial products immediately gain a price advantage, because your local currency turns cheap. Your commodities have a price advantage over foreign ones. There are more commodities exported and less imported. The trade surplus rises, and the exchange rate gains momentum again. That is to say, if your exchange rate depreciates slightly, it boosts exports, increasing the trade surplus and another rise in the exchange rate.

If we think of different currencies as balls thrown into the water, some countries’ balls are made of iron or copper, sinking fast and continually. Some are made of stone. Some are made of wood. What about some other balls? They’re hollow rubber balls. Those corresponding currencies’ exchange rates can’t be pushed down, no matter how hard you try. When you let go, they pop up again. The most typical example is the Japanese yen. Several friends working in Hedge Funds on Wall Street have told me that, when they previously saw how high the proportion of Japanese Government Bonds was relative to GDP, they all supposed that Japan was prone to risks, and thought they could “attack” it. They wanted to short the yen to give a fright to the market and see if anyone “runs away”, or even to cause a “stampede”, so they could profit from it. But in the end, they said, any fund managers on Wall Street who tried to short the yen came to a bad end. Note that, it wasn’t that the Japanese government wanted to teach them a lesson or were deliberately going against them. The Japanese government welcomed anyone to come and short yen. They also hoped that the yen would fall, so that the economic growth and export growth could quickly get a boost. However, there was no way to push down their exchange rate. Even if they invited Wall Street hedge funds to attack it, nothing would change. The theory of currency is just like the metaphor of balls that I mentioned.

[Title: Relationship between Key Factor Characteristics and Exchange Rate]

If your economy doesn’t rely on labor, but on resources like oil, natural gas, iron ore, and copper mine, I’m sorry to say your exchange rate will sink to the bottom like an iron ball thrown into the water, sinking as deep as the Mariana Trench goes. In the long run, your currency is worthless. If the proportion of manufacturing in an economy is high, and the R&D expenditure is the majority, your exchange rate will be like a rubber ball, always floating on the water and jumping up with any hits. So, the key factor in the currency is people. In my political economic theory, which I call the people-centric theory, what does “people” refer to? It’s not the ruler of a country, but the people, the average level of labor quality, which is the core competitiveness. The more brainpower your people own, the better your exchange rate will be. If your people rely on physical strength, your exchange rate may be weak. If there’s hardly any physical work in the economy and people depend on natural resources, selling whatever they can dig up that is left by ancestors, your exchange rate will be extremely weak. That’s what we found from analyzing data and we get a significant correlation which becomes our third point, key factor characteristics. Is the key factor natural resources or humans, is it about a human’s brain power or a human’s physical ability? This is very explanatory for exchange rates.  

[Title: The Relationship between Civilization Type and Exchange Rate]

Next, the fourth point is to explain currency exchange rates from the perspective of civilization type. As is known, there are different religions in this world, each of which has sub-systems. Religions shape one’s outlook and values and also lead to different behavioral patterns and different social organization characteristics. From the perspective of civilization type, we calculated the firmness of the exchange rate of different types of countries and found that there are obvious differences among them. There are two types of strong currencies in the world. One is Protestant civilization, which represents the currency of some economies in western Europe, northern Europe, North America, and Oceania. The issuers of these currencies have dominated most of the world in the past 400 years. In 400 years of domination, they spread grievances across the world. That’s Protestant civilizations’ contribution. Like the Netherlands, the United Kingdom, and Germany, who tried to compete for hegemony in the late 19th century to early 20th century, and now the current hegemon, the USA and northern Europe with pretty high living quality, are all Protestants. An important feature of Protestantism is the belief that individuals can communicate directly with God. In my understanding, Protestants regard their earthly accomplishments as evidence of God’s love for them and a ticket of admission to heaven. Their behavioral pattern is different from other traditional monotheistic believers.

The only civilization that can compete with Protestantism is the East Asian civilization, our civilization. It involves the line running from Japan, the Korean Peninsula, mainland China, then Taiwan, Hong Kong, and Singapore to Vietnam. In fact, after World War II, there has been a rise and fall of nations’ power in the global political and economic landscape, among which the rise of the East Asian dragon is a key event. The rise of China is just a part of the story of the rise of East Asia.  

This type of civilization has a common feature, disbelieving in gods. Their people have a pragmatic attitude towards gods. Let’s think about the various myths and stories left from ancient times. What did our ancestors want to teach us through “Nvwa mending the sky”, “Pangu opening up the world”, “Yugong moving mountains” and “Jingwei filling the sea”? The natural world or the gods didn’t leave us a friendly “user interface” when we, our ethnic group, came to the world. Things are usually imperfect. They don’t take too much care of us. We need to meet these challenges and excite our potential to deal with the imperfections of this natural world, with our wisdom, efforts, and adventurous and revolutionary spirit.

Some people think that East Asians are too practical. If you don’t believe in gods, you have no morals. This concept is unreasonable and conflicts with history. Chinese people did not quite believe in gods since ancient times. Confucianism, which respects and keeps away from ghosts and gods, advocates that human behavior should be regulated by morality and ethics, rather than expectations or fear of the next life. That’s a more responsible and realistic humanistic attitude. When our ancestors created this civilization, the underlying code was to tell descendants to stand facing God, not to kneel.  

Well, the currencies of Protestant civilization and East Asian civilization are both relatively reliable and have the potential to appreciate in the long run.

What is a weaker currency? That refers to South Asian and Southeast Asian currencies. People in those areas mainly believe in Theravada Buddhism or Hinduism. Their currencies are relatively weak and prone to depreciation, but not particularly severe. Take India as an example. Since the loosening of interest rate control in 1994, the average annual depreciation is about 3% to 3.5%. There is staged depreciation, but usually not dramatically and therefore tolerable.

So which types of civilization are particularly prone to depreciation? There are three major religions: Roman Catholicism, Orthodox Christianity, and Islam. They have something in common, which is that they don’t encourage their followers to pursue earthly wealth. They encourage followers to seek pleasure. For example, the Catholic culture of Latin America and southern Europe is to enjoy their life. That’s their life attitude. Both East Asian and Protestant civilizations encourage their believers to pursue worldly wealth and success to prove their self-value. As the Chinese saying goes, it is our virtue to be diligent and thrifty, and this is our heirloom. The so-called diligence is to work hard to produce, and the so-called frugality advocates none-consuming. If you produce but don’t consume, the surplus you save will become equity and make you a creditor to others. What we regard as a virtue, seems to be an expression of greed to the other three monotheistic civilizations. It’s a sin instead of a virtue.  

So why is the exchange rate of South Asia and Southeast Asia stronger than that of monotheism and not likely to depreciate sharply? Because Theravada Buddhism and Hinduism, in my opinion, encourage neither production nor consumption. They don’t advocate accumulation of wealth or pleasure, just meditating there all day long, pursuing inner peace. That is to say, supply and demand are both shrinking. They are not in competition with the whole world. Without strong desires, they are able to tolerate poverty. So, the deficit is not large.

What about the three monotheistic religions? They discourage consumption and encourage enjoyment instead of production. As a result, debt is common. As everyone in the country has no savings, they have to borrow from foreign countries, denominated in foreign currencies. If the borrowings accumulate to an unaffordable amount, its exchange rate will suffer a sharp depreciation.  

Well, we just talked about the civilization types, and finally, we will discuss two more interesting factors.

[Title: The Relationship between Average IQ and Exchange Rate]

These two actually refer to the same thing – the level of average IQ and religious seriousness. Some may doubt whether that statement is a little politically incorrect or offensive to some groups. However, we are here to talk about social science research, not to engage in political debate. Quantitative studies have found that IQ differs significantly in different countries, and some right-wing scholars tend to attribute this to genetic decision, while left-wing scholars believe that the difference is caused by nourishment and education. Anyway, it’s a fact recognized by global researchers that there are significant differences in the level of average IQ in different countries in the world. Because it’s a solid fact that can be tested.  

[Title: Relationship between Religious Seriousness and Exchange Rate]

What is interesting is that many researchers in religion and sociology have found that the average IQ is also significantly negatively correlated with the seriousness of religious piety. The lower the average IQ is, the more serious they are about religion. People with higher average IQ care less about religion. East Asia, the region with the highest average IQ in the world, has taken a very pragmatic attitude towards religion. East Asians’ praying for blessings and burning incense in front of Buddha, are all functional deals. No matter which god they are making wishes to, Buddha, Bodhisattva, or dragon king, they’re willing to worship so long as the god is said to be helpful. What are they thinking when praying? Bless me to get promoted. Bless me to have a baby. Bless my child to get enrolled in a certain school. When I achieve my little goal, I’ll burn high-grade incense and gild your status. Is this a belief? Obviously not a devout one. It’s like a concept in international trade called inquiry. Yes, inquiry. I’ve heard that you have some mana I need that can bring me good luck. And I have some cash to burn a high-grade incense and gild your status. Let’s make a deal.

[Title: Exchange Rate Risk in Overseas Investment]

The knowledge above is based on the data of the past 50 years. If it’s still applicable in the future, how can we make profits with it?

Now Chinese capital is going worldwide. The US and Europe no longer welcome our investment, so our domestic savings are in excess resulting in a lower and lower yield rate. We need to seek opportunities in the “Belt and Road Initiative”. There are dozens, even hundreds of countries involved in the BRI. The biggest risk of your investment is not political or diplomatic risk, but exchange rate risk.

An entrepreneur student came up to me and sadly complained that he ran his infrastructure business in Angola so assiduously for over ten years. In his heyday, he earned hundreds of millions of yuan. But because he was engaged in the construction industry with a large number of assets, high debt, and high leverage – these are the characteristics of this industry – his assets in Angola shrank dramatically when the exchange rate crashed. Since the money he owed was denominated in the US dollar and RMB, in these strong currencies, his debts didn’t change. After the storm, he was beaten back to his original shape, and he had worked in vain for more than ten years. Such an entrepreneur, he suffered from not understanding the law of exchange rate.

How can we identify which economies will see their currencies depreciate significantly? A country that cannot mobilize – unable to suppress bandits or integrate its local armed forces. A country that has a very young population with too many children. A country whose people are very much devoted to religions, free from competition, and live lives full of happiness without pressure. A country with low export volume and little international trade. A country where the economic structure is supported by natural resources. A country where its people believe in monotheism. If a country meets the descriptions above, you have to be careful. It’s likely that the currency of this economy will depreciate.

Conversely, people in a country are very greedy and would rather abandon their families and work themselves desperately to engage in fierce competition. They grudge improving food and clothing. They desire to stand out, with an endless yearning for wealth, success, and fame. They’re willing to pay anything for these worldly things. A country’s people who never believe in God in their minds, willing to kowtow and burn incense in any temple. A country whose people aren’t willing to have babies. Children are getting more and more educated. Products are becoming more and more high-grade, high-precision, and sophisticated. The proportion of R&D expenditures is getting higher and higher. With a rising position in global trade markets, their trade exports are increasing in global market share. Currencies in these countries are firm in the long run.  

If we can tell strong currencies from weak ones, we could seek profits and avoid harm. How can we do it? I will systematically sort it out for you in the last lecture.

[Key Takeaways]

1. Factors that affect the exchange rate in the long run: the price of a country’s tradable goods, which is determined by the technological level and the degree of aging of the population.

2. The deep-seated factors that affect a country’s long-term exchange rate: national capacity, trade openness, key factor characteristics, civilization types, average IQ, and religious seriousness.  

3. Chinese enterprises, industries, and capital abroad need to focus on preventing: the exchange rate risk of the target country.

Finally, let’s underline some key points.

First, the most direct and effective factor affecting the exchange rate, in the long run, is the price of a country’s tradable goods. This price is determined by technology and the degree of aging of the population.

Second, national capabilities, trade openness, key factor characteristics, civilization types, average IQ, and religious seriousness are all deep-seated factors that affect a country’s long-term exchange rate.

Chinese enterprises, industries, and capital abroad need to focus on preventing the exchange rate risk of the target country.

Well, that’s it for this lecture. You are welcome to leave a message below and join the discussion, or share this talk with your friends. See you next time.