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

Since the outbreak of the COVID-19 pandemic, unscrupulous politicians in many countries around the world have tried to make the Chinese government to compensate for their losses in the pandemic through judicial or political and diplomatic means. This is obviously nonsense, but we still have to take it seriously because the West does have a “hostage” in hand – China’s foreign exchange reserves in their treasury pool.

In the past, we always spoke a proud tone about our foreign exchange reserves. “It is the world’s largest.” “It represents the country’s comprehensive national power.” “It is the achievement of our industrialization growth.” Something like these. But in fact, things were far from what people thought. Taking a look around, it is often the periphery developing countries that really need to accumulate large foreign exchange reserves, while the developed countries are the destinations for other countries to invest their foreign exchange reserves. Therefore, massive foreign exchange reserves are not a sign of a great power, but a symbol of a vassal state. China’s foreign exchange reserves are becoming more and more of a problem for us. Because we have so much money that has nowhere to go.

So how were China’s foreign exchange reserves established? We will answer this question in this lesson.

[Title：Foreign Exchange Reserves Stem from Fear of Exchange Rate Fluctuations]

Let’s start with the conclusion. China’s large foreign exchange reserves originated from the instinctive fear of the periphery developing countries for the fluctuation of the exchange rates of their own currencies. After 1971, in terms of exchange rate, there was an asymmetric power relationship between the core and periphery countries in the global monetary system. The currency exchange rates in developing countries were very volatile and therefore had huge macroeconomic impacts. These countries could not withstand the impacts, so they need to build foreign exchange reserves.

In plain words, if we regard the global village as a big room with a huge central air conditioner, which can be used to regulate the temperature of the economy. Then the remote control of this air conditioner is in the hands of the core countries, which are the issuer of the global reserve currencies, and then the weak periphery countries can only passively accept the change of room temperature by the core countries. For example, when the United States changes the hot air to cold air, or the cold air to hot air, those in the room who do not need to cool down will be passively cooled, and those who are already boiling will still passively receive hot air and get even hotter. Therefore, countries that do not have a remote control in their hands can easily catch a cold, mainly because they have different body temperature and feel the room temperature differently.

Developing countries usually lack pricing power, so their profits are relatively small. Once the exchange rate fluctuates greatly, it will make their low-profit businesses become unprofitable. Exporters will not dare to sign contracts. Thus, governments in developing countries usually tend to keep their own exchange rates stable. So how do they intervene? We can see the entire East Asian, from Japan, to the Four Asian Tigers, to today’s China, and then Vietnam: We all have a natural tendency, that is, trying to bind the local currency with the mainstream global reserve currency in the process of industrialization, especially the U.S. dollar. Exchange rates should ideally remain stable or fluctuate slightly to benefit the country’s export industries and exporters.

[Title：How Were China’s Foreign Exchange Reserves Established?]

Next, we will use the building of China’s foreign exchange reserves as a case study to explain the details.

First, in order to achieve rapid industrialization, China engaged in large-scale investment promotion and mercantilist policies to encourage exports, and foreign capital came to China attracted by various preferential conditions. Of course, this was between 1992 and 2012, and apparently the policies are different now. Suppose a Taiwan-funded enterprise came to Dongguan and set up a factory to sell manufactured products globally. Let’s assume that the enterprise brought in capital of 100 million dollars. It needed to operate in China using the Chinese yuan, so the 100 million USD needed to be sold by the Taiwan-funded enterprise to its own bank in Dongguan under China’s system of Foreign Exchange Settlement and Sales, for example, Bank of China Dongguan Branch. The $100 million then went into there, and the bank was not allowed to keep the $100 million on its own accounts. Because there was an institutional binding mechanism called administration of banks’ foreign exchange positions. At any time, there was a limit to the amount of foreign currency that could be kept on the accounts of any financial institution. Let’s say, the bank had an account limit of $10 million, but today it received a settlement of $100 million. The bank would have to sell the extra $90 million on the interbank foreign exchange market before the evening close, so the $90 million was listed for sale on the national interbank foreign exchange market.

When the entire China was attracting investment and encouraging exports, banks across China would have excess foreign currencies to sell, rather than buying in. At this point, there would be pressure on the market. When there was a lot of demand for RMB and a surplus supply of foreign currency, there would be pressure for RMB to appreciate relative to the USD. If the RMB exchange rate was allowed to appreciate rapidly, it would hurt the price competitiveness of labor-intensive, low-profitability export enterprises such as garments, shoes and socks, and bags. So, this was the time when the central government should step in and intervene in the exchange rate of the yuan against the dollar to ensure the export competitiveness of the manufacturing sector. The People’s Bank of China came to the interbank foreign exchange market as a market participant, generously held out a hand and said, “Whoever is willing to sell USD at a price lower than 8.27 yuan, or the equivalent value of foreign exchange of these sell orders, I will buy them all.” Then it bought foreign exchange day after day, year after year, and eventually accumulated the peak of 4.2 trillion dollars of foreign exchange reserves. This is how foreign exchange reserves come.

The money was then placed in a sub-ministerial agency under People’s Bank of China, called the State Administration of Foreign Exchange. The Foreign Exchange Bureau then invested the money in the global major financial asset market. For example, the U.S. treasury bonds, European treasury bonds, Japanese treasury bonds, etc. This is how we built up our foreign exchange reserves.

You might ask: The People’s Bank of China (PBC) does not have the authority to collect taxes, and usually has little income, so what money does it use to buy foreign exchange? When the balance sheet is expanded to buy foreign exchange, we refer to the newly formed monetary base as the funds outstanding for foreign exchange. This is passively generated, not that the PBC wants to create so much money. The PBC has its own money printing machine. When it needs to buy foreign currency, it can print the required amount of RMB through this money printing machine. The PBC has to create this amount of money, which is known as the monetary base. We also call the monetary base high-powered money in finance. To draw an analog, the monetary base is like the original syrup of wine, and there is an exchange relationship between the original syrup and the final wine. The exchange mainly depends on the required reserve ratio. We had $4 trillion foreign exchange reserves at the peak. If we consider an average exchange rate of 7.50 yuan, then in order to maintain the stability of the RMB exchange rate, we passively increased the base currency (the funds outstanding for foreign exchange) to reach 30 trillion yuan. And assuming a money multiplier of 4, which is determined by the required reserve ratio, then it comes to 120 trillion yuan in broad money.

Then the central bank continuously and passively issued large amounts of money to expands monetary base significantly, and expanded its balance sheet. Theoretically this would trigger inflation. The primary duty of a central bank is to avoid high inflation. Faced with this inflationary pressure, it needs to hedge against liquidity. From how central banks practiced liquidity hedging in the past 20 years, there are three main methods.

The first method is that the central bank will issue central bank notes. The so-called central bank notes are the debt created by the central bank to borrow money from the financial market. This therefore releases liquidity to the market on the one hand, and absorbs liquidity back from the market on the other. The cost of funds for central bank notes is about 3%. In other words, it is costly to do so. Such a small interest can roll up to a huge amount of money.

The second method is to leverage the central bank’s identity as the treasury manager to put the money of the central government at the bottom of the treasury, instead of releasing it. The central government’s treasury deposits, if placed in the central bank, have an interest rate of only about 1%, which is equivalent to taking back some of the money.

The third option is to raise the required reserve ratio, which means to increase the reserve funds placed by commercial banks at the central bank.

In fact, regardless of the hedging method, there is always a cost. And in the end, it is the Chinese taxpayers, as well as Chinese lending firms and depositors, who share in different ways such a combined cost of foreign exchange reserves and foreign exchange holdings.

[Title：What Do Central Banks Do with the Foreign Currencies?]

You might ask: What do central banks do with these large amounts of foreign currencies? This is a further question than what we’ve just discussed. We’ve talked about what money the central bank uses to buy foreign currencies. Now the question is what they’ve done with the purchased foreign currencies? We all know that the central bank took foreign exchange to buy a lot of government bonds from the U.S. and Europe. But here is another fun fact: Is China’s central bank a force that’s going long on USD? Many people think that because the Chinese government is buying so much, of course it is predominantly long on the dollar. But a hedge fund in New York offers an alternative reverse thinking. It has discovered through examining the data that the opposite is true, and it’s not the same as we thought at all. They found that every time China’s State Administration of Foreign Exchange increased foreign exchange reserves rapidly, the dollar’s exchange rate was not rising but falling. And when the State Administration of Foreign Exchange decreased reserves, the dollar was actually rising. In other words, China’s Foreign Exchange Administration is the main shorting force for the dollar.

Why? Here is my hypothesis, well, just a hypothesis on how it works. China’s foreign exchange, as mentioned earlier, comes from China’s twin surplus: the capital surplus through attracting investment, and the trade surplus through large-scale exports. Let’s assume that $1 billion of capital flows into China, $900 million is in USD and $100 million is in other currencies like the euro and the yen. But when the State Administration of Foreign Exchange goes to allocate these huge foreign exchange reserves globally, it feels severe anxiety because “the eggs can’t be put in one basket.” So they put, say, 50% of the reserves in USD assets, and the remaining 50% into the euro, the yen, the pound, and some other pools of assets large and small.

If we regard the whole process as a black box, the money goes in at 9 to 1, 90% in USD and 10% in other currencies, and comes out as half and half. In other words, after going through a black box like the Chinese economy system, and through the State Administration of Foreign Exchange, the input and output goes from 9-to-1 to 5-to-5. So now, on the whole, the Chinese economy objectively becomes a major shorting force for the dollar.

So why’s this discovery important? It’s actually very useful. That hedge fund in Wall Street first discovered this counter-intuitive phenomenon, and they focused their eyes on China’s State Administration of Foreign Exchange every quarter. When the State Administration of Foreign Exchange reported rapid increases in foreign exchange reserves, they bet on the euro will continue to rise and the dollar will fall. Because the euro-to-USD exchange rate is not only the main metric of the dollar index, but also a base axis of various global commodity prices. This hedge fund had lots of products that yielded profits. They made good profits for years mainly by leveraging such a strategy.

[Title：Foreign Exchange Reserves Do Not Contribute to the Stability of the Exchange Rate]

About foreign exchange reserves, I want to share a somewhat exciting conclusion: Large foreign exchange reserves don’t actually contribute to exchange rate stability. Foreign exchange reserves are not a factor of exchange rate stability, but a result of the pursuit of exchange rate stability, or a by-product of our pursuit of exchange rate stability. Foreign exchange reserves are viewed by many and touted in many articles as a muscle we have built or an achievement we have made. But in my opinion, it is actually edema caused by poor blood flow in the financial and monetary system.

[Title：The Cost of Holding Large Foreign Exchange Reserves]

The holding of large foreign exchange reserves has led to massive funds outstanding for foreign exchange which resulted in the expansion of the monetary base. This further causes asset price bubbles, or the continued accumulation of costs from hedging for the central bank. That is, if you don’t hedge against that excess liquidity, there will be an asset bubble, and that asset bubble will pose more risks to the macroeconomy. Any slight disturbance could burst the bubble and bring huge turmoil. If the central bank adopts hedging policies leveraging central bank notes, fiscal low-interest deposits or raising the required reserve ratio, ultimately nothing is free of costs. That cost is passed on bit by bit to the real economy through the strong position of the financial system, which hurts the overall welfare of ordinary residents and ordinary lenders. It is the people of the country who are sharing the heavy cost of this huge edema.

Let’s look at the scale of this cost in another way. The U.S. gets our labor products at a very low cost. They can print more banknotes and take away our products. They provide just a promise to pay off, but we can’t get their high-tech products with their banknotes. We can’t buy American chips because they don’t sell them now. If we want to buy their strategic assets, for example, if we are interested in a high-tech company, a mine, or a port, the United States don’t sell them anymore. Then we can only passively hold their low-yielding treasury bonds, or quasi treasury bonds.

So, can we preserve or increase the value of this purchasing power through treasury and quasi treasury bonds? If you only look at the U.S. CPI, that seems to make sense because inflation is not high. But the problem is that the CPI does not include asset prices. If you then look at U.S. asset prices, the rise in U.S. stocks, the volatility of U.S. housing prices, and the rate of expansion of the Federal Reserve’s balance sheet, it is not hard to see that the under their modern monetary theory of QE infinity, the value of our nationwide reserves is constantly being diluted, and it is being taken away in broad daylight. Who should cover this loss? Who can provide any rational explanation for this huge and lasting loss?

Some people say that holding large foreign exchange reserves can protect our economic and financial security. Is that true? In my opinion this is clearly not possible.

[Title：Case: Brazilian Real Attacked in 2014]

In a free episode of my show “Zheng Jing Qi Di,” I mentioned that I had a friend who was the manager of a Wall Street hedge fund firm. He led the attack on the Brazilian real (BRL) in 2014, and it worked. His firm only held US$5 billion at the time, and the Brazilian government was holding the third largest foreign exchange reserves in the world at US$300 billion. It seemed impossible for a firm holding $5 billion to actively attack a sovereign government that held $300 billion in foreign exchange reserves. During their attack in 2014, I asked him in person, “What gave you the confidence that you could win?” He said, “First of all, I can add leverage. I just need to apply a 10-times leverage on this trade to expand the capital to $50 billion. I can use $5 billion as principal and apply a 10 times leverage on the trade to borrow $50 billion and then dump the BRL into the currency market. Therefore, the Brazilian government will have two options: They either watch the exchange rate of the BRL to USD continue to plummet after I dumped the BRL, or they will need to come forward with $50 billion to do a deal with me as my counterparty. Thus, they need to pay me $50 billion, and then will be left with $50 billion worth of BRL in their own hands. Ultimately, a large amount of Brazilian reals will flow back to the Brazilian central bank.” What does this mean? This means a sharp deflation.

Because the currency was issued by the central bank, the return of the local currency to the Brazilian central bank would lead to a monetary deflation, and with less money in the market, it would bring a scarcity of liquidity and a rapid depression. More importantly, the Brazilian central bank foreign exchange reserves would then show that $50 billion disappeared within a short period of time, say within a week or two. He said, “What does this mean? Can you imagine? It’s like when a cow falls into the Amazon and is attacked by the piranhas in the river. The $50 billion that flows out is equivalent to the first smell of the blood that flows out of the cow that day.”

He said his peers would start asking around why the Brazilian government’s foreign exchange reserves went from 300 billion to 250 billion so quickly. Who did this? What happened? Why did this happen? Then he said he would throw out a report. Note that this report was written by a former senior Brazilian politician, an expert, that he had brought in at great expense a year or two before. The report discussed the big problems of the Brazilian economy from all aspects in currency, politics, and trade. All these issues were real. None were fabricated. They were all verifiable. He said, after reading this report, his peers would immediately move into action. Most hedge fund firms don’t hold much capital themselves. However, they are like the Brazilian rainforest piranhas – not large, but their teeth are particularly sharp. They are strong and bold, and will add ample leverage before pouncing on the cow struggling in the water. So he said, not to mention the $300 billion the Brazilian government had in reserve, they could not even bear the attack even if they had $1000 trillion. Because the Brazilian businesses and citizens would panic and scramble to flee from the Brazilian economy and currency. So, when people were running away, the size of Brazil’s reserve would no longer matter. Because when these attackers added up the total funds, especially after adding the leverage, the result could be infinite – a larger number than the scale of any reserve.

Many people think that having large foreign exchange reserves can be the reason why others do not dare to attack you. This hypothesis is wrong. This is layperson knowledge.

[Title：Lessons from the Attack on the Brazilian Real]

For the attackers or short sellers, what they are really afraid of is not the foreign exchange reserves, but the controls on capital account transactions. Capital controls are really useful in times of crisis.

In 2014, someone suggested the Brazilian government should give up protecting the exchange rate. Thus, instead of being the counterparty against this hedge fund firm using foreign exchange reserves, Brazil held on to the $300 billion and let the exchange rate drop. The exchange rate then fell by 34% within a year. The Brazilian government’s preservation of foreign exchange reserves was a huge cost in terms of people’s livelihood and politics, as the exchange rate decline led to high domestic inflation and triggered domestic political unrest. Mrs. Rousseff, the left-wing leader at the time, resigned as a result.

Meanwhile, my friend’s firm ranked in the top among the global macro hedge fund firms that year. George Soros specifically invited him, this rising star, to have dinner together afterwards, to talk about the lessons learned from the battle of the Brazilian real.

So now with hindsight, what was the right thing to do? Certainly, from my personal point of view, I think there should be an orderly decline of the exchange rate. What does that mean? For example, in 2015 and 2016, RMB was also in the depreciation cycle, but it depreciated more slowly, about 4% per year. In fact, this was not a coincidence. It was actually the price difference between internal and external funds, an orderly depreciation. Along with the temporary strengthening of capital account controls, our all-encompassing approach was able to maintain macroeconomic stability when dealing with such risk shocks. The foreign exchange reserves did not actually play an important role in such an extreme scenario. So, in this sense, foreign exchange reserves alone cannot be used to ensure the safety of our exchange rate, and the long-term cost of holding foreign exchange reserves is huge.

[Title：China No Longer Needs Foreign Exchange Reserves]

I always hold a proposition, although it is still not accepted by mainstream academics and policy makers. For China, I want to emphasize that we no longer need to hold large foreign exchange reserves, but only need to reserve some gold. Because gold is after all humans’ most stubborn faith throughout the history of finance, other foreign exchange reserves are unnecessary, especially for a big country like China. How can the wealth of the people and the future of the nation be pinned on the promises made by others?

China has passed the early stage of industrialization: The low-end, low value-added, labor-intensive, and low-margin manufacturing industry has dropped to less than 20% of China’s total exports. China’s low-end labor force has started to become scarce due to our demographic structure, and the manufacturing industry in the south has been facing difficulties in recruiting workers for the past 10 years. I have discussed this previously in my show “Zheng Jing Qi Di”, so I won’t repeat myself here. We no longer need to pay a huge price to keep exchange rate volatility low; we no longer need to maintain large foreign exchange reserves in trillions of US dollars. China, as the world’s largest exporter and manufacturing country, is still advancing its technology and upgrading its industries. China is also facing a rapidly aging population. Such an economy does not need to worry about exchange rate decline at all, because the exchange rate will go down to make the manufacturing exports more competitive in price. The RMB exchange rate, as we discussed in the second lecture, can be regarded as a low-density ball, like a hollow basketball: If someone pushes it down into the water, once the pressing force disappears or decreases, the ball will float up quickly.

So, we can’t simply apply the case of Zimbabwe, Brazil, South Africa, the currency of these developing countries, and thus worry about the devaluation of the yuan. On the contrary, we really need to worry about the long-term strength of the yuan. If our yuan, like the yen, no matter how depressed the economy, how decaying the industry, it is righteously strong, there is no way to change. No matter how much money Abe Economics printed, it cannot make the yen depreciate significantly. This is what China needs to worry about in the long-run.

[Key Takeaways]

1. Foreign exchange reserves originated from the fear of exchange rate fluctuations.

2. Foreign exchange reserves are not a symbol of a great power, but a symbol of a vassal state.

3. Foreign exchange reserves are not the cause of the stability of the exchange rate.

4. Foreign exchange reserves are the result and by-product of the government’s pursuit of the stability on the exchange rate.

Let’s reiterate that foreign exchange reserves originate from the instinctive fear of periphery developing countries over their own exchange rate fluctuations. Foreign exchange reserves are not a sign of a great power, but a symbol of a vassal state. Foreign exchange reserves are not the cause of exchange rate stability, but the result and by-product of the government’s pursuit of exchange rate stability.

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