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.
In 2015 and 2016, along with the strong cycle of the U.S. dollar index, there was a significant devaluation of RMB against the dollar. The USD/CNY exchange rate went from 6.01 to 7. So the devaluation of the yuan was a common expectation around the world.
Many people, including foreign hedge funds, domestic capital predators, and ordinary middle-class, all swarmed to try to avoid the impacts of the devaluation of the RMB, and thus triggered a wave of speculation and panic. At that time, there was the so-called “double drop” in stocks and foreign exchanges. China’s capital market, stock market and the exchange rate of RMB were hit hard at the same time, and a crisis was imminent.
Among them, big capital groups like HNA, Wanda, Tomorrow and AnBang, dedicated themselves to only one thing – that is, to borrow hundreds of billions or even trillions of RMB loans, taking advantage of their licenses and resources in China’s financial market. In the name of foreign investment, such as acquisition of football teams, real estate, land, minerals and enterprises, these companies exchanged the funds into dollars and remitted money overseas.
Due to the fast economic growth in China and the relatively slow growth in the United States, Europe and Japan, China’s benchmark interest rate was high, while overseas risk-free yield was relatively low. The average financing cost of those large capital groups in China was above 6%. But when they converted RMB into dollars and invested in global dollar assets, generally they could only obtain a yield of slightly over 1.0%. This meant that despite a rather high financing cost, their return was low.
There were only two ways for them to make a profit. The first way was to embrace risk or accept low fluidity in the dollar’s asset pool, which meant to buy in junk bonds or real estates that were hard to sell, in order to gain a small margin of profit. You can imagine how difficult that would be. “Wealth comes from taking risks.” What was the other way then? To hope that yuan’s exchange rate would plummet. Based on their strategy, the yuan’s exchange rate against the dollar must drop over 5% annually to make profiting possible. If not, they would end up losing money. In other words, the premise of them making a fortune was to have drastic changes happen to China, to quickly make the average Chinese person poorer. They would be basically playing against Chinese people’s living standard and gambling on the possibility that China could fall into a decline.
Looking back at the situation, you might find it pretty absurd. Later these capital predators ended up either selling at a loss or getting dragged down into lawsuits – some of them even fell victim to murder. Those who casually talked about trades of billions a few years ago might not even be able to afford to achieve the “small goal of making 100 million” now. Why were these smart and savvy people acting so muddled and recklessly? Because they trusted the reasons proposed by many economists who were betting against the yuan, and these reasons seemed very valid. To summarize, there were five main points.
[Title：Five Wrong Reasons to “Short” the Yuan]
The first reason was that China’s economy had passed the high-growth area. Due to the demographic structure and industrial structure, China’s economic growth rate was expected to gradually decline in the future. So, people were bearish on the long-term prospects of RMB exchange rate.
The second reason was that China’s assets and real-estate were, in their opinion, in a bubble and unsustainable. One could sell a property in China’s first-tier cities such as Beijing and Shanghai, and that would be enough money to buy a beautiful villa on America’s West Coast. They believed that China’s asset prices were overvalued and would definitely return to fundamentals in the future. Then, either the house price would fall, or the currency exchange rate would drop. They were wondering whether the central government would save the housing prices or the exchange rate? They assumed it must be the house price – Why? Because housing prices are related to land prices, land prices are related to the financing capacity of local governments, and land prices and housing prices are also related to banks’ credit collateral and financial security. If the housing prices plummeted, banks would have a large number of non-performing loans, and China’s financial security would be in trouble. So, these economists came to the conclusion that the Chinese government would definitely make adjustments by devaluing the yuan in the future. This was their second reason.
And what was the third reason? They said that Chinese local governments had already borrowed too much money, at massive scales and with very high debt risks. If the debt bubbles of local governments or some central and state-owned enterprises were to burst, the RMB exchange rate would fall.
The fourth reason was that foreign-funded enterprises and manufacturing capital in East Asia had been doing well in China. But now in the more developed China, labor and environmental protection costs have risen. The capital from Japanese, Korean, Taiwanese, and Hong Kong started to move to Southeast Asia, to Vietnam and other countries. China faced premature de-industrialization. At the same time, we were also working on the Belt and Road Initiative. Some people believed that the Belt and Road Initiative was there to transfer the domestic high-polluting, labor-intensive, and low-value-added manufacturing industries to the outside world. You see, as the industries transferred out, the capital would too, and therefore RMB exchange rate would fall.
The last reason was simple and crude: China’s GDP was about 50% of the US GDP and China’s M2 broad money supply was over 150% of the US M2. China and America competed to “make the cake.” We added more water when the flour was too much, and added more flour when the water was too much. Our cake had less flour and more water than theirs. So they said that the RMB exchange rate would depreciate significantly.
In short, in those three years of 2014, 2015 and 2016, you could always hear the so-called economists putting forward a variety of judgments and reasoning in all kinds of entrepreneur programs and C-suite courses. Everyone’s the final conclusion was more or less the same. The RMB exchange rate was bound to plunge in the future. That was the popular view in the market at that time. So, if that was the case, what should we do? I’m afraid that ordinary people could only use the name of their children studying abroad or themselves visiting relatives overseas to exchange the amount of $50,000 per year from their deposit bank. But these capital predators had licenses in their hands such as financial licenses, and banks, financial holding groups, wealth management companies, securities companies, trust funds and public funds. So they had a great advantage to borrow a large amount of RMB and then sell it short for the dollar. They conducted it on a scale of hundreds of billions of yuan.
The sad thing is that all of the above reasons are wrong, and in my opinion, all are pseudo knowledge. Let me briefly sort out how they were wrong.
[Title：Why Are These Views on Exchange Rates Wrong?]
(What was wrong with the bearish view of RMB)
As a university professor and senior researcher at the International Monetary Institute of Renmin University, I together with my team did some systematic quantitative research. We reviewed the history of global exchange rate fluctuations over the past 50 years to confirm or disprove some popular propositions. Why 50 years? Because before 1971, the US dollar was pegged to gold and other currencies were pegged to the US dollar, and there was no such thing as a floating exchange rate. So, from 1971 to the present 50 years, there are about 60 or 70 proper currencies in the world that have a sizable population and economy. These economies issue currencies that fluctuate in relation to the dollar and other currencies. By examining the past 50 years and the fluctuations of these 60 or 70 currencies, we can see some clues and can debunk the above five propositions.
[Title：The Relationship between Economic Growth Rate and Exchange Rate]
Regarding the first proposition: Is economic growth related to the exchange rate? Through investigating empirical data, we find that this is true for some economies. When the economic growth rate is good, their exchange rates will rise, and during recession, their exchange rates will fall. This principle applies to the vast majority of developing countries in the world. Especially for those economies that sell raw materials, their exchange rates basically behave like this – their currencies are clearly pro-cyclical.
Of course, there are also some economies that have clearly counter-cyclical currencies. That is, when the economic growth is good, the exchange rate will fall, and when economic growth is bad, its exchange rate will rise. Typical currencies include the Japanese yen, the Swiss franc, the US dollar, etc., which are the financing currencies in what we often call “carry trade”. These are also the safe-haven currencies for capital to flee to when the economy is in crisis.
We all know that the world can be divided into core and periphery countries. Most countries and developing countries belong to the periphery. A few countries such as the United States are at the core. The core countries have abundant capital and lower interest rates, while periphery countries have scarce capital and higher interest rates. Therefore, investors, especially those who do carry trade, usually borrow funds from capital-rich countries and then go to these so-called emerging economies, which are developing, peripheral countries, to make a profit from the interest rate spread. When the economy is bad, everyone avoids taking more risks. What do they do? They sell the assets in the periphery countries, cancel these carry trades, sell the currencies of the periphery countries after selling the assets, then return to the core countries and pay back the money. Therefore, we can see that the currencies in the periphery countries are pro-cyclical, and the currencies in the core countries are counter-cyclical.
So which economies are acyclic? For example, data from previous years show that South Africa’s currency is a non-cyclical currency, which has little correlation with the economic cycle, while RMB has changed from a pro-cyclical currency in the early days to a non-cyclical currency in the past 20 years. RMB began to exhibit the characteristics of a pro-cyclical currency in the past two years, as China was changing from a capital-scarce country to a capital-surplus country. In official reporting, we say we are advancing from the periphery to the core of the global economic arena. This is why it is logically invalid to conclude that RMB will depreciate because of the slowdown of China’s economic growth.
[Title：The Relationship between Asset Bubbles and Exchange Rates]
The second proposition is asset bubbles and real estate bubbles. We reviewed the relationship between historical asset bubbles and exchange rate fluctuations around the world, and find that there is no obvious correlation between the two. Why does the formation and bursting of asset bubbles not really affect the fluctuations of exchange rates? The reason is that the price of assets and real estate does not conform to the Law of One Price between countries. Assets are not like mobile phones, computers, or bags. If there is a huge price gap between different countries, computer, bags, and mobile phones are tradable items that can be purchased at low price somewhere and sold at high price in some other areas, which is like arbitrage and carry trades. This will eventually force the prices to converge. But for real estate, most people live in one place. Even if they know their local housing has become more expensive, they won’t sell their properties and move to a place with cheaper housing to live more spaciously and comfortably? Will you? Very few people will do so, especially across borders. So, asset prices do not follow the Law of One Price. That is to say, when Beijing’s housing prices are getting increasingly higher, even higher than New York or Tokyo, there is no inevitable trend that it must return to the mean and return to equivalence in the future. Therefore, the so-called dilemma of the Chinese government between protecting the housing prices and the exchange rate is false. It is a false proposition, and such a dilemma does not exist. It implies a hypothetical premise of the Law of One Price for transnational assets, which does not hold.
[Title：The Relationship between Debt Ratio and Exchange Rate]
The third proposition is the debt issue of Chinese local governments. What is the truth about local government debts? The truth is that China’s central government debt to GDP ratio is actually one of the lowest among the world’s major economies. The absolute value of local government debts may seem large, but compared to China’s huge GDP, it is relatively small.
According to the research of Professor Zhang Ming’s from the Academy of Social Sciences, as of 2017, the debts of the central and local governments, calculated on a reasonable basis, accounted for about 65% of the GDP. Note that this has already been adjusted for some contingent debts in the calculation. For example, the risks that the government should bear in the PPP have been taken into account. If you look at European countries, excluding local governments, the ratio of central government debt to GDP, such as southern Europe, was generally over a hundred percent. Germany was the best and most reliable in Europe. Its debt ratio also reached 60%. America’s debt-to-GDP ratio reached 107% in 2017. Then in 2020, they carried out QE infinity due to the impacts of the pandemic. Now this ratio is about to reach 130%. In Japan, it reached about 250% at its peak. Now it has been reduced by adopting negative interest rates.
So what is the relationship between the debt ratio and the exchange rate? We have also done empirical quantitative research and find that the relationship is not significant – they are slightly correlated, and actually negatively correlated. In other words, the more debt you have, the higher the exchange rate will be, and the less debt you have, the lower the exchange rate will be.
I talked to Professor Xu Yuan of Peking University about this discovery. At first, we thought perhaps the students did something wrong when processing the data. Later, we verified that there was no mistake – the data was correct. Then why? Our final guess was that the truth about debts in this world should be that only the rich could borrow more money. Many developing countries cannot borrow money. Their debt ratio is only 30% or 40%, and their exchange rate is actually low. Of course, there is a more important truth here, which I realized later on, that it is not the debt rate or the rate of change of the debt rate that measures the debt risks, but the pricing currency of the debt. As long as you borrow the debt in local currency, in essence it is not really a debt, but an invisible tax levied on all who hold this currency. In other words, shorting the yuan based on the debts of China’s local government and state-owned enterprises is a very bold, blind and even stupid gamble. What kind of debts do the Chinese government and local governments borrow? It is a debt in local currency, a debt defined by RMB, by the count of Chairman Mao printed on notes, so it can be regarded as a tax in essence. To paraphrase Mr. Greenspan’s original words when he testified in the U.S. Congress, “Ladies and gentlemen, don’t worry. We will never have to repay these debts.” To illustrate this point, I once created the concept of “Di Coin” – feel free to look it up if you are interested, my friends.
[Title：The Relationship between Capital Transfer and Exchange Rate]
Regarding the fourth proposition: Will the outward transfer of industries and the outflow of capital lead to the depreciation of the yuan? Our investigation find that after capital is exported, the exchange rate does not drop. When you become an exporter of capital, your exchange rate has more stability and counter-cyclicality. You can recall the logic behind carry trading which we just talked about: when your economy is good, your exchange rate will go downwards, and when the economy is bad, your exchange rate will be higher.
Let’s look at the case of Japan. Since the 1970s and 1980s, Japan’s industrial debt has continuously transferred out of the country, has the yen depreciated? Not at all. The yen is still generally on an upward trend, because through capital exports, Japan can obtain a large amount of investment income from outside, and then the profits are continuously repatriated to the home country, resulting in the long-term strengthening of the yen.
[Title：The Relationship between M2 and Exchange Rate]
Last but not least, let’s discuss the simplest and crude proposition, the comparison between GDP and M2. This proposition is actually quite amateurish, because different countries have different financial systems. Direct financing in the United States is very developed, and financial derivatives are also well-developed. So when assessing the financing and investment risks in the United States, we should refer to the concept of broad money M3. China mainly relies on bank credit, so M2 should be used. It is illogical to simply place these together and compare, because different countries have very different financial systems.
We have investigated global data and found that there is clear irrelevance between the growth rate of currency issue in a country and its exchange rate. This is actually quite counterintuitive. Due to time constraints, I won’t expand on it here, so I’ll just talk about such a phenomenon. After the outbreak of the financial crisis in 2008, the five central banks of the United States, Europe, Japan, the United Kingdom, and China all printed a lot of money. Have you seen high inflation in any of these five economies? Have any of these currencies been used as scrap paper? As I explained previously on my show “Zheng Jing Qi Di”, there’s no such a mechanism that printing a huge amount of money will cause high inflation. The key is that in an aging and industrialized society, excess liquidity does not gather in commodities, but flows to assets and underdeveloped regions in the global periphery. So the relationship between the growth rate of currency issue and the exchange rate is decoupled, just like how we disassociated money printing and inflation just now. They are essentially the same thing. If you can make sense of the first, you will also understand the second.
In short, all these reasons for capital predators to gamble their fortunes and their lives to short RMB and make a fortune from the country’s misfortunes cannot stand the test of empirical data. What surprises me is that none of these filthy rich people were willing to pay 100,000 yuan to hire a Ph.D. student to find a database and verify these popular propositions before gambling their fortunes and even lives on it. They basically listened to the preaching of some so-called economists, and with blind confidence, each invested hundreds of billions of yuan, and used the borrowed money with relatively high interest to exchange for a low-yield asset. Then they expected the Chinese economy to collapse and the RMB exchange rate to plummet, so that they could make a fortune on China’s misfortune. In hindsight, they were neither ethical nor prudent.
The mistake on economics may only cost them some money, but the more fatal mistake they made was trying to short RMB. This is essentially shorting China which is politically unacceptable. They touched the bottom line of the law and the bottom line of politics. The self-protection measure of the Chinese society and governance was to ask these people to return the money as soon as possible, but the money could not come back. Why? Because the risk-free yields in USD assets are too low – so in order to obtain higher yields, they all exchanged the money for USD, and then bought long-term illiquid assets, such as a large piece of land or real estate. When they then hurried to sell, they found that the building they originally bought in New York with $400 million could not even be sold for $250 million. In order to pay back the money, they had to tolerate the loss to survive and sell their assets at a low price, including high-quality domestic assets.
[Title：RMB Is a Strong Currency]
Finally, we have to answer another question. These capital tycoons hope that RMB would depreciate. But contrary to their expectations, RMB has appreciated rapidly after 2017. Why did this happen? Well, some people in the market have said that the Chinese government has artificially restricted capital outflows and pushed up the RMB exchange rate by manipulating the exchange rate to squeeze the shorts. In fact, this is a misunderstanding. As a strong currency, RMB is actually under upward pressure in the long run. The devaluation between 2014 and 2016 might seem to be a sharp depreciation. But if we look back, it took three years for the USD/CNY exchange rate to drop by 10% in total from 6 to 7. If it weren’t for the trade war that started in March 2018, the exchange rate would probably have risen to above 6 by now. And it was only because of the trade war that the exchange rate of RMB against the US dollar experienced a new round of adjustments. Therefore, the bankruptcy of these capital tycoons is not so much caused by the Chinese government’s counterattack, but rather by the inherent laws of the market. The inherent strength that supports the strong RMB actually comes from two things: the first is China’s industrial upgrading, and the second is China’s aging society.
The exchange rate is determined by the economic growth rate.
The exchange rate is determined by housing price fluctuations.
The exchange rate is determined by the debt ratio.
The exchange rate is determined by foreign investment and industrial relocation.
The exchange rate is determined by the growth rate of currency issue.
Let’s finish with a short summary. We mainly dispelled some popular fallacies in this lecture. We know that there are appalling fallacies about exchange rates that are popularly told in the CEO classes, Weibo posts and WeChat Moments. A country’s exchange rate is not determined by its economic growth rate, debt ratio, foreign investment, industrial relocation, or its currency issue growth rate. These five popular prepositions are all pseudo-knowledge. So what determines the exchange rate in the market in the long run? What type of currency should we trust? Which currencies will appreciate? Which currencies will depreciate? I’ll expand on this for you later in the course.
Well, that’s it for the first lesson. You are welcome to leave a message below and join the discussion, or share this talk with your friends. See you next time.