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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.

Does the market determine the exchange rate? We know that the commodity price depends on its production costs. Gold and silver are precious metal currencies and they have production costs. But after 1971, our global monetary system moved away from precious metals and has been in a fiat money system. Theoretically, the government can print as much money as it wants. Therefore, it no longer has an objective market cost but contains the government’s will and policy, and sovereign credit. So, when the U.S. government and some liberal economists emphasize that a country’s currency exchange rate should entirely be determined by the market, their proposal contains logical defect.  

Since currency has become a pure sovereign credit of the government, the government’s role in exchange rate determination is enormous. In today’s talk, I would like to review the forty-year history of the exchange rate fluctuation of the RMB against the US dollar. We will learn from the past and discuss the government’s role and their means to price the exchange rate.

[Title: Pre-2005: The Exchange Rate Supported Export-oriented Industrialization]

An agricultural country that wants to transform itself into an industrial country by leveraging the increase in export manufacturing, needs a moderately undervalued exchange rate and a stable exchange rate. If the exchange rate of the local currency is overvalued, the export goods are not competitive; if the exchange rate is volatile, those export enterprises with low-profit margins are afraid to sign contracts. Before 2005, the RMB exchange rate served China’s development strategy of export-oriented industrialization quite well.

Since the 1980s, the exchange rate of RMB to USD was around 1.5 RMB to 1 USD. And there were multi-track prices at that time, with the most mainstream price being 1 dollar to 1.5 yuan. This has continued to depreciate at an annualized rate of about 15% for more than a decade since then. By early 1994, it eventually depreciated to 8.70 yuan per dollar, and the black-market price even reached 11 yuan per dollar. Such a devaluation rate meant that throughout the 1980s, although China’s economic growth rate reached 10% per year, if we used the U.S. dollar and other mainstream international currencies to measure, China’s GDP per capita growth rate was far less than what’s on paper. Relative to the American economic scale, China’s economic size declined for a few years.

This problem doesn’t only apply to China in the 1980s. To this day, this is very common among the vast majority of developing countries. They report nice economic growth figures to the UN, the World Bank, and global media every year, but this doesn’t mean much because their exchange rates depreciate very fast in the long run. A few years ago, India liked to claim that its growth rate finally surpassed that of China. But if you consider that since 1994, the Indian rupee has depreciated against the dollar by an average of between 3% and 3.5% per year. Its real wealth growth rate is not as fast as it appears.

In the early 1990s, Deng Xiaoping’s “Talks in the South” opened the era of export-oriented industrialization in China, combining investment attraction and export encouragement. Imagine that, China, a giant developing economy with a population of more than 1 billion people, is rapidly squeezing into the East Asian supply chain by depreciating the exchange rate and depressing the prices of its labor, land, environment and other factors. This has led to a competitive disadvantage for those economies in East Asia that were originally engaged in labor-intensive manufacturing and processing trade. The most typical example is the Tiger Cub Economies, including Thailand, Malaysia, the Philippines, and Indonesia. The government’s organizational capacity and national labor quality of the Tiger Cub Economies, in general, are no match for mainland China. Therefore, their export sector cannot compete with their rivals on the southeast coast of China. There was a popular point of view at the time, where they argued that in the mid-1990s, their export sector was failing while the real estate and capital markets were still rising under the influx of low-interest dollar hot money. So the virtual economy continued to rise while the real economy continued to decay. The divergence formed a bubble, which shaped the foundation for the Asian financial crisis from 1997 to 1998.  

Other regions have had similar phenomena since then. We know that during the expansion of the EU to the east, part of the population and the land of the Soviet East camp was incorporated into the Single European Market. That was the former Central and Eastern European countries. Their government organizational capacity, national education quality, and competitiveness were generally higher than the Southern European countries. Germany, France, Britain, the Netherlands, Belgium, Luxembourg, Northern Europe, and other high-income economies of the market were originally open to exporters from Southern European countries, but those exporters were gradually replaced by new exporters from Central and Eastern European countries in the first decade of this century. This gradually formed the fundamentals of the 2012 European subprime crisis in the Southern European region. Therefore, we should pay attention when we see similar migration, growth and decline in the real industries. We must make the necessary psychological preparations for the potential financial crisis, exchange rate turbulence, and debt crisis in the following years.

In the second phase, from 1994 to July 21, 2005, in general, the exchange rate of the yuan against the dollar was at a stable stage for 11 years. The exchange rate ranged from 8 yuan 29 cents to 8 yuan 28 cents for a long time. Officially, it was called a managed floating exchange rate, but the ten-year stability required the central bank to fight pressure from different sides. A very interesting story was the refusal of the RMB exchange rate to depreciate during the Asian financial crisis from 1997 to 1998. At that time, the Chinese government publicly announced early in the Asian financial crisis that we would never devalue the RMB. Why did they make such a public statement? It was not so much foresight as a series of misjudgments and misunderstandings. There was a misunderstanding of both Soros’ motives and the financial crisis, in terms of the extent of the impact and subsequent effects. July 1, 1997, witnessed Hong Kong’s return to China. It is a very important political event and moment for China. It was at this juncture that Thailand, then the whole of Southeast Asia, and finally the whole of East Asia began to experience a financial crisis and a significant devaluation of the exchange rate. It was Soros who took the lead to impact the Thai baht. He had dealt with China for several years and often invested large sums of money to fund NGOs, and reactionaries, and to promote the political revolutions of other countries, in order to achieve his so-called political concept of a globalized open society. And he had been involved in Chinese politics before. Therefore, it was normal for Beijing to suppose that such an American financial predator, who liked to subvert other people’s regimes, was starting to fan the flames in Thailand and would then attack Hong Kong’s capital market and the Hong Kong currency. Then, by causing the markets to crash and economic depression, Soros could prove that Communist Party of China was unable to stabilize the Hong Kong capitalism market and effectively govern Hong Kong, thereby challenging China’s recovery of Hong Kong’s sovereignty. If that was the case, we had to firmly counter his political intention.

Therefore, the decision at that time was made mainly from a political viewpoint. On the other hand, no one can succeed without honesty. The Chinese government have always attached great importance to its global credit, and will behave as their promise. Therefore, what we saw later was that Hong Kong’s linked exchange rate was not abandoned and RMB was kept stable against the US dollar. It was without depreciation. But after the summer of 1997, there was a wave of devaluation of currencies throughout East Asia, and there has been more than one wave. The devaluation ranged from 30% to 40% and Chinese manufacturing products in the early stages of industrialization suffered a big loss in terms of exchange rates, because we did not devalue while our competitors devalued. So those two years were very difficult for China’s export industries on the southeast coast. It was only after China acceded to the WTO in 2001 that we really reopened the global commodity market and the global market for manufactured goods, and thus opened up a new way of growth for the Chinese economy.  

What you lose on the swings you get back on the roundabouts. The fact that RMB did not depreciate in a crisis won us unexpected benefits. After 2001, the US shifted its strategic focus to the Middle East to fight terrorism, so it had no time for East Asia and Southeast Asia, and competition for leadership in the region emerged between China and Japan. At a major regional international conference in 2005, several small Southeast Asian countries took the position that China was the most reliable in this region. For example, the then President of the Philippines, Mrs. Arroyo, said publicly at a regional international forum that, it was fortunate that we had a responsible elder brother like China, which refused to devalue the yuan in the middle of the Asian financial crisis, thus avoided a cycle of competitive devaluation for the export-oriented economies of East Asia. Therefore, we are all fortunate that China has traded its economic difficulties for the economic stability of the entire region. With that statement, we can infer that the relationship between China and the whole of Southeast Asia progressed very well in the first decade of the 20th century. This phase ended in the summer of 2010, when the U.S. Secretary of State Hillary started to return to East Asia.

As for China’s unintentional success, who was unhappy? The Japanese government. Why? Because before 2010, Japan’s GDP was far larger than China’s. In terms of economic strength, they were the undisputed economic leader in East Asia with a much higher level of industry, technology, and financial strength. The problem, however, was that the Japanese government was unwilling to assume the responsibility of a regional power during the East Asian financial crisis. When it encountered the wave of devaluation brought about by the interest rate hike cycle of the US dollar, it ran faster than others, and the Japanese yen quickly took the initiative to devalue. So after this incident, everyone saw who was reliable and responsible.

In 2006, when I was hosting an academic forum in Europe. A Japanese scholar spoke of his regret at the recent Asian financial crisis in 1997 and 1998, which was not so terrible for Japan. Japan could have played a more assertive and responsible role, but Japan, a large economic country, displayed the typical behavior of a small country. It hid and ran away when it encountered difficulties. Japan wanted to lead the East Asian countries to set up an East Asian version of the IMF, an East Asian reserve system. The U.S. immediately raised public opposition against Japan’s attempt. Once the U.S. objected, Japan gave up and did not stand firm against the implementation of this regional strategic plan. Instead, the Chinese picked the opportunity. In essence, this is just an important manifestation of Japan’s lack of political responsibility and political independence for so many years after World War II. In this regard, Japanese elites are very jealous of China in their hearts.

[Title: Is the Active and Moderate Appreciation of the Exchange Rate A Good Thing? ]

After China acceded to the WTO, the situation changed again. You can see that in the five years after 2002, the growth rate of China’s export economy reached about 20% to 30% per year. At its peak, China’s trade surplus in 2007 was at such an exaggerated point that it accounted for 10% of GDP. In the process, people were beginning to realize perhaps RMB was significantly undervalued. What percentage was it undervalued by? The United States said that RMB was undervalued by 27.5%, and demanded that RMB quickly appreciate by 27.5%, otherwise it would impose trade penalties. In fact, there is a funny story here. Two members of Congress in the United States, Schumer was a Democrat and Graham was a Republican. Both believed that RMB was undervalued and called for an appreciation of the RMB exchange rate, but they had different views on the extent of the undervaluation. One said the yuan was undervalued by 15%; the other one claimed 40%, which was nonsense, and finally, they both compromised. 15% plus 40% divided by 2, and they got this figure of 27.5%, which looks quite scientific. It was an average figure that the two men came up with. They put forward a motion calling for the appreciation of RMB which imposed very strong pressure on the Chinese government.

The pressure to appreciate the yuan not only came from abroad, from the United States, but also from within us. As the proportion of the trade surplus to GDP got larger and larger and foreign exchange reserves increased, the People’s Bank of China wanted to keep the exchange rate of the RMB against the US dollar stable at around 8.27 yuan and 8.28 yuan. The bank had to buy more and more foreign exchange and to continue to expand their foreign exchange reserve. This increased the cost of hedging these foreign exchange funds more and more, and the pressure of inflation and asset appreciation also increased. So the central bank leaders at the time began to give constant feedback and complaints to the Premier. At the same time, there was another reverse pressure within China for the Premier to reject RMB appreciation, mainly from the export manufacturing sector and the southeast coastal region. At that time, there was a rather dramatic scene my friend told me. Several comrades from the Textile Industry Association and the Ship-building Industry Association ran to the Premier to deal with the situation with carrot and stick. They told the Premier that these two industries’ export profit margins were particularly low, and they were particularly sensitive to the exchange rate. If RMB appreciated 3%, the industry profits would be zero. If the RMB appreciated by 5%, the whole industry would lose money. If the yuan appreciated by more than 10%, then 20 million industrial workers would lose their jobs. As you can imagine, China’s economic policymakers at the time faced huge pressure from both sides, external pressure and central bank pressure, and both external pressure and central bank pressure demanded that the RMB be properly liberalized, floated, and appreciated. But what was the pressure from the export sector on the industrial side? They demanded no appreciation. So, how was it resolved in the end?

On July 21, 2005, RMB jumped two percentage points against the US dollar and maintained a smooth curve of continuous gradual appreciation in the following years. The principle behind the exchange rate reform is the so-called three principles of autonomy, gradualness, and controllability. Looking at it in hindsight, it means that RMB appreciates about four to five thousandths against the US dollar every month, and then the cumulative appreciation will be about 5% to 6% over the course of a year, so this curve will be a smooth appreciation. The person who came up with this idea probably considered like this: after the RMB exchange rate fluctuates against the U.S. dollar, some manufacturing companies would have to bear exchange rate risk, because the process from signing the contract to getting the payment for the goods took months and nobody knew how much the exchange rate would change. These companies might not be willing to sign large contracts. But through gradual, autonomous, and controlled exchange rate appreciation, it was equivalent to helping enterprises to eliminate the uncertainty of the relevant exchange rates in the export contract. For example, if the period from the signing of the agreement to the receiving payment is six months, the exporter would factor in about 3% of the exchange rate appreciation in the contract. Once this factor is included, the contract is basically safe to sign.

But from a financial market perspective, it is very dangerous and reckless for the government to step in to help remove uncertainty from the market. Because it is equivalent of the government contracting out the market risk. So from the point of view of any fund manager, from the point of view of anyone playing the finance game, if a price movement is predictable, then all you have to do is add enough leverage to operate according to its predictability and you can make a huge profit. Since the Chinese government decided to openly swear to a gradual, autonomous, and controllable currency, and since it was clear that it would appreciate by almost five-thousandths of a percentage point per month, many people began to engage in arbitrage trading, that is, carry trade. Regarding the specific practices: China was not fully liberalized in the capital accounts at the time, so what did they do? In offshore markets such as Hong Kong, Japan and other foreign countries, one would bring in huge amounts of low-interest dollars, and then in the name of trade, get into the Chinese financial market of the yuan to obtain the interest rate and exchange rate differential.

Let’s say one opens a trading company in Shenzhen and Hong Kong, and then uses the trade contract between the two companies in Shenzhen and Hong Kong to export expensive products, such as precious metals or expensive electronic components. The Hong Kong company obtains cheap US dollar financing from the Hong Kong financial market. Let’s say the interest rate is 3% per year on a US dollar loan, and then, in the name of trade payments, pay this money to a sister company in Shenzhen. The Shenzhen company then exchanges it from its local bank to RMB, and then the RMB agreement deposit income interest is more than 4%. In other words, the interest paid by the Hong Kong company is 3%, and the deposit income of the Shenzhen company is more than 4%. So the interest margin alone has a profit of one point, but more importantly, they value the appreciation of the exchange rate, which appreciates by 5% to 6% every year. Then the interest rate and the exchange rate add up to a gain of about 7% a year. But note that this is only the income of one transaction. Through the continuous increase of the leverage ratio, the leverage can be doubled every three working days, and it can be cycled. In one year, some people have leveraged more than 70 times. If you think about it, if a person raised 100 million principals, and then used this 100-million principal to do a 7-billion business, you can calculate the amount of money he has made this year. What is the annualized profit margin? Therefore, such an opportunity for huge profits has led to the continuous inflow of huge amounts of hot money into mainland China.

In other words, this smooth appreciation curve of the RMB against the US dollar is equivalent to inviting speculators in the global financial market to bet on the appreciation of RMB to take a free ride. China’s capital account is not open, so these investors often bring in hot money through trade items, or in the name of FDI industrial investment to bring in hot money. The result is that it exaggerates China’s trade surplus and the scale of direct investment. This in turn further strengthens the confidence and motivation for hot money to flow into China. So this amounts to a self-fulfilling prophecy and a self-reinforcing trend, forming a certain bubble. Let’s have a look at 2005 to 2008. Such a self-fulfilling prophecy eventually formed a corresponding bubble in China’s capital market. That is, at that time, the Shanghai Composite Index rose rapidly from 1,000 points to 6,000 points in less than two years, which created huge financial risks.

If only we could travel to the past and give advice to the decision makers at that time with today’s hindsight: to achieve an annual appreciation of about 5% to alleviate such pressure from the United States and the central bank, it is necessary to ensure that the exchange rate fluctuations have certain randomness. In other words, the daily appreciation and depreciation should be very random, and there may be odd numbers for many consecutive days, or even numbers for many consecutive days. Add a small constant to such a formula, and you can achieve a probability of an appreciation of about 5% in 250 trading days. But when it comes to a certain week and a certain month, it is unpredictable. The advantage of this is that although there will still be some carry trades to bet on the appreciation of RMB, due to its random walk characteristics on the daily and weekly levels, no one dares to add 70 times leverage to bet on its appreciation. At most, doubling or tripling the leverage will be a big deal. In that case, its yield will not be as exaggerated and the incentive for hot money to flow in will be greatly reduced. But unfortunately, around 2005, few people in China’s policy circles or think tanks had enough experience in financial market operations.

[Title: In the Post-financial Crisis Era, What Happens with the RMB Exchange Rate now?]

After the financial crisis in 2008, we saw that the RMB exchange rate pegged to the dollar for a short period, stabilizing at around 7 USD/CNY. After the crisis, the economy returned to stability, and RMB gradually began appreciation against the dollar. But this time, the appreciation rate was much slower. I remember Fred Bergsten, the director of the Peterson Institute of International Economics, once spoke to me on an English radio program. We discussed that the U.S. side still expected a 5% annual appreciation, or even more, but I told him that the undervaluation extent of the RMB was not much now. I thought it was quite reasonable that now RMB rose to 6 USD/CNY. I believed it was impossible to expect the exchange rate to appreciate significantly; it was normal to appreciate by 2% annually. At that time, Fred felt that China was being unreasonable, but from 2014 to 2016, the Chinese yuan began a devaluation cycle. It depreciated by more than 10% in three years, with an average annual depreciation of more than 4%. This 4% was quite particular, because at that time, the interest rate of loans from the RMB financial market, i.e. the combined cost of financing, was about 6%. But if you put money in dollar assets, the risk-free return you would get is little more than 1%. So if you borrowed RMB to buy dollars, you should lose a little more than 4% per year. If the yuan depreciated too fast, those who were shorting the RMB would make profits. If it didn’t depreciate, the potential depreciation pressure could not be released. So keeping the depreciation rate at about 4% was a more reasonable and prudent “trading time for space” approach.

So why did the RMB go through a devaluation cycle? That was a process of releasing the pressure accumulated in the early stages, and there were two large sums of money waiting to be released.

The first money was the huge inflow of hot money accumulated in the process of continuous appreciation in the past. They were willing to stay in Chinese RMB assets for a long time because they saw that RMB was a strong currency appreciating against the USD, and once the devaluation cycle started, they would leave. The money itself does not intend to follow us to truly build socialism with Chinese characteristics, they are hot money.

Another sum of money was related to the development path of our industrialization. After 1992, in our export-oriented industrialization model, there was a unique factor that differed from Japan and Korea, and that was the huge amount of foreign direct investment. Each year, tens of billions of dollars of foreign capital flowed into China to set up enterprises, and they came for the various super-national treatments given by China, such as tax relief, land discounts, subsidies for labor, infrastructure, and various other factors. They came to share this industrialized feast. This part of foreign investment was equivalent to nomads. They lived by water and grass, and what they harvest was the young laborers in less developed countries. But for China, the purpose of our development was not to make foreign investors rich, but to allow Chinese children to enjoy the fruits of development in the future.

Therefore, as we entered a new era, starting from 2012 and 2013, with the initial completion of industrialization, what we needed was no longer scale, but the quality of development. The supranational treatment offered to these foreign investors slowly disappeared, and labor and environmental factors were no longer sold so cheaply. Those FDIs then left China to find the new green pastures. That is why we witnessed the process of the RMB exchange rate depreciation, accompanied by the gradual withdrawal of these long-term industrial capital from China. The departure of the two moneys is logical and is inevitable once development reaches a certain stage. It is also a healthy and necessary adjustment for the Chinese economy, because China’s local brands and industrial competitiveness have now grown up and are gradually replacing foreign capital in China. This should be considered a good thing.

That was why, in 2016 and on various occasions, I advocated that we should not panic about the devaluation phase of the RMB exchange rate. As long as we recognize the process of China’s industrial upgrading, technological progress, sound economic development fundamentals, and recognize that China’s tradable sector continues to improve itself in global competitiveness, we should have sufficient confidence in the long-term prospects for the RMB exchange rate.

Unsurprisingly, once these two pressures were almost fully released, the RMB entered a rapid appreciating process again due to a combination of policy adjustments by the Chinese government and intrinsic market forces. Throughout 2017, the RMB appreciated rapidly against the USD from 1 to 7 to 6.26. And the main force in this process was the market. The reason why the rebound was so fierce was that some people were previously too pessimistic and the exchange rate depreciation was overshot. People who borrowed RMB loans in China and wanted to make money by buying US dollars suffered both interest losses and exchange rate losses during the appreciation process in 2017, so they were forced to cancel the hundreds of billions of dollars in their RMB shorts. The massive selling of shorts on the RMB exchange rate caused panic and currency appreciation, a short-squeezing phenomenon.

Then in 2018 and 2019, due to the trade war and tariff war launched by Trump, the market once again raised expectations for the depreciation of the RMB. But during this devaluation, first of all, we saw that although it depreciated faster, the Chinese government did not repeatedly appease the market as it did in 2015 and 2016. The Chinese government didn’t say a word, letting the RMB exchange rate fluctuate according to market sentiment. So whenever Trump imposed tariffs, the market would panic, and the exchange rate would depreciate rapidly for a while. The trade war led to a decline in China’s exports to the U.S., but the scale of Chinese exports was stable in 2018 and 2019 due to the moderate devaluation of RMB. Because our exports to ASEAN, the Belt and Road countries, and the European Union have increased, thereby offsetting the decline in exports to the US caused by the tariff war.

By 2020, as a result of the global impact of the Covid-19 epidemic, China responded well and took the lead in the recovery. As a result, RMB rose significantly against the dollar. In the past few years, China’s dependence on the US market has significantly reduced, not only because the importance of the US market to China’s exports has dropped from the first to the third, but also the RMB exchange rate is no longer pegged to the US dollar but is centered on its own. A CFET index is formed with a basket of currencies in China’s main export markets, which is the RMB index. This index has stabilized between 92 and 95 for the past two years. At this moment when our lecture is being recorded, the CFET index is around 97. In fact, this is the process of active and orderly decoupling of the Chinese economy from the US economy. The process of gradual decoupling in the fields of economy, trade, currency, and finance is also the process of changing what “anchor” the RMB exchange rate ties itself to. In the past, an important “anchor” was the U.S. dollar. In the future, we will use the currencies of a basket of our trading partners as the “anchor”. From now on, the stable exchange rate of RMB no longer refers to the stable exchange rate of RMB against the U.S. dollar, but refers to the stabilization of that basket of currencies from our major trading partners.

By sorting out the exchange rate of RMB against the US dollar over the past 40 years, it is not difficult to see that the Chinese government has played a very important role in the exchange rate. There are many ways for the government to intervene in the exchange rate. Firstly, direct buying or selling foreign exchange; secondly, relaxing or tightening the exchange rate and the control on foreign exchange; thirdly, guiding market expectations. Governments can, to a large extent, shape the level of their exchange rates and the way they fluctuate. But we should note that such a shaping and influencing intervention can only be achieved in the medium- and short-term. In the long run, the cost of government intervention will increase. And the longer it takes, the cumulative cost will eventually exceed the ability and tolerance of any government. Currency exchange rates still have to obey the inherent forces of the market, that is, the forces of economic fundamentals.

 [Key Takeaways]

1. During the East Asian financial crisis, China won the trust of neighboring countries and opened up market space for neighboring diplomacy. And Japan lost regional leadership.

2. The gradual appreciation of the exchange rate transfers the risk borne by market participants to the government, and attention should be paid to market regulation.

3. The government’s ability to shape the short- and medium-term exchange rate and influence the way it fluctuates is strong, but the long-term artificial distortions will be costly.

4. A smart exchange rate policy should take care of the needs of the real economy while taking in account all aspects of the laws inherent in the financial markets.

Again, let’s get to the point.

First, China’s responsible performance in the East Asian financial crisis has won the trust of neighboring countries and opened up market space for neighboring diplomacy at the beginning of the 21st century. Japan’s opportunistic monetary policy made it lose its regional leadership.

Secondly, it is extremely risky to apply gradual appreciation of the exchange rate as it enables transferal of the risk that should be borne by market participants to the government. In the future, we must pay attention to this when we carry out market regulation.

Thirdly, the government’s ability to shape the short- and medium-term exchange rate and influence the way it fluctuates is strong, but in the long term, the power of fundamentals is humanly impossible to go against. There is a hefty price to pay for artificial distortion.

Finally, a smart exchange rate policy should take care of the needs of the real economy while taking full account of the laws inherent in the financial markets.

Well, that’s it for the 4th lecture. You are welcome to leave a message below and join the discussion, or share this talk with your friends. See you next time.