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Chapter 16 Exchange Rate: Leveraging the Pivot of Global Trade (2)
In 1944, the economist Nukes gave a more succinct definition of the equilibrium exchange rate, that is, "the equilibrium exchange rate is such an exchange rate, which maintains the balance of international payments in a certain period of time without causing international reserves to net change". In 1945, he further revised the concept of the equilibrium exchange rate: the equilibrium exchange rate is the exchange rate when maintaining a country's balance of payments within a period of about three years without causing a large number of unemployment or resorting to trade controls.

Since then, Keynesians have used employment as the criterion for judging whether the exchange rate is balanced.

The equilibrium exchange rate theory is not actually a theory about explaining exchange rate determination and exchange rate changes, but considers whether the exchange rate level is reasonable from a country's domestic economic conditions, changes in the balance of payments, etc., and judges whether the exchange rate is overvalued or undervalued. And decide whether the exchange rate level should change.Therefore, the equilibrium exchange rate theory is actually a policy tool.It fails to answer the question of exchange rate decision policy, but builds a bridge between exchange rate theory and exchange rate policy, so it is also of great significance.However, some basic content of the equilibrium exchange rate theory is based on the premise that "everything else remains unchanged", and this condition hardly exists in reality. This defect limits the "equilibrium exchange rate theory" as a policy tool. Operability", thus reducing its practical application significance.

First of all, we make it clear that the concept of equilibrium exchange rate is a medium-to-long-term concept, and the exchange rate will fluctuate in the short term, that is to say, the exchange rate equilibrium when the supply and demand in the foreign exchange market are equal should refer to the short-term equilibrium exchange rate.From a medium-to-long-term perspective of a country, when the currency value of the domestic non-tradable goods market reaches equilibrium and the equilibrium currency value of the external tradable goods market is equal, it is a relatively stable economic operating environment. key.Therefore, the concept of equilibrium exchange rate has become the focus of most economists and state leaders.And it should also be clear that there are many interpretations of the concept of equilibrium exchange rate, and there are many schools of thought in the economy itself.What is the purpose of a concept and what economic phenomena are used to explain these problems often determine the connotation and extension of a concept.

Fixed or Floating: Exchange Rate Regime

Since July 2005, 7, my country has begun to implement a managed floating exchange rate system based on market supply and demand and adjusted with reference to a basket of currencies.The RMB exchange rate is no longer pegged to a single US dollar, forming a more flexible RMB exchange rate mechanism.

On July 2005, 7, the transaction price of US dollar against RMB was adjusted to 21 US dollar to RMB 1. listed exchange rate.Since then, the daily trading price of USD against RMB in the inter-bank foreign exchange market is still fluctuating within the range of three thousandths of the middle price of USD trading announced by the People's Bank of China. The middle price fluctuates within a certain range.

The People's Bank of China will adjust the exchange rate floating range in due course according to market development and economic and financial situation.At the same time, the People's Bank of China is responsible for managing and adjusting the RMB exchange rate based on the domestic and international economic and financial situation, based on market supply and demand, and with reference to changes in the exchange rate of the basket of currencies, maintaining the normal fluctuation of the RMB exchange rate, and maintaining the RMB exchange rate at a reasonable and balanced level. Basic stability, promote a basic balance of international payments, and maintain the stability of the macroeconomy and financial markets.So far, the reform of the RMB exchange rate has broken the ice for the first time, triggering an active market.

Why did the RMB abandon the fixed exchange rate system and change to a floating exchange rate system?Why is this path of reform so difficult?
The fixed exchange rate system means that the formulation of the exchange rate is based on the gold content of the currency, forming a fixed ratio between the exchange rates.The exchange rate under this formula is either regulated by the input and output of gold, or fluctuates within the legal range under the control of the monetary authority, so it is relatively stable.It is conducive to the stable development of the economy, and is conducive to the calculation of cost and profit of economic entities in international trade, international credit and international investment, and avoids the risk of exchange rate fluctuations.

But the fixed exchange rate system is pegged to the U.S. dollar, which means that the exchange rate of the RMB is only pegged to the U.S. dollar.This weakens the RMB's ability to regulate the exchange rate.Adopting a managed floating exchange rate pegged to a basket of currencies, including the U.S. dollar, Japanese yen, euro, Korean won, etc., can give full play to the country's autonomy and enhance the RMB's ability to regulate and control.

Floating exchange rate system can be divided into free floating exchange rate system and managed floating exchange rate system.The free floating exchange rate system means that monetary authorities seldom intervene in the foreign exchange market, and the exchange rate changes with market supply and demand.The disadvantage of this system is that large fluctuations in nominal (and real) exchange rates may distort resource allocation, and the exchange rate is highly random and inflation-biased.A managed floating exchange rate system means that the monetary authorities intervene in the foreign exchange market through various measures and means to make the exchange rate change in a direction that is beneficial to the country's economic development.Although monetary authorities intervene in the foreign exchange market, they do not defend any fixed parity, and the frequency of intervention depends on the exchange rate target.The advantage of a managed floating exchange rate system is that it avoids excessive fluctuations in the exchange rate. The main disadvantage is that the behavior of the central bank sometimes lacks transparency, which may cause certain uncertainties.

Under the current international monetary system, most countries implement a managed floating exchange rate system.Managed floating exchange rates are based on supply and demand in the foreign exchange market and are floating, not fixed.The difference between it and the free floating exchange rate is that it is managed by macro-control, that is, the monetary authority announces the exchange rate according to the price formed in the foreign exchange market, allowing it to float up and down within the specified floating range.Once the exchange rate fluctuates beyond the prescribed range, the monetary authorities will enter the market to buy and sell foreign exchange to maintain a reasonable and relatively stable exchange rate.

Currency Board System - The Exchange Rate System That Created Argentina's Dilemma
After World War II, the Argentine economy once achieved rapid development.However, due to the long-term domestic political turmoil, frequent government changes, and lack of continuity in economic policies, Argentina's economy has experienced a major recession. From the 20s to 70, there were seven currency crises in Argentina, and each currency crisis was accompanied by severe inflation.In the 1990 years from 7 to 1975, except for 1990 when the inflation rate was 16%, the inflation rate in other years was above 1986%.Whipped by chronic hyperinflation, investors have lost confidence in the Argentine currency, leading to a full dollarization of the economy.Under such circumstances, in order to reverse the trend of economic recession, in 90.1 neoliberal economist Carvalho took office as the Minister of Economy of Argentina. The bank guaranteed the free convertibility of the two currencies with foreign exchange, gold, and other foreign securities. The "Convertibility Act" brought hyperinflation under control, and by 100 the inflation rate fell to 1991%. From 3 to 1, Argentina's economy achieved continuous growth.It can be said that the currency board system became an important measure for the Argentine government to save the economy at that time, and it also achieved encouraging results.

Soon, however, this strict currency board system was challenged from both inside and outside, and the Argentine economy fell into trouble again.

In 1995, under the influence of the Mexican financial crisis, the Argentine economy experienced negative growth.Since the currency board system deprived the central bank of monetary policy tools, fiscal policy became the only option for the Argentine government when the economy was in recession and unemployment was rising.The Argentine government relies on issuing bonds to stimulate investment projects and achieve economic growth.But this approach created a situation that was out of control. From 1995 to 1996, the government's fiscal deficit rose from $24 billion to $40 billion.What is more serious is that the accumulation of debt has also driven up domestic interest rates. In 1997, under the influence of the Asian financial turmoil, the Argentine economy entered recession again.By 2001, Argentina's external debt had reached a staggering $1400 billion.

So far, Argentina's financial difficulties are still continuing, and it is hard to imagine how embarrassing the country's financial burden has become.All this seems to be caused by the "currency board system".

The currency board system refers to the exchange rate system that clearly stipulates in the law that the exchange rate between the domestic currency and a foreign currency convertible currency is fixed, and imposes special restrictions on the issuance of the domestic currency to ensure the fulfillment of this legal obligation.The currency board system usually requires that a certain (usually 100%) foreign currency must be used as a reserve in currency issuance, and it is required to always meet this reserve requirement in currency circulation.The monetary authority in this system is called the currency board, not the central bank.

The "currency board system" has two important features:
1. The country's currency is pegged to a strong currency, and a fixed exchange rate relationship is established with it. This strong currency is called the anchor currency;
2. The country's currency issuance is guaranteed by foreign exchange reserves, especially the currency reserves of the anchor currency, to ensure that the local currency and foreign currency can be exchanged at a fixed exchange rate at any time.

Countries that establish such currency systems generally do not have the political and economic strength to independently establish their own currency systems.If a country or region has a small economic scale and a high degree of openness, and its imports and exports are concentrated on certain commodities or a certain country, the currency board system is an option.

Implementing the currency board system means losing the initiative to implement monetary policy independently.

Why did Argentina use a currency board system?This is because the currency board system also has its own advantages.Because a relatively stable exchange rate helps to stabilize investor confidence and maintain the stable development of international trade.In addition, some countries and regions with serious inflation have adopted the currency board system to control the high hyperinflation, stabilize the currency value, and restore the economy.But compared with the central bank system, the currency board system has its own shortcomings.One is that the government cannot control the amount of money issued and the interest rate. The interest rate is set by the base currency issuing country, and the total amount of money depends on the balance of payments and the money multiplier in the banking system.Therefore, in formulating monetary and credit policies, the currency board system has much less freedom than the central bank system.Second, the government cannot use the exchange rate to adjust the impact of external factors on the domestic economy (such as the rise of import prices, the transfer of capital circulation, etc.), but can only adjust some actual domestic economic variables (such as wages, commodity prices, etc.), resulting in economic fluctuations.Third, the orthodox currency board system will not act as a "lender of last resort" by borrowing money from the government and commercial banks like the traditional central bank system.

But in any case, the collapse of the Argentine currency board system has brought profound enlightenment to people.It allows us to see that the currency board system is an extremely strict currency issuance system, which has freed Argentina from the troubles of hyperinflation for many years; at the same time, it is an extreme fixed exchange rate system. When it emerged, the currency board system lacked a flexible monetary policy and exchange rate policy to deal with shocks.

Exchange Rate Overshooting: Exchange Rate Responses to External Shocks

Wu Xiaoling once pointed out at the Everbright Financial Forum in 2008 that although China's financial market has not been seriously affected by the subprime mortgage crisis, for the healthy development of China's financial industry, we should learn from where others have stumbled.With the increasing inflow of foreign funds, the financial risks facing China are also constantly accumulating.After the outbreak of the financial crisis, China seems to have become an investment oasis in the world, and a large amount of foreign funds will increase into China.This will create overshooting pressure on the exchange rate. Once overshooting, capital profits will be withdrawn, which will cause turmoil.As a result, China's financial risks are accumulating.Exchange rate adjustment needs to be more cautious.

The so-called overshoot usually means that the short-term response of a variable to a given disturbance exceeds its long-term stable equilibrium value, and is thus followed by an opposite adjustment.The reason for this phenomenon is that the price in the commodity market has the characteristics of "stickiness" or "lag".

The so-called sticky price means that the price of a commodity stays fixed in the short term, but as time goes on, the price level will gradually change until it reaches its new long-term equilibrium value.

When the market is subject to external shocks, there is a big difference in the adjustment speeds of the currency market and the commodity market. Don Bush believes that this is mainly due to the commodity market due to its own characteristics and the lack of timely and accurate information.Under normal circumstances, the adjustment speed of the commodity market price is slow, the process is long, and it is in a sticky state, which is called sticky price.However, the price adjustment in the financial market is faster, so the exchange rate responds to shocks faster, almost instantly.The excessive adjustment of the exchange rate to external shocks, that is, the expected change in the exchange rate deviates from the adjusted PPP exchange rate under the condition of complete price elasticity, this phenomenon is called exchange rate overshooting.As a result, purchasing power parity cannot be established in the short term.After a period of time, when the price adjustment in the commodity market is in place, the exchange rate changes from the initial equilibrium level to the new equilibrium level.

Don Bush's exchange rate overshooting model has clear policy implications: it shows that the long-term end result of the monetary expansion (or contraction) effect is a proportional rise (or fall) in prices and exchange rates.But in the short run, monetary expansion (or contraction) does have real effects on interest rates, terms of trade, and aggregate demand.When the government adopts expansionary or contractionary monetary policy to regulate the macroeconomy, it is necessary to be alert to whether the exchange rate will overshoot and how much to avoid unnecessary fluctuations in the economy.

Among them, one thing to note is that the exchange rate overshoot model assumes that the demand for money remains unchanged, which means that demand for money will not affect the exchange rate. However, in practice, short-term fluctuations in the actual exchange rate often affect the current account. This will further affect the total assets of a country, which will have an impact on the demand for currency, which in turn will lead to a corresponding change in the exchange rate.

The overshoot model implies the assumption that capital is completely free to flow and the exchange rate system is completely free to float.Under such conditions, the excessive volatility of the foreign exchange market caused by the overshooting of the exchange rate will inevitably bring shock and damage to a country's economy and even the global financial market.In order to avoid impact and damage, the government will inevitably manage and intervene in the flow of funds and fluctuations in exchange rates.Therefore, the above assumptions cannot be fully realized in reality.

(End of this chapter)