Contents Chinese financial markets International Monetary System and the Part 4: the Foreign Exchange Markets and rmb internationalization Purchasing Power Parity and Interest Parity History of RMB Exchange Rate Reform Foreign Exchange Markets, RMB Offshore Sept. Dec 2016 Market and RMB Internationalization By Zhang Xiaorong Currency Terminology 4.1 International Monetary System Foreign Currency Exchange Rate the price of one country s currency in units of another nd the"Impossible Triangle Spot Exchange Rate to be delivered at nce, or in two business days for interbank transacti Exchange Rate Regime he rules and arrangements on how and how much the exchange rate can change Currency Terminology International Monetary System Devaluation of a Currency In simple words, the international monetary system efers to a drop in foreign exchange value of a currency is composed of the rules and procedures for The opposite is revaluation More academically, the international monetary Weakening, deterioration, or depreciation of a ystem is the structure within which foreign Currency exchange rates are determined, international trade refers to a drop in the foreign exchange value of a floating and capital flows are accommodated and the balance-of-payments adjustments made The opposite is strengthening or appreciation
2016/11/2 1 Chinese Financial Markets Part 4: the Foreign Exchange Markets and RMB Internationalization Sept.-Dec.2016 By Zhang Xiaorong Fudan University, Shanghai, China 4-1 Contents • International Monetary System and the “Impossible Triangle” • Purchasing Power Parity and Interest Parity • History of RMB Exchange Rate Reform • Foreign Exchange Markets, RMB Offshore Market and RMB Internationalization 4-2 4.1 International Monetary System and the “Impossible Triangle” 4-3 Currency Terminology • Foreign Currency Exchange Rate – the price of one country’s currency in units of another currency. • Spot Exchange Rate – the quoted price for foreign exchange to be delivered at once, or in two business days for interbank transactions. • Exchange Rate Regime – the rules and arrangements on how and how much the exchange rate can change – Can be fixed (pegged) or floating (flexible) 4-4 Currency Terminology • Devaluation of a Currency – refers to a drop in foreign exchange value of a currency that is pegged to gold or another currency. – The opposite is revaluation • Weakening, deterioration, or depreciation of a Currency – refers to a drop in the foreign exchange value of a floating currency. – The opposite is strengthening or appreciation 4-5 International Monetary System • In simple words, the international monetary system is composed of the rules and procedures for exchanging national currencies. • More academically, the international monetary system is the structure within which foreign exchange rates are determined, international trade and capital flows are accommodated, and the balance-of-payments adjustments made. 4-6
Hist ry International Monetary System International Monetary System Gold Standard (1876-1913) WWl and Wwll Years(1914-1944) Rules of the ga each country set the rate at which it urgencies were allowed to fluctuate over a fairly wide urgency unit could be converted range in terms of gold and each other. in effect faxes. the ratio or par values or currences, were Increasing fluctuations in currency values became realized due to speculation and hurt the international trade. Expansionary monetary po governments supply of gold The US adopted a modified gold standard in 1934 Was in effect until the outbreak of wwi as the free movement of gold was interrupted he only major trading currency that continued to be convertible History of Bretton Woods Agreement International Monetary System WWI and WWll Years Bretton Woods Agreement(1944-1973) Us dollar based international monetary system established: nflation!!I fixed price between US dollar and gold: fixed price between the International Monetary Fund(IMF)and the World Bank Helps countries defend their currencies against cyclical, seasonal, or random occurrences Assist countries having structural trade problems if they promise to take adequate steps to correct these problems After Bretton Woods Agreement Bretton Woods Agreement Worked pretty well during the post-wWll era of reconstruction An Eclectic Currency Arrangement(1973- and growth in world trade ch 1973, exchange rates have becom ore volatile and less predictable than they inflation and various currency shocks among countries the"fixed flation(oil crisis, vietnam War) in US transferred to other There have nificant world countnes for example, the birth of Triffin dilemma for a reserve currency: requiring trade deficit but too much debt would lead to confidence crisis occurred Dollar is challenged by not only euro but also emerging After efforts of US suspend official purchases or sales of gold by the US Treasury on August 15, 197 Most currencies started to float from march. 1973
2016/11/2 2 History of International Monetary System • Gold Standard (1876-1913) – “Rules of the game” : each country set the rate at which its currency unit could be converted to a weight of gold – Exchange rates, the ratio of par values of currencies, were in effect “fixed” – Expansionary monetary policy was limited to a government’s supply of gold – Was in effect until the outbreak of WWI as the free movement of gold was interrupted 4-7 History of International Monetary System • WWI and WWII Years (1914-1944) – Currencies were allowed to fluctuate over a fairly wide range in terms of gold and each other. – Increasing fluctuations in currency values became realized due to speculation and hurt the international trade. – The US adopted a modified gold standard in 1934. – During WWII and its chaotic aftermath the US dollar was the only major trading currency that continued to be convertible. 4-8 History of International Monetary System • WWI and WWII Years (1914-1944) – Inflation! – Hyper-inflation!!! 4-9 Bretton Woods Agreement • Bretton Woods Agreement (1944-1973) – US and UK representatives met in 1944 at Bretton Woods, New Hampshire to create a post-war international monetary system – a US dollar based international monetary system established: fixed price between US dollar and gold; fixed price between other currencies and US dollar – the International Monetary Fund (IMF) and the World Bank • IMF – Helps countries defend their currencies against cyclical, seasonal, or random occurrences – Assist countries having structural trade problems if they promise to take adequate steps to correct these problems 4-10 Bretton Woods Agreement • Worked pretty well during the post-WWII era of reconstruction and growth in world trade • experienced inconsistency of monetary and fiscal policies, inflation and various currency shocks among countries • Inflation (oil crisis, Vietnam War) in US transferred to other countries • Triffin dilemma for a reserve currency: requiring trade deficit , but too much debt would lead to confidence crisis occurred • After efforts of US suspend official purchases or sales of gold by the US Treasury on August 15, 1971 • Most currencies started to float from March, 1973 4-11 After Bretton Woods Agreement • An Eclectic Currency Arrangement (1973 – present) – Since March 1973, exchange rates have become much more volatile and less predictable than they were during the “fixed” period – There have been numerous, significant world currency events over the past 30 years, for example, the birth of euro, financial crises in Latin America and Asia. – Dollar is challenged by not only euro but also emerging market currencies. 4-12
After After Bretton Woods Agreement Bretton Woods Agreement Exchange Rate Regime Exchange Rate Regime Classification in IME Classification in IMF (2014) de jure classification(1975-1998 IMF judges the regime based on the stated commitment of de facto classification(since 1999) their de facto policies after asian Crisis information on each country's 1 eserves and official and secondary market rates floating 39 Choice of Exchange Rate regime The Impossible Trinity A nation s choice as to which currency regime to follow The forces of international economics do not alloy eflects national priorities about all facets of the the simultaneous achievement of all three conomy, including inflation, unemployment, interest rate levels, trade balances, and economic growth The choice between fixed and flexible rates may change over time as priorities change. However, increasing capital mobility complicates the hoices after 1970s Any currency will encounter the"impossible trinity Pure floating ntegration
2016/11/2 3 After Bretton Woods Agreement 4-13 After Bretton Woods Agreement 4-14 Exchange Rate Regime Classification in IMF • de jure classification (1975-1998) – IMF judges the regime based on the stated commitment of the central bank; • de facto classification (since 1999) – IMF began to characterize countries’ regimes based on their de facto policies after Asian Crisis – Available information on each country’s exchange rate and monetary policy framework; observed movements on reserves and official and secondary market rates; quantitative and qualitative analysis 4-15 Exchange Rate Regime Classification in IMF (2014) 16 Number of Countries and Regions Examples No separate Legal Tender 13 Ecuador, San Marino Currency Board 12 HK SAR, Bulgaria, Lithuania Conventiona Peg 44 Aruba, Jordan Stabilized arrangement 21 Guyana, FYR Macedonia, Singapore, Vietnam Crawling peg 2 Nicaragua, Botswana Crawl-like arrangement 15 Honduras, Ethiopia, China, Argentina Pegged echange rate within horizontal bands 1 Tonga Other arrangements 18 Cambodia, Czech Rep., Russia, Costa Rica Floating 36 Afghanistan, Brazil, Korea, Thailand, New Zealand Free floating 39 US, Australia, Canada, Chile, Japan, Mexico, Norway, Poland, Sweden, UK, Somalia, EMU Choice of Exchange Rate Regime • A nation’s choice as to which currency regime to follow reflects national priorities about all facets of the economy, including inflation, unemployment, interest rate levels, trade balances, and economic growth. • The choice between fixed and flexible rates may change over time as priorities change. • However, increasing capital mobility complicates the choices after 1970s. • Any currency will encounter the “impossible trinity” problem. 4-17 The Impossible Trinity • The forces of international economics do not allow the simultaneous achievement of all three 4-18 Pure floating Full capital controls Monetary independence Monetary union Full financial integration Exchange rate stability Increased capital mobility
The Impossible Trinity The Impossible Trinity Where are the Us, Euro countries and china? Where will China be? Erchange rate stabilin What is the cost and benefit of the gradual path in reforming RMB? Why Determines the Exchange Rate? A somewhat popular argument xchange rate stable 4.2: Purchasing Power Parity and Interest Rate Parity but every country can do so More fundamentally Issue more RMB- inflation Try to buy the whole world >sell RMB) depreciation Stabilize exchange rate thorough FX cont nflation currency depreciation Why Determines the Exchange Rate? Why Determines the Exchange Rate? Another popular argument Our major purposes for holding a foreign currency If we raise interest rate and attract more foreign capital our currency will appreciate. consumption: to buy products from that counts\,to An intuitive refutation but then you have to keep them in our country and Parity conditions Purchasing Power Parity: Price levels(inflation rates) More fundamentally affect exchange rat Raising interest rate is costly for the domestic economy Interest Rate Parity: rates of return on financial assets acts hot money and brings instability in the affect exchange rate Deviation on one variable will be FDI capital looks for better investment environment ther if there is no limit to arb 4
2016/11/2 4 The Impossible Trinity 4-19 Where are the US, Euro countries and China? Pure floating Full capital controls Monetary independence Monetary union Full financial integration Exchange rate stability Increased capital mobility The Impossible Trinity 4-20 Where will China be? Pure floating Full capital controls Monetary independence Monetary union Full financial integration Exchange rate stability Increased capital mobility • If pure floating is the only direction that China will go, why don’t we jump to it over one night? • What is the cost and benefit of the gradual path in reforming RMB? 4.2: Purchasing Power Parity and Interest Rate Parity 4-21 Why Determines the Exchange Rate? • A somewhat popular argument – If we issue RMB as much as possible and keep RMB exchange rate stable, we can buy the whole world! • An intuitive refutation – but every country can do so! • More fundamentally – Issue more RMB inflation – Try to buy the whole world sell RMB depreciation – Stabilize exchange rate thorough FX control?Then you have no way of buying the world • Inflation currency depreciation 4-22 Why Determines the Exchange Rate? • Another popular argument – If we raise interest rate and attract more foreign capital, our currency will appreciate. • An intuitive refutation – but then you have to keep them in our country and never let them go back • More fundamentally – Raising interest rate is costly for the domestic economy – It attracts hot money and brings instability in the FX market – FDI capital looks for better investment environment 4-23 Why Determines the Exchange Rate? • Our major purposes for holding a foreign currency – Consumption: to buy products from that country – Investment: to invest in that country (FDI or portfolio investment) • Parity conditions – Purchasing Power Parity: Price levels (inflation rates) affect exchange rate – Interest Rate Parity: rates of return on financial assets affect exchange rate – Deviation on one variable will be compensated by the other if there is no limit to arbitrage 4-24
2016/11/2 Commodity price and Exchange Rates Purchasing Power Parity Law of one price Absolute ppp does not hold If the identical product or service can be sold in Transportation costs, which depend on geography and different markets, and no restrictions exist on the sale or chnology nsportation costs of moving the product between Tariffs non-tariff trade barriers arkets arbitrage would soon equalize the products price Other border frictions in the markets Purchasing Power Parity ue for all goods and services, the purchasing er parity (ppp) exchange rate could be found from any individual set of prices. A simple conversion from US dollar price ps to RMB price But it tells how much international goods market is integrate P gives PsxS=P" and where competitiveness of multinational firms lie at. The PPP Exchange Rate The Real Exchange Rate PPP exchange rate is the rate implied by the commodity prices Implication for a country's export It gives an estimate of what rate would make the same basket A made-in-China product, priced in RMB as Y300, given of goods and services cost the same in two different countrie the nominal x/s rate 0. 15, the s price should be $45. If rising labor costs in China lead Y price rising to 350, at is about 4.5 Price of Chinese goods to Americans rises by 16.67%]loss While the nominal rate is 6.6 of competitiveness in the global product market Therefore, RMB is undervalued according to its purchasing real terms, the us dollar has fallen in value(depreciated) power. lative to RMB; or, RMB appreciates against uS dollar in screpancy The Real Exchange Rate PPP and Currency Under- or Over-Valuation 3 options to gain back the competitivene Another perspective of PPp ncies often need to be evaluated 2. keep s price unchanged, accept thinner profit margin gainst other currency values to determine relativ 3. Use the nominal rate as a weapo preciation of RMB from 0.15 to 0.1286 offsets the 50×0.1286=545 The objective is to discover whether ons exchang Real exchange rate rate is " overvalued or*undervalued"in terms of Ppp RER=S"P*/PS: let s suppose US-made products sell at S50 Before depreciation: RER=S'P/Ps =0. 15300/50=0.9 Examples: BigMac Index, Starbucks Index, GDP After depreciation: RER=S*P/P5=0.1286*350/50=0.9 adjusted Big Mac Index
2016/11/2 5 Commodity Prices and Exchange Rates • Law of One Price – If the identical product or service can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the product between markets, arbitrage would soon equalize the products price in the markets. • Purchasing Power Parity – If LOP were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. – A simple conversion from US dollar price P$ to RMB price P¥ gives P$ x S = P¥ 4-25 Purchasing Power Parity • Absolute PPP does not hold well because there are barriers – Transportation costs, which depend on geography and technology – Tariffs & non-tariff trade barriers – Other border frictions • But it tells how much international goods market is integrated and where competitiveness of multinational firms lie at. 4-26 The PPP Exchange Rate • PPP exchange rate is the rate implied by the commodity prices in the two countries. • It gives an estimate of what rate would make the same basket of goods and services cost the same in two different countries. • Example – the IMF’s current estimate of the PPP exchange rate for RMB is about 4.5 – While the nominal rate is 6.6 – Therefore, RMB is undervalued according to its purchasing power. – Implication: Firms or individuals should in general sell products in $ and buy in ¥ (don’t forget the discrepancy among products!) 4-27 The Real Exchange Rate • Implication for a country’s exporting – A made-in-China product, priced in RMB as ¥300, given the nominal ¥/$ rate 0.15, the $ price should be $45. – If rising labor costs in China lead ¥ price rising to 350, at the unchanged nominal rate, the $ price is $52.50. – Price of Chinese goods to Americans rises by 16.67%loss of competitiveness in the global product market! – In real terms, the US dollar has fallen in value (depreciated) relative to RMB; or, RMB appreciates against US dollar in real terms. 4-28 The Real Exchange Rate • 3 options to gain back the competitiveness: 1. cut cost: and how? 2. keep $ price unchanged accept thinner profit margin 3. Use the nominal rate as a weapon: An depreciation of RMB from 0.15 to 0.1286 offsets the effect. (350×0.1286= $45.) • Real exchange rate • RER=S*P¥ /P$ ; let’s suppose US-made products sell at $50 • Before depreciation: RER=S*P¥ /P$ =0.15*300/50=0.9 • After depreciation: RER=S*P¥ /P$ =0.1286*350/50=0.9 4-29 PPP and Currency Under- or Over-Valuation • Another perspective of PPP – Individual national currencies often need to be evaluated against other currency values to determine relative purchasing power. – The objective is to discover whether a nation’s exchange rate is “overvalued” or “undervalued” in terms of PPP. • Examples: BigMac Index, Starbucks Index, GDPadjusted BigMac Index 4-30