Exchange rate, house price and reform

Since April 2021, the RMB has been rising rapidly against the USD. Data show that from March 31 to May 27, 2021, the RMB/USD exchange rate mid-rate rose from 6.5713 to 6.4030. on May 28, the offshore and onshore RMB rose above 6.37 and 6.38, respectively, both of which have hit a three-year high.

Exchange rate, house price and reform

The exchange rate fluctuations triggered market turmoil and also drew the attention of the central bank and regulators. the seventh working meeting of the national foreign exchange market self-regulatory mechanism on May 27 stressed: “resolutely crack down on all kinds of malicious market manipulation and malicious creation of unilateral expectations”. The meeting asserted that “the exchange rate cannot be used as a tool, neither devaluation to stimulate exports, nor appreciation to offset the impact of rising commodity prices.”

On May 31, China’s central bank released news that in order to strengthen foreign exchange liquidity management of financial institutions, it decided to raise the foreign exchange reserve ratio of financial institutions by 2 percentage points from June 15, 2021, i.e., the foreign exchange deposit reserve ratio was raised from the current 5% to 7%. Upon the news, the exchange rate of RMB against USD fell back in response.

What is the future trend of RMB exchange rate? How does the exchange rate relate to housing prices, the stock market and the macro economy? This article understands macroeconomics from the perspective of exchange rate.

The logic of this article

I. Exchange rate trend

II. Mead Conflict

III. Institutional reform

01 Exchange rate trend

Over the past year, the RMB has continued to rise against the USD, by about 10%. The main reason is that after the outbreak of the new crown epidemic, the Federal Reserve expanded its currency significantly, pushing the dollar to depreciate. in 2020, the Fed’s base currency grew by 76.8%, while China’s base currency grew by only 4% (China’s credit expansion is larger than that of the U.S.). The size of the fiscal stimulus implemented in the US far exceeds that of countries like Germany, Italy and France.

In the first quarter of 2021, the momentum of RMB appreciation eased for a while as the U.S. economy recovered rapidly with the rapid rise of the new crown vaccination rate and the continued rebound of the U.S. dollar index. However, after entering April, the US dollar index weakened again and the RMB rose rapidly against the US dollar. Data show that from April 1 to May 28, the U.S. dollar index fell from above 93 to as low as 89.7. the trend of the RMB against the U.S. dollar exchange rate is almost synchronized with the U.S. dollar index. from March 31 to May 27, 2021, the mid-rate of the RMB against the U.S. dollar exchange rate rose from 6.5713 to 6.4030. on May 28, the offshore and onshore RMB rose above 6.37 and 6.38, respectively, both It has set a new three-year high.

However, the main reason for the appreciation of the yuan against the dollar is not in China, nor in the United States, but in Europe. The euro component of the U.S. dollar index accounts for 56% of the index, with the euro rising and the dollar weakening. There is a certain competition between the euro and the dollar, and during the easing cycle, the dollar index has a direct correlation with the movement of the euro. Since April, vaccination rates in Europe have risen, economic recovery has accelerated and the euro has tended to strengthen, driving the dollar weaker.

The dollar index has weakened and many currencies have appreciated against the dollar. Data show that from March 31 to May 21, 2021, the euro, British pound, Chinese yuan and Japanese yen appreciated against the U.S. dollar by 3.7%, 2.6%, 2.2% and 1.5%, respectively. Among them, the euro appreciated the most against the U.S. dollar, with the yuan in the middle of the pack.

In addition to this, a large influx of international hot money, as well as the huge foreign exchange from the foreign trade surplus, pushed the RMB to rise against the USD.

The weakening of the US dollar index and the influx of large amounts of international hot money into the Chinese securities market for arbitrage. Data show that from April 1 to May 27, 2021, the net inflow of funds from the north into the A-share market reached 103.7 billion yuan. This scale is 50% of the cumulative net inflow for the whole year of 2021.

China’s goods trade surplus was a whopping $117.1 billion in the first quarter of 2021, much higher than the $75.9 billion in the first quarter of 2019 before the epidemic. Recurring epidemics in emerging countries such as India and Brazil, lack of mining and manufacturing plant starts, economic recovery in the US and European markets, expanding demand and inventory replenishment pressures have driven a rapid increase in Chinese exports. The large amount of foreign exchange coming in in the short term stimulated the rise of the RMB against the USD.

However, there is no room for a sustained appreciation of the RMB against the USD. Why?

The main reason is the probability that the Fed will exit from easing in the second half of 2021. Vaccination rates for the new crown vaccine are increasing rapidly and the U.S. economy recovered rapidly in the first quarter. The latest statistics from the Centers for Disease Control and Prevention (CDC) show that as of the morning of May 30 local time, the U.S. has completed more than 294 million doses of the new crown vaccine and has distributed more than 366 million doses; nearly 168 million people have received at least one dose of the vaccine, accounting for more than half of the total U.S. population; and more than 135 million people have been fully vaccinated, accounting for more than 40% of the population. This is the basis for the Fed’s exit from easing.

However, the economic recovery in 2021 is uneven. In the U.S., inflation is rising rapidly, with prices and house prices rising rapidly. inflation was recorded at 4.2% in April, well above the Fed’s regular target of 2%. According to Redfin, U.S. home prices are up a crazy 19% a year through April, and the nationwide median price continues to set a record to $341,600. Let’s look primarily at the year-over-year: the house price index, which measures the nation’s 10 largest cities, rose 1.1% in March; the index, which measures the nation’s 20 cities, rose 1.3% year-over-year.

Prices and house prices are rising rapidly, but consumer services and employment are not boosted enough. in the first quarter of 2021, stimulated by household subsidies, the demand dynamics were stronger than the supply dynamics, with consumption increasing by 7.9% and inventories falling by 3.1% instead. Within the consumer sector, consumption of durable goods grew by 9% and nondurable goods by 3.4%, but consumption of services was only 1.1%. Goods consumption and real estate investment have recovered to pre-outbreak levels, but services consumption still has a shortfall of around 5.7%. initial jobless claims for the week of April 24, 2021, registered 553,000, higher than the previous value of 540,700 and the expected value of 540,000. This indicates that the employment rate is not keeping pace with the economic recovery.

This is the key to the Fed’s “hesitation” in its decision. The employment rate is not boosted enough, mainly in the field of consumer services gap is large. The global epidemic has not been fully controlled, the United States and Europe has not been completely “unblocked”, schools have not fully resumed, the consumer services market is slow to recover, there are millions of workers have not returned to work. Of course, there may be other reasons to hinder job recovery. For example, the granting of family assistance may have reduced the sense of urgency to return to work. More than half of the U.S. states have now withdrawn from family employment programs. Another example is that companies have upgraded electronically and networked during the epidemic, and some of the original jobs have disappeared, resulting in some transient or structural “technical unemployment.

The Fed’s policy “hesitation” is also a reason for the global economic recovery is uneven. This unevenness comes mainly from the unevenness of vaccination rates. As of June 2, the number of vaccination doses per 100 people, Israel 122.33, the United Kingdom 96.72, the United States 88.78, Germany 63, France 55.43, Italy 59.24, China 48.97, while India 15.63, Russia 20.42, Indonesia 10.1, Bangladesh 6.07, Malaysia 9.93.

The global economic recovery is uneven and prone to push up the U.S. inflation rate, especially commodity price increases passed downstream; at the same time, dragging down consumer services and employment rate boost. This is beyond the Fed’s control.

When the Fed ends its easing policy determines the trend of the U.S. dollar index, which also affects the RMB exchange rate. Globally, the global money supply growth rate peaked in February. Starting in March, the Fed, the ECB and the Bank of Japan all reduced the pace of expansion, and the year-over-year growth rate of total assets fell from 60% in February to 25% in April.

On when to end the easing policy, there are differences within the Federal Reserve. New York Fed President Williamson said on June 3, now is not the time for the Fed to adjust QE to buy debt. However, Philadelphia Fed President Harker has repeatedly called for consideration of slowing the pace of asset purchases. Dallas Fed President Kaplan also believes that potential excessive growth in the housing market and other inflation signals suggest that the central bank should begin to slow the pace of asset purchases. June 15, the Federal Open Market Committee will hold a rate meeting to see if the Fed will reduce the size of QE into the discussion topics.

Inflation, employment and financial stability (home prices, Treasury yields) in the second quarter will be the main indicators considered in the Fed’s decision. The Fed’s decision determines the trend of the U.S. dollar index, and we hereby judge the macro trend of the RMB/USD exchange rate.

02 Mead Conflict

Exchange rate fluctuations cause certain impact on financial markets and macroeconomics. It is argued that RMB appreciation helps fight imported inflation. commodity prices surged in the first quarter of 2021, and rising upstream raw material prices put huge cost pressure on the manufacturing chain. However, there is a limit to how much RMB appreciation can do to counteract rising commodity prices.

In fact, the most important source of imported inflation in China is not the price transmission of upstream commodities, but the massive foreign exchange account placement. The foreign exchange account mainly comes from international capital investment and foreign exchange earned from export surpluses. This has something to do with China’s foreign exchange settlement and sale system. The exchange rate system is key to understanding China’s economy, but is often overlooked. Companies and individuals are limited in the amount of foreign exchange they can apply for and must sell their excess foreign exchange to commercial banks, which in turn sell it to the central bank, thus creating the country’s foreign exchange reserves.

From the second half of 2020 to May 2021, a large influx of hot money and a substantial increase in foreign exports lead to a large increase in the size of China’s foreign exchange. Let’s look at these two data: the size of foreign institutions and individuals holding domestic stocks is 1.8 trillion yuan (RMB) in March 2020 and increases to 3.5 trillion yuan by February 2021. According to customs statistics, the total value of China’s import and export of goods trade in 2020 is 32.16 trillion yuan (RMB). Of this, exports will be 17.93 trillion yuan, up 4%; imports will be 14.23 trillion yuan, down 0.7%; and the trade surplus will be 3.7 trillion yuan, up 27.4%.

A large amount of international capital is invested, if Chinese enterprises and individuals also invest a large amount of foreign exchange abroad, then the capital account tends to balance; a large amount of goods exported to generate foreign exchange, if Chinese enterprises and individuals also use a large amount of foreign exchange to import goods, or travel abroad, etc., then the current account will also tend to balance. However, China’s implementation of the foreign exchange settlement system and the accumulation of large amounts of foreign exchange have the advantage of making the family base look very strong, but the problem is that the capital account, especially the current account, has been out of balance for a long time.

When we look at the data, during the decade from 2004 to 2014, China’s balance of payments, both capital account and current account, was in surplus, known as double surplus. During the double surplus period, the RMB continued to appreciate unilaterally against the dollar. There is a paradox here: the unilateral appreciation of the RMB against the dollar did not curb exports and did not reverse the surplus. Why is this? There are perhaps two reasons here: first, the exchange rate is not fully marketized and the true exchange rate is not known; second, the capital account is regulated and the size of the surplus is not determined by the market. after 2014, China’s capital account ran a deficit and the RMB no longer appreciated unilaterally against the dollar, but began to fluctuate in both directions after 2016.

However, the large-scale accumulation of foreign exchange and RMB appreciation overlap easily to form risks, which are manifested as external appreciation and internal depreciation.

The accumulated foreign exchange will be even more when travel, study, business and investment abroad are restricted by the new crown epidemic in 2020, and trade in services declines. Due to the implementation of the settlement and sale of foreign exchange system in China, a large amount of accumulated foreign exchange is converted into foreign exchange accounts through the central bank system. Foreign exchange accounts have been the most important way for China’s central bank to put money. Large-scale foreign exchange accounts have put in a large amount of RMB, and this currency has entered the stock market, where stock prices have been more volatile recently. This currency may also enter the real estate market and commodity futures market, bringing asset bubble pressure and inflationary pressure.

Therefore, a rise in the exchange rate of the yuan against the dollar, to a certain extent, to inhibit exports to generate foreign exchange, can reduce the foreign exchange account of the investment, reduce inflationary pressure. However, the obstruction of exports is not conducive to the development of the manufacturing industry. The rise in the exchange rate of the yuan against the U.S. dollar, and the incentive of international hot money into the Chinese capital market, increasing the money put on the market, increasing the risk of inflation and asset bubbles.

In the first quarter of 2021, emerging countries are taking the initiative to reduce liquidity, raise market interest rates, or reduce the amount of base money being invested. The financial statistics report released by the Central Bank of China in April showed that at the end of April, the balance of broad money (M2) was 226.21 trillion yuan, an increase of 8.1% year-on-year, the growth rate was 1.3 and 3 percentage points lower than the end of the previous month and the same period last year, respectively; the balance of narrow money (M1) was 60.54 trillion yuan, an increase of 6.2% year-on-year, the growth rate was 0.9 percentage points lower than the end of the previous month and 0.7 percentage points higher than the same period last year. The growth rate was 0.9 percentage points lower than at the end of last month and 0.7 percentage points higher than a year earlier. At the same time, some commercial banks raised home mortgage loan rates in some major cities.

As I said in my previous article, monetary policy in emerging countries in the first half of 2021 is preparing for a monetary policy turn by the Federal Reserve. China started to strictly control the excessive rise in housing prices and financial risks in the second half of 2020, gradually reducing the growth rate of basic money supply and social financing, with the aim of removing some leverage in advance and curbing the reflation of asset bubbles.

According to past experience and the logic of the currency, if the Fed ends the easing policy and contracts the dollar liquidity, the currency depreciation of emerging countries is under pressure, and some countries such as Argentina and Turkey may also explode into currency crisis, asset bubble crisis and inflation crisis. Therefore, at this critical point, the appreciation of the RMB against the USD is risky. The faster and larger the appreciation of the RMB, the easier it is to raise the risk of asset bubbles. Once the dollar enters the tightening channel, international hot money withdraws in large quantities, and international capital takes advantage of the opportunity to short, there is a risk of rapid depreciation of the RMB. This is what the current central bank’s monetary policy seeks to avoid.

On May 31, China’s central bank decided to raise the reserve requirement ratio for foreign exchange deposits of financial institutions by 2 percentage points from June 15, 2021, i.e., the reserve requirement ratio for foreign exchange deposits was raised to 7% from the current 5%. This is aimed at recovering more foreign currency liquidity and curbing foreign currency loan placement by commercial banks. According to the estimation, the balance of foreign currency deposits in financial institutions was about USD 1 trillion as of the end of April. A 2 percentage point increase in the reserve requirement ratio for foreign currency deposits would mean freezing commercial banks’ funds at around $20 billion. China’s central bank has not used the reserve requirement ratio for foreign exchange deposits as a tool for 14 years. The foreign exchange reserve management system started in 2005, when the reserve ratio was set at 3%, and was raised to 4% and 5% in 2006 and 2007, respectively, in order to curb the excessive appreciation of the yuan. Now, raising the reserve requirement ratio for foreign exchange deposits again, it can be seen that the central bank does not want the RMB to appreciate during this critical period.

Against the backdrop of the global liquidity inflection point, the massive foreign exchange holdings put pressure on the central bank’s monetary policy. In addition to reserve adjustments, the central bank is limiting liquidity through open market operations and higher interest rates. Starting in 2020, the central bank recovers some of the RMB that was heavily injected by the foreign exchange accounts through instruments such as central bank bills. In other words, the central bank is putting in base money on one side and recovering it on the other. When we look at monetary policy in 2020, it is basically tight money and easy credit. 2020 credit from commercial banks grew by 18% and China’s base money grew by 4%. the 3.7 trillion yuan trade surplus in 2020 did not translate into a massive base money injection. Why is this? It is mainly because the central bank recovered base money through open market operation tools.

However, the effect of open market operations and reserve ratio increases is limited. If the domestic liquidity contraction is excessive, it will raise the expectation of RMB appreciation and increase the risk of foreign exchange market. In this way, the central bank’s monetary policy is caught in a “dilemma” and can only be fine-tuned, not completely resolve the conflict.

In economics, this is called the Mead conflict. The Mead conflict is that monetary or fiscal policy alone cannot guarantee both internal inflation stability and external balance of payments. Specifically, in the current situation of RMB appreciation, the external balance of payments is out of balance, the surplus continues to expand, resulting in a huge foreign exchange balance, and the internal injection of excessive RMB, which affects the stability of inflation. This is the pressure of “external appreciation and internal depreciation”.

03 Institutional Reform

How to solve the “Meid Conflict”?

The seventh working meeting of the national foreign exchange market self-regulatory mechanism on May 27 advocated that “the exchange rate should not be used as a tool, neither to stimulate exports with devaluation nor to offset the impact of rising commodity prices with appreciation.” Recent statements by the top management of China’s central bank conveyed a neutral attitude of “two-way exchange rate fluctuation”. Unless the exchange rate fluctuates significantly, the central bank will not use foreign exchange appreciation or depreciation to achieve specific policy goals.

Since the 1960s, the conflict between internal and external markets has become a core issue in monetary economics and international macroeconomics. International macroeconomics, represented by Mundell, advocated the use of both monetary and fiscal policy combinations to resolve the Mead conflict. This is the Mundell-Fleming model. However, monetarism, represented by Friedman, advocates exchange rate liberalization to solve the problem. The two men had a classic debate on this issue at the University of Chicago.

Today, most developed countries use floating exchange rates, most developing countries use a soft pegged exchange rate mechanism, and a few use a hard pegged exchange rate mechanism. A hard pegged exchange rate mechanism is a fixed exchange rate. For example, Hong Kong’s linked exchange rate system is a hard pegged exchange rate mechanism that is pegged to the US dollar. The soft pegged exchange rate mechanism is anchored to a limited float of the U.S. dollar, and the central bank uses policy to intervene in the exchange rate under special circumstances.

Mondale argues that his approach is more appropriate for developed countries. Developed countries have well-developed financing markets and monetary autonomy, and they can use monetary tightening and fiscal easing in tandem. However, developing countries do not have this condition, and they implement loose fiscal policy, which must be accompanied by loose monetary policy. Thus, Mondale does not recommend developing countries to use the Mondale-Fleming model. Essentially, Mondale’s approach is still an interventionist instrument.

Can Friedman’s exchange rate liberalization solve the problem?

Friedman’s approach can be traced back to the 18th century British economist David Hume’s doctrine of the price-coin flow mechanism. Hume proposed this theory in his essay “On the Balance of Trade”. Hume’s logic was simple: under the gold standard, if too much money flowed out and the price of commodities thus fell, it would enhance the competitiveness of industrial products in foreign markets, thus causing money to flow back in until the ratio between money and commodities, labor, industry and skill was restored to equilibrium. This is the earliest balance of payments doctrine. With this theory, Hume criticized the prevailing mercantilist notions of the time, saying, “Even in countries where commerce is well understood, there still prevails a strong fear of the balance of trade, lest all their gold and silver should go out of the country. This fear is, in my opinion, in any case simply unfounded and unfounded”.

Hume’s price-coin flow mechanism illustrates the unsustainability of either international trade surpluses or trade deficits. Friedman’s price theory explains the equilibrium relationship between exchange rates (prices) and international capital and international trade. If a country has a persistent trade surplus, a large number of foreign purchases, the price of domestic goods and labor will also rise, or the exchange rate will rise, thus discouraging exports, easing the surplus and gradually converging to trade balance.

Under the open capital account, the country will hide foreign exchange in the people, and enterprises and individuals who have a large amount of foreign exchange in their hands will also expand commodity imports or travel abroad, which will promote the balance of payments and thus suppress the rise of the exchange rate. Balance of payments and free exchange settlement can reduce the scale of currency injection, reduce the risk of asset bubbles and solve the internal market problem.

If the amount of domestic money put in is too large, interest rates fall, capital outflows, and exchange rates fall, thus curbing monetary over-issuance. If too much hot money pours into the internal market, the exchange rate rises, the trade surplus shrinks, or there is a trade deficit and foreign exchange outflows. This is the regulating effect of free flow of capital and free floating exchange rate on the internal and external markets, thus promoting international capital account and international current account balance.

However, the reality is that trade deficits and trade surpluses persist for a long time. This indicates that capital, commodities and talents in the market are not fully mobile, and the price mechanism and supply mechanism are not fully functional.

Currently, many developing countries are in a swing between exchange rate intervention and floating exchange rate. In 1988, at the time of Friedman’s visit to China, China was facing huge inflationary pressures as prices were breaking down, and he suggested that China open up its exchange rate to ease inflationary pressures.

In February 2021, an article from China’s central bank pointed out that the Foreign Exchange Bureau was studying the feasibility of allowing domestic individuals to make overseas investments in securities and insurance within an annual US$50,000 facilitation quota; and cooperating with the People’s Bank of China to do a good job in the Guangdong, Hong Kong and Macao Greater Bay Area “Wealth Management Pass” pilot. In this regard, many people speculate, is this a “test” of exchange rate liberalization? Is it really open to residents of cross-border investment?

On June 2, the State Administration of Foreign Exchange recently issued $10.3 billion in qualified domestic institutional investors (QDII) quotas to 17 institutions. After the current round of issuance, the SAFE has approved 173 QDII institutions with a total investment quota of US$147.319 billion.

Increasing the convenience of foreign exchange investment for residents and increasing the foreign exchange investment quota for domestic institutional investors can, to a certain extent, alleviate the “Mead conflict”. For the time being, residents and institutional investors holding foreign exchange can ease the pressure of foreign exchange accounts, reduce the amount of domestic currency injection, “channel” part of the capital abroad, reduce the pressure of internal inflation and asset bubbles, and also reduce the difficulty of the central bank’s monetary policy. In addition, residents’ foreign exchange stash and foreign exchange investment can increase the efficiency of foreign exchange use and investment. The large amount of foreign exchange reserves formed by the settlement and sale of foreign exchange system, concentrated in the investment of U.S. debt, investment efficiency needs to be improved, and the risk is not easily diversified.

However, this is only a “fine-tuning” policy. To really resolve the Mead conflict, a greater degree of emancipation is needed. Finally, to conclude with a quote from Hume, who summed up his doctrine of price-mint flow: “In short, the government of a country has good reason to love its people and to protect its industry. Then it has no need to fear for its currency, as the course of human affairs has proved to be reliable. In other words, if a government really wants to care for the latter, it only has to love the former”.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/exchange-rate-house-price-and-reform/
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