Opinion leaders | Wen Bin, Li Xin
Summary
Since the establishment of the inter-bank foreign exchange market in 1994, China's foreign exchange market construction and exchange rate marketization reform have been deepening in the past 30 years, the market breadth and depth have been gradually expanded, the exchange rate flexibility has been significantly enhanced, the exchange rate management tools have been increasingly improved, and the balance of payments has become increasingly balanced. However, there are also too concentrated currency structure and too small daily fluctuation flexibility of the exchange rate It is prone to pro cyclical behavior and other problems. The article puts forward relevant policy suggestions.
1、 Remarkable reform results and significantly improved marketization
In 1994, China's foreign exchange management system underwent a major reform, and a real foreign exchange market, the inter-bank foreign exchange market, was established. In the following 30 years, China's foreign exchange market construction and exchange rate marketization reform have made positive progress.
（1） The breadth and depth of the foreign exchange market continue to expand, and the foundation of the RMB exchange rate market is becoming more solid
When the China Foreign Exchange Trading Center was established in 1994, its participants only included the State Administration of Foreign Exchange and a few designated foreign exchange banks. Since then, the number of trading entities in different types of markets has continued to increase. As of January 2024, there are 25 RMB and foreign exchange market makers, 25 RMB and foreign exchange pilot market makers, and more than 700 RMB and foreign exchange members. At the same time, diversified foreign exchange demand can be increasingly met. In 2009, the products directly listed in the onshore foreign exchange market were also limited to major international currencies such as the US dollar, the euro, the Japanese yen and the British pound, as well as the Hong Kong dollar as an important regional currency. Today, there are more than 40 currencies that can be traded. In addition, since 2005, China's foreign exchange market has successively launched forward, foreign exchange swaps, currency swaps and options and other products, and the foreign exchange derivatives product system has been constantly improved. The improvement of market participation and the increasingly rich product system will inevitably promote the RMB exchange rate to better reflect the market supply and demand relationship. In 2023, the transaction volume of China's foreign exchange market will be 35.85 trillion US dollars, and the scale of bank customers using forward, options and other foreign exchange derivatives to manage exchange rate risk will be 1.28 trillion US dollars.
（2） Improve the exchange rate formation mechanism, enhance the exchange rate flexibility, and the market will gradually play a decisive role
After the exchange rate reform in 2005, the People's Bank of China took advantage of the situation to expand the floating range of the exchange rate and continuously strengthen the flexibility of the exchange rate. On May 18, 2007, April 14, 2012, and March 15, 2014, the daily fluctuation was adjusted from 0.3% to 0.5%, 1%, and 2%. At the same time, we will continue to improve the formation mechanism of the central parity rate between the RMB and the US dollar, improve the level of regularity, transparency and marketization, so as to accommodate normal market exchange rate changes as much as possible. Since 1994, the annual fluctuation rate of the RMB dollar exchange rate has gradually increased, and the annual maximum fluctuation difference (calculated using the closing price of the RMB dollar exchange rate) has also gradually expanded; In 2023, the annualized volatility of the RMB US dollar exchange rate will be 4.9%, and the annual maximum fluctuation point difference will exceed 6000BP. With the gradual withdrawal of the People's Bank of China from its normal intervention and the increasing linkage between domestic and overseas markets, the central parity rate, onshore price and offshore price of the RMB against the US dollar have basically achieved "three in one". The RMB exchange rate, which is determined by market supply and demand, not only plays the role of price signal, but also improves the efficiency of resource allocation.
（3） Exchange rate management tools are becoming more and more perfect. Strengthening expectation management helps the foreign exchange market run smoothly
While the reform of exchange rate marketization continues to deepen, China's foreign exchange macro prudential management system is also gradually improving. First, establish a foreign exchange risk reserve system for forward foreign exchange sales business, and guide market entities to reasonably arrange forward foreign exchange settlement and sales based on the actual demand background through price means. The second is to establish and improve the macro prudential management system of cross-border financing, so that the level of cross-border financing of market players can adapt to the macroeconomic heat, overall solvency and balance of payments. The third is to implement macro prudential management of full caliber cross-border financing in the integration of local and foreign currencies. Fourth, dynamically adjust the reserve ratio of foreign exchange deposits and optimize the use of foreign exchange funds by financial institutions. It is through a variety of tools to strengthen expectation management and guidance that the People's Bank of China has been able to withdraw from its normal intervention. Since 2017, China's foreign exchange reserves have always been around $3 trillion. In addition, in 2015, China Foreign Exchange Trading Center released three RMB exchange rate indexes, which guided the market from focusing on the RMB exchange rate against the US dollar to focusing on the weighted average exchange rate of RMB against a basket of currencies. From the perspective of actual operation effect, the RMB exchange rate index is relatively stable compared with the RMB US dollar exchange rate, and the change is relatively gentle.
（4） The exchange rate will play a better role as an automatic stabilizer and the balance of payments will become more balanced
The RMB exchange rate rapidly adjusts with the changes in market supply and demand, so that it can better play the role of macroeconomic and balance of payments automatic stabilizer. At the same time, the improvement of the depth of the foreign exchange market also helps to enhance the market's ability to withstand external shocks. Especially in recent years, although the two-way fluctuation of exchange rate has significantly increased, the foreign exchange market has operated in an orderly manner and the market expectation has remained stable. With the continuous improvement of exchange rate marketization, the scale of foreign exchange settlement and sales by banks has become more balanced, and the willingness of enterprises and other entities to settle and purchase foreign exchange has become increasingly stable; The balance of international payments has also become more balanced, especially the ratio of current account surplus to GDP has been basically stable within a reasonable equilibrium range in recent years. In addition, the marketization of exchange rate also helps to enhance the autonomy of China's monetary policy. The People's Bank of China (PBC) has adopted a steady monetary policy of "focusing on ourselves" to ensure that the level of domestic interest rates is compatible with China's development stage and economic situation, whether it is when developed economies generally implement loose monetary policies or when they have aggressively raised interest rates in succession, which depends on the strengthening of the elasticity of the PBC exchange rate.
2、 Structural problems still exist and deserve further attention
（1） The currency structure is too centralized, causing excessive attention to the bilateral exchange rate against the US dollar
The market pays too much attention to the exchange rate of RMB against the US dollar, which is prone to irrational behavior when the US dollar fluctuates significantly. Although there are more than 40 tradable currencies in the foreign exchange market today, many people still equate the RMB exchange rate with the exchange rate of RMB against the US dollar, and the market is prone to irrational behavior when the US dollar fluctuates significantly. In September 2022, the US dollar index rose by 3.2% in a single month, and the depreciation of RMB against the US dollar was the same as that of the US index. However, the CFETS RMB exchange rate index only fell by 0.6%, but the foreign exchange market still showed irrational panic, and the spot exchange rate of RMB against the US dollar began to deviate significantly from the middle rate. On the contrary, in September 2023, the US dollar index rose by 2.5% in a single month. This time, the exchange rate of the RMB against the US dollar was stable, falling by only 0.1%, which led to significant fluctuations of the RMB against other non US currencies. The CFETS RMB exchange rate index rose by 2.5% in a single month. This time, the deviation of the central parity rate of the RMB against the US dollar from the closing price of the day before last remained at about 1000BP.
The deviation between the foreign collection and payment structure and the trade structure is the main reason why the market pays too much attention to the US dollar. In recent years, the proportion of US dollars in foreign currency funds received and paid by banks on behalf of customers has increased, to 89.8% in 2023. On the contrary, the weight of the US dollar in the CFETS currency basket has declined from 26.4% at the beginning of the index release to 19.46% in 2024. The weight of euro, Japanese yen and Hong Kong dollar in the currency basket is 18.1%, 9.0% and 3.0% respectively, but they only account for 5.0%, 1.6% and 1.9% of foreign currency payments received and paid by banks on behalf of customers. In view of the fact that the basket currency weight of the CFETS RMB exchange rate index is calculated by using the trade weight method taking into account the factors of entrepot trade, which means that the currency structure of China's foreign collection and payment is significantly different from China's foreign trade structure. Because 90% of foreign exchange demand comes from the single currency US dollar, many people still focus on the bilateral exchange rate of RMB against US dollar.
（2） The volatility of the RMB against the US dollar is relatively small, which hinders the approach to the equilibrium level
The daily fluctuation elasticity of the RMB exchange rate against the US dollar is significantly less than that of other major currencies. Although the daily fluctuation limit range of the RMB against the US dollar has been expanded to 2%, the daily fluctuation range is still significantly small in actual operation. From 2022 to 2023, there will be 35.5% of the daily changes (up or down) of RMB against the U.S. dollar in less than 0.1%, and 57.4% of the daily changes will be less than 0.2%. In the same period, the probability distribution of the daily volatility of the euro, sterling and yen against the dollar is generally similar. The proportion of trading days with a daily volatility of less than 0.1% is about 15%, and the proportion of trading days with a daily volatility of less than 0.2% is about 30%. During the same period, the trading days with daily fluctuations of 1% or more between sterling and yen and the US dollar accounted for more than 10%, while the trading days with daily fluctuations of 7.2% for euros were still far lower than the corresponding proportion of 2.0% for renminbi; The trading days with daily fluctuation of 0.8% or more of the euro and sterling against the dollar accounted for about 15%, the proportion of the yen was even close to 20%, and the corresponding proportion of the RMB was only 3.9%.
When there is a trend change, the smaller daily fluctuation elasticity will prevent the exchange rate from approaching the equilibrium level. When the dollar index fluctuates in both directions due to short-term factors, a smaller daily volatility elasticity will help stabilize the RMB exchange rate. Taking June August 2022 as an example, the US Index rose 4.51% from June 27 to July 14, and the RMB depreciated only 0.89% against the US dollar; Since then, the US dollar has weakened, falling 3.25% to the high point on August 11, and the RMB has appreciated 0.14% against the US dollar; From the whole process, the RMB exchange rate is obviously stable. In the case of March May 2022, on the contrary, the dollar index rose 3.02% from March 30 to April 18, and the RMB depreciated only 0.27% against the dollar in the same period; Then, until May 16, the US Index rose further by 3.41%, and the RMB depreciated significantly against the US dollar by 6.28% in less than a month. It can be seen that when some long-term factors promote the trend change of the US dollar index, the price of too small daily volatility elasticity is that the exchange rate needs more drastic short-term adjustment when the equilibrium level changes.
（3） Unilateral and pro cyclical behavior is easy to occur, and the micro foundation of exchange rate stability is weak
The "key point" of exchange rate still exists, which is easy to induce unilateral and pro cyclical behavior. In the case that the People's Bank of China gradually withdraws from the normalized intervention, the continuous deviation between the central parity rate and the onshore price can generally be used as an indicator of pro cyclical behavior in the foreign exchange market. In recent years, the fact that the central parity rate has deviated significantly from the closing price of the previous day for several times is basically related to the fact that the exchange rate of RMB against the US dollar has broken 7; And every time when the RMB exchange rate against the US dollar continues to return to within 7.1, the middle price and the onshore price tend to be consistent. It can be seen that the foreign exchange market is still very sensitive to the "key point" of the RMB US dollar exchange rate. On the contrary, when the "key point" is not touched, even though the RMB has experienced a more severe depreciation against the US dollar in the short term, there is no continuous significant deviation between the middle price and the onshore price. This point effect shows that the main body of China's foreign exchange market has still failed to fully establish the concept of "risk neutrality", and the blind following of unilateral and point gambling still exists.
The concept of "risk neutrality" has not been widely established, and the micro foundation for maintaining exchange rate stability is weak. Although the proportion of derivatives transactions in the total scale of bank to customer foreign exchange transactions has gradually increased, spot foreign exchange transactions still account for 70% of the total scale of customer to customer transactions. The BIS survey shows that the spot foreign exchange transactions of global non bank financial institutions and non-financial customers account for less than 40%. The overall utilization of foreign exchange derivatives by domestic enterprises is significantly lower than the international average, and only about 20% of enterprises actively respond to changes in the foreign exchange market. A large number of enterprises have not fully established the "risk neutral" exchange rate management concept: some enterprises only pay attention to exchange rate risk when the exchange rate fluctuates violently; A small number of enterprises use foreign exchange transactions for speculation or arbitrage; What's more, they are used to betting on the exchange rate from a subjective perspective, and directly "streaking" in the market for immediate operations. The participants lack the concept of "risk neutrality", which means that the market micro foundation for maintaining exchange rate stability is relatively weak.
3、 Continue to deepen reform and improve market-oriented mechanism
First, better provide diversified currency options and guide the use of African American currencies. Promote policies and measures such as trade and foreign exchange facilitation in a balanced manner for all currencies, and improve the level of cross-border trade, investment and financing facilitation in all currencies. Enrich the exchange market transaction currencies, improve the foreign exchange market product system, improve the service level of foreign exchange infrastructure covering all major currencies, and better provide diversified currency choices for economic entities. We can increase policy preference for the currency use of major trading countries, guide market players to increase the use of African American currencies and pay attention to the exchange rate of RMB against a basket of currencies.
Second, the market should play a decisive role in the formation of the RMB exchange rate. We will continue to promote the construction of a multi-level foreign exchange market system, and strengthen the ability of financial institutions to discover prices, allocate resources, and manage risks. Adhere to the principle that the exchange rate is mainly determined by market supply and demand, broaden the daily actual floating range of the exchange rate within the fluctuation limit, avoid unilateral quotations caused by short-term centralized adjustment of the exchange rate, achieve the coordination of the dual objectives of balanced exchange rate and exchange rate stability, and better play the role of the exchange rate as a price signal. Fully tap the interaction between the onshore and offshore markets to achieve balanced and coordinated development of the two markets.
Third, further guide enterprises and financial institutions to establish the concept of "risk neutrality". We will guide financial institutions to increase the publicity of the "risk neutral" concept of exchange rate, promote financial institutions to improve the long-term mechanism of exchange rate risk management services, improve the professionalism of foreign exchange services, actively provide and continuously optimize exchange rate hedging services based on the principle of real demand and the risk neutral principle, and help enterprises improve their awareness of exchange rate hedging and active management capabilities. We will strengthen the construction of the self-discipline mechanism in the foreign exchange market, promote the members of the self-discipline mechanism to improve their self-discipline awareness and compliance management level, consciously maintain market stability, and resolutely resist speculation, inciting customers and other acts that disrupt the order of the foreign exchange market.
Fourth, strengthen the "macro prudential+micro supervision" management of the foreign exchange market. We will strengthen the full coverage of foreign exchange regulation, strengthen regular regulation, use scientific and technological regulatory means to improve regulatory effectiveness, and explore institutional and systematic arrangements for coordinated facilitation and risk prevention. We will improve the cross-border transaction management mechanism that is "authentic in substance, diversified in approach, dutiful and exempt from liability, safe and efficient", improve the monitoring, early warning and response mechanism for cross-border capital flows, and focus on expectation management to prevent the formation of unilateral consistent expectations and self reinforcement. Adhere to the bottom line thinking, and correct the market procyclical and unilateral behavior when necessary.
Source: China's money market
(About the author: Chief Economist of Minsheng Bank)
