Unraveling the Underlying Logic of Exchange Rate Fluctuations

Fu Yingjun

Exchange rates are a crucial factor in international trade and play an important role in national economic development. Therefore, exchange rate issues have been closely watched on the market and remain a lasting topic of hot debate. How can we interpret the fluctuations of exchange rates? How can we analyze and predict exchange rate trends? For foreign trade companies and investment entities, how can we effectively avoid exchange rate risk? In his book "The Logic of Exchange Rates" (Zhongguo Fanyi Chubanshe, 2022), Guan Tao, the chief economist at Zhongying Securities, conducted in-depth analysis and thinking on the exchange market, providing important guidance and inspiration for our deep understanding of macroeconomic trends, scientific analysis of exchange rate fluctuations, and rational investment strategies.

At the end of October 2023, a meeting of the Central Financial Work Conference emphasized speeding up the construction of a strong financial country and promoting high-quality financial development for the new era. As the financial strong country strategy is gradually implemented, China's domestic financial market will continue to deepen its opening-up, and the RMB exchange rate will become increasingly marketized and asset-price-oriented. Thus, "herd behavior" and exchange rate deviations from fundamentals will occur frequently. In the process of high-level opening-up, how can we research the changes and trends in the RMB exchange rate? What framework should we adopt? What logic should we follow? These are some of the most concerned questions.

The author candidly admitted that he has correctly predicted the trend of the RMB exchange rate most of the time because he has consistently followed the analytical framework "logic is more important than conclusions." He combined market logic with policy logic and abstracted out four main aspects: one is the logical analysis based on historical experience; two is the relative price logic, which requires us to consider not only what will happen in China but also what will happen overseas, especially in the United States; three is the mean reversion logic, where no currency can only go up or down forever; and four is the policy rationality logic, where there is no single optimal exchange rate that suits all countries and all periods.

As the RMB exchange rate becomes increasingly volatile, export-oriented enterprises face uncertainty in their foreign exchange costs. The book emphasizes that one of the main strategies for coping with exchange rate fluctuations is to establish a risk-neutral financial awareness, actively using offshore foreign exchange derivatives, and controlling and managing exchange rate risks. Risk-neutral awareness refers to the enterprise's ability to incorporate exchange rate fluctuations into its daily financial decisions, focus on its core business, and minimize the negative impact of exchange rate fluctuations on its main operations and financials.

In general, domestic enterprises have become more aware of the need to actively manage exchange rate risks in recent years, but there is still a significant gap between their awareness and international standards. The foreign exchange derivatives market has always been a key area for China's financial market reform and development, as the demand for avoiding exchange rate risk continues to rise. At present, apart from foreign exchange futures, China already has a range of basic RMB offshore foreign exchange derivative instruments, such as forward contracts, swaps, and options, which can generally meet the demand for market-based exchange rate hedging.

There have been long-standing discussions about the relationship between the RMB exchange rate and A-shares. Some market opinions believe that there is a logical relationship: when the RMB appreciates, the stock market rises; when the RMB depreciates, the stock market falls. But does reality really bear this out? The book "The Logic of Exchange Rates" in-depth analyzes the relationship between the exchange market and the stock market. According to the author's research, from an international comparison perspective, the correlation between exchange rates and stock prices varies significantly across different economies and periods.

Since the "7.21" currency reform, the correlation between the RMB exchange rate and stock prices has been generally weak until 2017, when the correlation suddenly increased. The relationship between the stock market and the exchange market is a real economic phenomenon that reflects the existence of certain correlations between the two markets, but it does not imply a necessary causal relationship between them. In reality, many factors affect both exchange rates and stock prices, and we cannot overemphasize the impact of exchange rate fluctuations on stock prices, nor can we simply trade stocks based on exchange rate trends or vice versa.

The A-share market should focus more on China's economic fundamentals and macroeconomic policies, as well as capital market reforms and regulatory policy orientations. Regulatory authorities should pay attention to expectations management, guiding market participants to rationally view the relationship between stock markets and exchange rates, and stabilize investor expectations. This is crucial for maintaining the stability of the RMB exchange rate.

This column article represents only the author's personal views.