China’s Trilemma

BEIJING – The Nobel laureate economist Robert Mundell showed that an economy can maintain two – but only two – of three key features: monetary-policy independence, a fixed exchange rate, and free cross-border capital flows. But China is currently juggling all three – an act that is becoming increasingly difficult to sustain.

At first glance, this may not seem to be the case. Given that the People’s Bank of China (PBOC) has largely maintained its monetary-policy independence over the last three decades, and actively manages the renminbi’s exchange rate, it is natural to conclude that China imposes strict controls on capital flows. In fact, China liberalized inward foreign direct investment more than 20 years ago, and eased controls for much of the capital account thereafter.

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China’s efforts to regulate cross-border capital flows have never been very effective. During the Asian financial crisis of the 1990s, China had to implement draconian measures to prevent capital flight. In the early 2000s, short-term capital began to flow into China, with investors betting on the renminbi’s appreciation and, from 2004-2006, on rising asset prices. Since renminbi internationalization was launched in 2009, exchange-rate arbitrage and the carry trade have surged.

Certainly, China’s capital controls, though porous, increase the transaction costs of moving short-term capital to and from China, thereby reducing upward pressure on the renminbi’s exchange rate; in extreme circumstances, this could play a decisive role in China’s financial security. But capital continues to flow – if not entirely freely – across China’s borders.

This raises an obvious question: How has China managed to defy the Mundell trilemma by maintaining all three policy objectives simultaneously? The answer lies in China’s sterilization policy.

China has run a capital-account surplus for most of the last 30 years, and a trade surplus every year since 1993. The PBOC keeps the exchange rate stable by intervening heavily in the foreign-exchange market, creating so much liquidity that the authorities must engage in massive sterilization to avoid overshooting the targeted increase in the monetary base.

In China, unlike in advanced countries, monetary and sterilization policy are often one in the same. The degree to which monetary policy is expansionary depends on the degree to which the liquidity created by currency-market intervention has been sterilized.

The most frequently used monetary instrument in sterilization is open-market operations. Given China’s twin surpluses, the PBOC sold all of the government bonds that it had accumulated in 2003, so it has been selling central-bank bills ever since, with CN¥5 trillion ($812 billion) in such bills currently held by banks.

Another important instrument for sterilization is the reserve-requirement ratio, which, when raised, locks a large amount of liquidity in the banking system. The ratio, which the PBOC has changed 42 times since 1998, currently stands at 20% – double the ratio for large banks in the United States.

Whatever the mechanism, the costs of sterilization are very high. For starters, by maintaining an undervalued real exchange rate, China has fallen into the so-called “dollar trap,” boosting the US dollar’s international importance at China’s own expense. As time passes, the senselessness of this policy will become increasingly apparent.

Sterilization also leads to a serious misallocation of resources, most obviously by functioning as a subsidy to the export sector, at the expense of the rest of the economy. A less noticed form of resource misallocation stems from the fact that only sellers of foreign exchange gain liquidity, but the whole economy feels the effects. As a result, small and medium-size enterprises that produce non-tradable products are denied much-needed funds and suffer from sterilization’s negative externalities.

Furthermore, the high reserve ratio and forced purchase of central-bank bills squeezes commercial banks’ profits severely – a phenomenon that will be intensified by interest-rate liberalization. The quest for yield on available funds will drive banks to make riskier investments.

There are also quasi-fiscal costs involved. Fortunately, despite the low returns on foreign assets, this is not yet a major problem for China, owing to the low costs of the corresponding PBOC liabilities.

Nonetheless, though predictions that China would abandon its exchange-rate controls in order to uphold monetary autonomy have proved wrong over the last decade, this time may be different. With China’s liberalization of interest rates and short-term capital flows making it increasingly difficult for the country to juggle Mundell’s “irreconcilable trinity,” one hopes that Chinese leaders will finally allow the renminbi to float, while keeping in place existing capital controls.