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China’s Incompatible Goals

CAMBRIDGE – As Chinese policymakers attempt to address what ails their country’s economy, they are pursuing two goals that will almost certainly turn out to be incompatible. Very seldom have central banks been able to maintain a fixed exchange rate over an extended period of time while providing liquidity to troubled banks and an ailing economy. Indeed, the task becomes especially difficult as the monetary stringency needed to prop up the currency intensifies strains on domestic banks and the real economy.

Those looking for a rough outline of the Chinese economy’s future would be wise to revisit what happened in Thailand in 1997, when the collapse of the baht precipitated the Asian financial crisis. Of course, China in 2016 is different in many ways from Thailand in 1997; but there are key similarities in their responses to ongoing capital outflows.

After a prolonged credit boom, commercial banks typically face a mounting volume of nonperforming loans. The natural monetary-policy response is to increase liquidity, lower interest rates, and, in many cases, provide direct assistance in the form of loans from the central bank. This was exactly what was done, for example, in advanced economies after the 2008 financial crisis.

But lowering interest rates and easing monetary conditions to support the exchange rate is not a wise course of action when confidence in the currency and the economy is faltering, foreign investors are pulling their money out of the country, and domestic residents are trying to do the same. No matter how justifiable such a policy may be on other grounds, the result in such circumstances is almost always more capital flight and mounting reserve losses.