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.

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.