Navigating the trilemma:Capitalflows and monetary policy in China§Reuven Glick a,Michael Hutchison b,*
a Economic Research Department,Federal Reserve Bank of San Francisco,United States
b Department of Economics,University of California,Santa Cruz,CA,United States
1.Introduction
The trilemma paradigm of open economy macroeconomics asserts that a country may not simultaneously target the exchange rate,run an independent monetary policy,and allow full capital mobility.1In the mid to late1980s most developing countries addressed the trilemma by maintaining a combination of exchange rate stability and monetary independence,with relatively closed capital accounts.In the late1980s and early1990s,some developing countries,such as
Journal of Asian Economics20(2009)205–224
A R T I C L E I N F O
JEL classification:
E5
engage in
F3
F41
Keywords:
Trilemma
Capitalflows
Monetary policy
China
A B S T R A C T
In recent years China has faced an increasing trilemma—how to pursue an independent
domestic monetary policy and limit exchange rateflexibility,while at the same time facing
large and growing international capitalflows.This paper analyzes the impact of the
trilemma on China’s monetary policy as the country liberalizes its good andfinancial
markets and integrates with the world economy.It shows how China has sought to
insulate its reserve money from the effects of balance of payments inflows by sterilizing
through the issuance of central bank liabilities.However,we report empirical results
indicating that sterilization dropped precipitously in2006in the face of the ongoing
massive buildup of international reserves,leading to a surge in reserve money growth.
We also estimate a vector error correction model linking the surge in China’s reserve
money to broad money,real GDP,and the price level.We use this model to explore the
inflationary implications of different policy scenarios.Under a scenario of continued rapid
reserve money growth(consistent with limited sterilization of foreign exchange reserve
accumulation)and strong economic growth,the model predicts a rapid increase in
inflation.A model simulation using an extension of the framework that incorporates
recent increases in bank reserve requirements also implies a rapid rise in inflation.By
contrast,model simulations incorporating a sharp slowdown in economic growth such as
that seen in late2008and2009lead to less inflation pressure even with a substantial
buildup in international reserves.
ß2009Elsevier Inc.All rights reserved.
§The views expressed below do not represent those of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. Hutchison’s work on this project was started while a visiting fellow at the Hong Kong Institute for Monetary Research(HKIMR).We thank Kenneth Chow and Katherine Chen for excellent research assistance and Dong He for data.We also thank participants at the conference‘‘Global Liquidity and East Asian Economies’’held at the HKMIR in Hong Kong on June26–27,2008,especially our discussants Hiro Ito,Hans Genberg,and Dong He,as well as participants at the American Committee on Asian Economic Studies(ACAES)conference‘‘Asian Economic Integration in a Global Context’’held in Rimini,Italy on August 29–31for helpful comments.
*Corresponding author.Tel.:+18314592743;fax:+18314595077.
E-mail addresses:reuven.glick@(R.Glick),hutch@ucsc.edu(M.Hutchison).
1See Obstfeld,Shambaugh,and Taylor(2005)for further discussion and references dealing with the trilemma.Related papers have raised the possibility that a pegged exchange rate is a trap in the era of greaterfinancial ,Aizenman&Glick,2008a;Eichengreen,1999;Edwards&Levy-Yeyati, 2005;Frankel,1999).
Contents lists available at ScienceDirect
Journal of Asian Economics
1049-0078/$–see front matterß2009Elsevier Inc.All rights reserved.
doi:10.1016/j.asieco.2009.02.011
Mexico,Thailand,and Korea,embraced growing financial liberalization and openness.However,as they opened more financially,many of these countries also tried to maintain some degree of exchange rate stability and monetary independence,and failed to successfully navigate the trilemma.Their inconsistent policy goals resulted in severe financial crises,in Mexico during 1994–95and in Asia during 1997–98.In the early 1990s Argentina adopted another trilemma configuration i
nvolving exchange rate fixity,supported by a version of a currency board,and complete financial integration.Argentina also experienced a crisis when ceding monetary policy independence to a currency board arrangement was no longer viable.
China has pursued a more cautious path towards greater financial openness.Although tax benefits and other incentives have been used to promote inward foreign direct investment,other forms of inflows,particularly portfolio capital and external debt,have been traditionally discouraged.Capital controls have also played a role in protecting the banking system from external competition by restricting the entry of foreign banks and by making it harder for capital to flow out of the country.The limited development of debt and equity markets in the past preserved the role of the state-owned banking system as the main international intermediary for Chinese borrowers and savers.
As China slowly liberalizes its capital account,it faces a key challenge of maintaining domestic monetary and price stability.2To avoid the trilemma problem,China has allowed somewhat more exchange rate flexibility in recent years.But growing balance of payments surpluses through both the current and financial accounts have put upward pressure on the currency.To limit appreciation of the domestic currency,the renminbi (Rmb),Chinese monetary authorities have intervened in the foreign exchange market and accumulated massive amounts of foreign reserve.As a result,China’s holdings
of foreign reserves have risen from $140billion in 1997(15%of GDP)to over $1.5trillion at the end of 2007(more than 45%of GDP),with two-thirds of this buildup occurring in the last three years.
This reserve buildup has raised concerns about monetary and inflation stability in China,as both money aggregates and prices have grown faster.A not-so-distant memory is the excessive expansion of the monetary base,money,and credit between 1991and 1994–when these aggregates grew at times by over 40%per annum –resulting in high inflation,with CPI rising near 30%at its peak.3The current foreign reserve boom lead to similarly large increases in the monetary base in 2007and the first half of 2008,threatening a return of higher inflation.In 2007the monetary base grew over 30%and CPI inflation rose above 8%.4
As long as China continues to place a higher priority on exchange rate stability than on using monetary policy as a tool for macroeconomic control,China’s scope for an autonomous monetary policy is constrained.Chinese monetary authorities have addressed this challenge by more aggressive open market sterilization operations as well as by raising reserve requirement ratios and employing window guidance measures when concern about overheating was paramount.The extent to which China will successfully confront the trilemma problem depends on achieving the right balance of policy objectives.As reserve accumulation continues,the conflict between monetary and e
xchange rate objectives will become increasingly harder to resolve,particularly as remaining controls on capital flow become more difficult to maintain.
In this paper we investigate the extent to which the rise in China’s foreign reserves has affected the country’s monetary policy and been a source of monetary instability contributing to higher inflation.We begin by characterizing the nature of China’s balance of payment flows and the effectiveness of its capital controls.We find that pressure on China’s exchange rate regime increased after its ascension to the World Trade Organization in 2001and the emergence of growing current account surpluses.These surpluses,together with large long-standing inflows of foreign direct investment,have presented China’s authorities with a structural imbalance in the country’s balance of payments.This imbalance,combined with bouts of ‘‘hot money’’capital inflows spurred by speculation on Rmb appreciation against a backdrop of greater capital account openness,the People’s Bank of China (PBC)to engage in ever-increasing foreign exchange market purchases and foreign asset accumulation to dampen appreciation of the currency.
The second part of our analysis measures the degree to which the PBC has been able to insulate reserve money growth from the liquidity effects associated with rapid foreign asset accumulation.We present estimates of how China’s marginal propensity to sterilize the effects of foreign asset accumul
ation on the monetary base has changed over time,rising until 2006and then sharply declining as the authorities found it increasingly more difficult to limit the liquidity effects of massive foreign exchange asset accumulation.
The third part of our analysis addresses the broader monetary and inflationary impacts of the foreign reserve buildup.We formulate and estimate a vector error correction model (VECM)characterizing the evolution of reserve money,broad money,real GDP,and prices.Although each variable individually appears to follow a stationary process in first differences,formal cointegration tests suggest that two long-term stable relationships (cointegrating vectors)characterize the system.We interpret these cointegrating relationships as long-run money demand and money supply functions.Estimates of the VECM model,which captures both short-run dynamics and long-term relationships in the data,allow us to carry out model simulations for alternative paths of foreign reserve accumulation and sterilization.Under a scenario of rapid foreign
2
For example,China in recent years has permitted limited expansion of portfolio capital flows through ‘‘qualified investment’’programs.Moreover,unofficial flows into and out of China have grown over time.3
This episode was also characterized by a sharp deterioration of asset quality,resulting in substantial increases in non-performing bank loans.4
Since much of this inflation has shown up as a sharp increase in food prices,attributable to food shortages caused by bad weather and livestock disease,some have argued that the recent inflation was not monetary in origin.Rogoff (2008)has described these alternative views as the ‘‘pork’’versus ‘‘money’’debate and states that ‘‘Those who believe that the cause of China’s inflation is too little pork,rather than too much money,are seriously mistaken.’’
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206
exchange reserve accumulation,limited exchange rate flexibility,and rapid economic growth –the economic environment until recently –the model predicts a rapid increase in inflation if sterilization continues to have limited effectiveness.An extension of the model incorporates increases in bank reserve requirements and predicts similar inflationary pressures.However,an alternative scenario with slow economic growth but continued rapid reserve money growth predicts a decline in inflation over a three-year horizon.
The paper is organized as follows.Section 2describes the pattern of balance of payments flows that underlie the surge in China’s accumulation of foreign reserves.Section 3analyzes the PBC’s efforts to sterilize the effects of the reserve inflows on the conduct of monetary policy.Section 4presents the VECM results capturing the dynamic interaction of reserve inflows and monetary control in China.This section also presents alternative monetary policy simulations.Section 5concludes the paper.
2.Foreign reserve accumulation and capital account openness in China 2.1.Pattern of balance of payments flows
China’s holdings of foreign exchange reserves have risen dramatically in recent years.Table 1shows China’s balance of payments (BOP)and pattern of reserve accumulation over the past two decades and decomposes the reserve buildup into the current account,foreign direct investment inflows,and a residual component consisting of net securities,other capital inflows,and errors and omissions.We interpret these non-FDI capital inflows,as ‘‘hot money’’that could potentially switch direction within a short horizon.5Fig.1a and b provides a visual summary of the changes in these components unscaled and scaled by nominal GDP (converted into dollars by the average Rmb/$exchange rate),respectively.Table 2compares the average level and changes in BOP flows over different subpe
riods.
The increase in foreign reserves over time is associated most prominently with growing current account surpluses and FDI inflows.6The annual current account balance rose from $17billion in 2001(1.3%of GDP)to $326billion in 2007(almost 10%of GDP).Direct investment inflows have grown steadily over this period,though less rapidly.
The figures also show the relative variability of non-FDI capital flows compared to the current account and FDI flows.Hot money outflows were large in the aftermath of the 1997–98crisis,switched to inflows in 2001–04,then outflows in 2005–06,and large inflows again in 2007.7More specifically,non-FDI capital inflows (including errors and omissions),swung from an average of minus $54billion in 1998–2000to plus $24billion in 2001–04,a turnaround of $78billion more inflows on an annual basis (as compared to an increase in the average current account surplus by $18billion over the period).They then switched to an annual average of minus $46billion during 2005–06,before changing to $102
Table 1
China’s balance of payments,1985–2007(billions of US$).
1985–891990–941995
1996199719981999200020012002
2003
2004
2005
20062007Foreign reserve accumulation 0.511.422.531.635.7  6.48.510.547.375.5117.0206.4207.0247.0532.2as %of GDP 0.1  2.4  3.1  3.7  3.80.60.80.9  3.6  5.27.110.79.39.316.2Current account À5.3  5.5  1.67.237.031.521.120.517.435.445.968.7160.8249.9325.7as %of GDP
À1.6  1.40.20.8
3.9
3.1
1.9
1.7
1.3
2.4
2.8
3.67.2
9.49.9Financial account    6.413.438.740.021.0À6.3  5.2  2.034.832.352.8110.7
58.9
6.017
7.4as %of GDP
1.8
2.5  5.3  4.7  2.2À0.60.50.2  2.6  2.2
3.2  5.7  2.60.2  5.4Direct investments,net    1.813.633.838.141.741.137.037.537.446.847.253.167.860.3101.8Securities investment,net na    1.40.8  1.7  6.9À3.7À11.2À
4.0À19.4À10.311.419.7À4.9À67.6À9.7Other investments,net na À1.7  4.0
0.2À27.6À43.7À20.5À31.516.9À4.1
À5.937.9À4.0
13.385.2Errors and omissions À0.6À7.5À17.8À15.6À22.3À18.7À17.8À11.9À4.97.818.427.0À16.8À12.926.2Memo:non-FDI financial account (including errors and omissions)  3.9
À7.7
À13.0À13.7À42.9À66.1À49.6À47.4
À7.4
À6.7
24.0
84.6À25.7
À67.1
101.7
as %of GDP
1.2À1.5À1.8À1.6À4.5À6.5À4.6À4.0À0.6À0.5  1.5  4.4À1.2À
2.5
3.1
Memo:stock of foreign reserves    3.325.073.6105.0139.9145.0154.7165.6212.2286.4403.3609.9818.91066.31528.2
as %of GDP 0.9  5.0
10.112.314.714.314.313.816.019.724.631.636.640.146.6
Note :Sum of current account,financial account,and errors and omissions differs (slightly)from reserve accumulation by omission of capital account.
Change in stock of foreign reserves differs from reserve accumulation because of valuation and other effects to holdings.
5
This interpretation is standard in the literature (e.g.Prasad &Wei,2005b ).Ma and McCauley (2007)suggest that hot money inflows also may occur through the current account,in the form of rising inward remittance transfers and lagging dividend and interest payments,as well under-and over-invoicing of exports and imports in years when the Rmb is expected to appreciate.6
Note that because GDP grew so fast between 2004and 2005,reserves as a ratio of GDP fell slightly during that period.7
These figures do not incorporate adjustments that have been suggested in order to deal with the PBC’s use of foreign exchange reserves to recapitalize state banks in 2003and 2005(adding these in
would increase the reported foreign reserve inflows),the capitalization of the CIC at the end of 2007and into 2008,and the PBC’s ‘‘encouragement’’of state banks to use dollar assets to meet reserve requirements in 2007and 2008.
R.Glick,M.Hutchison /Journal of Asian Economics 20(2009)205–224
207
billion in 2007,a remarkable swing of $148in additional inflows (compared to an increase of $120billion in the average current account balance).8
To gain further insight into the determinants of the swings in ‘‘hot money,’’Fig.2a and b presents disaggregate results for the subcomponents of net securities inflows,errors and omissions,and ‘‘other’’inflows (data is not available on all components before 1997).Observe that all of these subcomponents moved similarly during the aforementioned cyclical swings of overall hot money.Securities inflows,other investments,and errors and omissions rose by $7billion,$43billion,and $28billion,respectively,between 1998–2000and 2001–04;and declined by $37billion,$7billion,and $27billion,between 2001–04and 2005–06;and then rose by $279billion,$81billion,and $41billion between 2005–06and 2007.10
These swings in hot money suggest that China’s capital flows are sensitivity to market considerations.Fig.3plots measures of the expected appreciation of Rmb based on $/Rmb forward contracts and of the US–China interest differential (positive values of ‘‘expected Rmb appreciation’’correspond to an expected rise in the $/Rmb).The immediate post-Asia crisis period coincided with depreciation pressures on the Rmb,prompting capital outflows.The increase in money inflows during the period 2001–04coincided with U.S.Federal Reserve interest rate cuts beginning in January 2001,relatively stable Chinese interest rates,and expectations of an Rmb appreciation.The incentive for capital to flow into Rmb assets was
highest
Fig.1.(a)Decomposition of China’s reserve accumulation,billions of $and (b)decomposition of China’s reserve accumulation,percent of GDP.
Table 2
China’s balance of payments,1998–2007(billions of US$).
Avg.
1998–2000
Avg.
2001–2004Avg.
2005–20062007
Change
from 1998–2000to 2001–2004Change from 2001–2004to 2005–2006Change from 2005–2006to 2007Foreign reserve accumulation 8.5111.6227.0532.2103.1115.5305.2Current account
24.441.8205.3325.717.5163.5120.4Financial account
0.357.732.4177.457.4À25.2145.0Direct investments,net 38.546.164.0101.87.617.937.8Securities investment,net À6.30.3À36.2À9.7  6.7À36.626.6Other investments,net À31.911.2  4.685.243.1À6.680.6Errors and omissions À16.112.1À14.826.228.2À26.941.0Memo:non-FDI financial account (including errors and omissions)
À54.4
23.6
À46.4
101.7
78.0
À70.1
148.1
8
The swing in the flow of securities between 2006and 2007amounted to $169billion.
9
Net securities inflows increased sharply from $5billion in 2005to $68billion in 2006,before declining to $10billion in 2007.This reflects inflows attracted to China’s booming stock market in 2006,which fell off in 2007as equity prices fell.10
Prasad and Wei (2005b)suggest that errors and omissions may reflect valuation changes of official foreign exchange reserves (positive when the dollar falls against major currencies,leading to an errors and omission inflow),rather than unrecorded capital inflows.
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when (i)the yuan was expected to appreciate and (ii)the US–China differential was negative,as was the case during the period 2004to mid-2005and more recently,from the latter part of 2007.
The unpegging of the Rmb to the dollar and subsequent currency appreciation beginning in July 2005temporarily curtailed these speculative inflows and lead to the emergence of net outflows,particularly as US interest rates rose.Subsequently,the emergence again of a positive interest differential between China and the United States combined with ongoing perceptions of an undervalued Rmb may have exacerbated the speculative movement into Rmb-denominated instruments,by essentially creating the perception of a one-way bet for investors,without an associated carrying cost.
We can gain further insights by investigating details about the subcomponents of ‘‘other’’net investment flows –trade credit,loans,currencies &deposits,and ‘‘other’’–as plotted in Fig.4a and b.Observe that since 2001,loans and (foreign)currencies &deposits have been the most volatile components,with both growing strongly since 2005.11
Next we examine the evolution of gross flows of assets and liabilities of selected categories of capital flows.These details help shed some light on how capital account liberalization has affected different c
ategories of financial transactions.Fig.5a and b shows asset and liability movements of equity and debt securities.Observe that capital account liberalization evidently lead to sharply increased equity market inflows on the liability side in 2006,particularly as the stock market boomed,and on the outflow (asset)side,to greater holdings of foreign debt securities.This reflects limitations placed on Chinese investors in acquiring foreign stocks.Gross equity security inflows increased from $2billion in 2002,to $11billion in 2004,$20billion in 2005,and $44billion in 2006,before declining to $31billion in 2007.This reflects inflows attracted
to
Fig.2.(a)Decomposition of China’s non-FDI capital inflows,billions of $and (b)decomposition of China’s non-FDI capital inflows,percent of
GDP.
Fig.3.US–China interest differential and expected Rmb appreciation,in percent.Note:positive values o
f ‘‘expected Rmb appreciation’’correspond to an expected rise in the $/Rmb rate,as measured by the 12-month premium on non-deliverable forward contracts for the Rmb.The total net asset return to holding Rmb equals the expected appreciation of the Rmb minus the US–China interest differential,measured by difference between the US Treasury bill rate (IMF line 60c)and China 90-day interbank offer rate (PBOC).
11
The interest rate differential and exchange rate expectations especially affected the evolution of Chinese foreign currency deposits (Ma &McCauley,2002,2003,2007),as the share of onshore foreign currency deposits as a proportion to Rmb deposit held by Chinese households and firms in China’s banking system declined during the period over the period 2002–05when the Rmb was expected to appreciate.
R.Glick,M.Hutchison /Journal of Asian Economics 20(2009)205–224209
China’s stock market that was newly reformed 12in 2005and boomed through 2006,but then fell off in 2007as equity prices fell.Gross outflows in the form of the acquisition of foreign debt securities rose from $7billion in 2004,to a remarkable $109billion in 2006,which then fell to $20billion in 2007.Fig.6a
–c shows asset and liability movements of loans,currency &deposits,and ‘‘other’’other investment flows.2.2.China’s capital account controls
Capital controls,which prevent money from moving in an out of an economy easily,can insulate domestic monetary policy to some extent.Since the start of China’s reform and open-door policies,foreign direct investment (FDI)inflows have been encouraged,while other inflows and capital outflows were initially heavily controlled.13Non-bank Chinese
residents
Fig.4.(a)Decomposition of other investment inflows,net $billions and (b)decomposition of other investment inflows,net percent of
GDP.
Fig.5.(a)Equity securities,billions of $and (b)debt securities,billions of $.
12The main reform was the elimination of the ‘‘overhang’’from nontraded government-owned shares.
13
The Rmb has been convertible for current account transactions since December 1996,when China satisfied the IMF’s Article VIII criteria for membership.
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