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China’s currency: The impossible trinity - Part 1 of 3

By: Mat Lystra, Sr. Research Analyst[1]

There’s an economic axiom called “The Impossible Trinity” which states that a country cannot simultaneously control its exchange rate and its monetary policy while also allowing unrestricted cross-border capital flows.[2] Those anticipating the fall of the Chinese currency, the Renminbi, often point to this theory to support their hypothesis. In this economic juggling act, as the theory goes, something must drop. Historically it’s been a managed exchange rate that countries have most often let go of, often with dramatic effects on asset prices.[3] Can China defy this proposed inevitability?

In this first of a three-part series, we’ll explore China’s efforts to maintain a stable Renminbi/USD (CNY/USD) exchange rate. Subsequent posts will examine the other two pieces of the trinity—monetary policy and capital flows. For now, let’s take a look at how the Renminbi is valued and the steps China is taking to maintain at least partial control of its exchange rate.

The value of CNY relative to USD does not float freely, but is allowed to move within a certain range above or below a daily reference point set by the People’s Bank of China (PBOC). China has continued to make progress towards internationalizing the Renminbi, doing enough to be awarded membership in the IMF’s “Special Drawing Right” basket of currencies. However, it is also straining to resist the forces pressing for devaluation.

As illustrated below, to ward off a devaluation, China has spent almost $800B of what was a nearly $4T foreign currency reserve fortress to support the Renminbi in the last year—selling dollars into the market to buy back its own currency. Thus, reversing a multi-year build-up of foreign exchange reserves.

China Forex reserves vs. reserves of other BRIC Countries (Brazil, Russia, India)

 

Source: Bloomberg through January 31, 2016.[4]

This tactic does come with a downside as a liquidity-inflation dilemma emerges when the Renminbi is moved out of the global market and piles up onshore.[5] A secondary symptom of the buyback program arises from the need to “sterilize” the repurchased CNY before inflation sets in -- leading to the second leg of the trilemma -- monetary policy. 

The currency sterilization process seeks to “trap” as much of the incoming excess currency as possible in order to avoid an imbalance between an increasing supply of money and a limited number of goods and services that can be purchased.[6] Since banks are viewed as natural sponges that can soak up the extra liquidity, the PBOC has maintained a high reserve requirement ratio (RRR) for the country’s deposit-taking institutions.  The higher RRR means domestic banks must hold on to more cash thus decreasing the lending activities that could help to stimulate the economy. 

We can see in the chart below that China’s RRR is significantly higher than those of the other BRIC countries. However, as the CNY/USD exchange rate has been allowed to appreciate in recent months, China has taken to cautiously reducing the RRR to leave room for some lending to help boost the ailing economy. 

BRIC required reserve ratio comparison

 

Source: Bloomberg through January 31, 2016.

The banded-exchange rate, expenditures of foreign reserves and a higher peer-relative RRR are all strong indicators that China is committed to a partially-controlled exchange rate regime (i.e. not pegged to a completely fixed CNY/USD rate), at least in the near term. 

As the three-part series concludes, we’ll end up with a view as to the three currency-related tests of the “trilemma” with which we can weigh-in on whether China may be able to bend the rules of the trinity without breaking them.

Watch for part two of this blog series which will examine the second piece of the impossible trinity: monetary policy.

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[1] The author wishes to thank Tom Goodwin and Catherine Yoshimoto for their contributions to this research.

[2] Grenville, S. (2011). The Impossible Trinity and Capital Flows in East Asia.  Asian Development Bank Institute accessed on March 1, 2016 at: http://www.eaber.org/sites/default/files/documents/2011.11.07.wp319.impossible.trinity.capital.flows_.east_.asia_.pdf

[3] Buiter, W.H., Corsetti, G.M., & Pesenti, P. (1998). Interpreting the ERM Crisis: Country-Specific and Systemic Issues.  Princeton University, accessed on March 9, 2016 at: https://www.princeton.edu/~ies/IES_Studies/S84.pdf; and Whitt, J.A. (1996). The Mexican Peso Crisis.  U.S. Federal Reserve Bank of Atlanta Policy Paper, accessed on March 3, 2016 at: https://www.frbatlanta.org/-/media/Documents/filelegacydocs/Jwhi811.pdf 

[4] India’s most recent figure was from 12/31/2015 as was carried forward to 1/31/2016.

[5] Glick, R. & Hutchison, M. (2011). Currency Crises.  U.S. Federal Reserve Bank of San Francisco Working Paper, accessed on March 1, 2016 at: http://www.frbsf.org/economic-research/files/wp11-22bk.pdf

[6] Lee, J-Y. (1997).  Sterilizing Capital Inflows.  International Monetary Fund, access on March 29th, 2016 at: http://www.imf.org/EXTERNAL/PUBS/FT/ISSUES7/INDEX.HTM

 


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