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Navigating the trilemma: Capital flows and monetary policy in China

  • Glick, Reuven
  • Hutchison, Michael

In recent years China has faced an increasing trilemma--how to pursue an independent domestic monetary policy and limit exchange rate flexibility, while at the same time facing large and growing international capital flows. This paper analyzes the impact of the trilemma on China's monetary policy as the country liberalizes its good and financial 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 in 2006 in 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 late 2008 and 2009 lead to less inflation pressure even with a substantial buildup in international reserves.

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Article provided by Elsevier in its journal Journal of Asian Economics.

Volume (Year): 20 (2009)
Issue (Month): 3 (May)
Pages: 205-224

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Handle: RePEc:eee:asieco:v:20:y:2009:i:3:p:205-224
Contact details of provider: Web page: http://www.elsevier.com/locate/asieco

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  1. Reuven Glick & Michael Hutchison, 1994. "Foreign reserve and money dynamics with asset portfolio adjustment: international evidence," Pacific Basin Working Paper Series 94-09, Federal Reserve Bank of San Francisco.
  2. Maurice Obstfeld & Jay C.Shambaugh & Alan M.Taylor, 2003. "The Trilemma in History:Tradeoffs among Exchange Rates, Monetary Policies,and Capital Mobility," DNB Staff Reports (discontinued) 94, Netherlands Central Bank.
  3. Guonan Ma & Robert McCauley, 2003. "Opening China’s capital account amid ample dollar liquidity," BIS Papers chapters, in: Bank for International Settlements (ed.), China's capital account liberalisation: international perspective, volume 15, pages 25-34 Bank for International Settlements.
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  8. Edwards, Sebastian & Levy Yeyati, Eduardo, 2005. "Flexible exchange rates as shock absorbers," European Economic Review, Elsevier, vol. 49(8), pages 2079-2105, November.
  9. Joshua Aizenman & Reuven Glick, 2008. "Pegged Exchange Rate Regimes-A Trap?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(4), pages 817-835, 06.
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  12. Burdekin, Richard C.K. & Siklos, Pierre L., 2008. "What has driven Chinese monetary policy since 1990? Investigating the People's bank's policy rule," Journal of International Money and Finance, Elsevier, vol. 27(5), pages 847-859, September.
  13. Vincent Bouvatier, 2006. "Hot Money Inflows in China : How the People's Bank of China Took up the Challenge," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00111153, HAL.
  14. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-80, November.
  15. Ouyang, Alice Y. & Rajan, Ramkishen S. & Willett, Thomas D., 2010. "China as a reserve sink: The evidence from offset and sterilization coefficients," Journal of International Money and Finance, Elsevier, vol. 29(5), pages 951-972, September.
  16. Guonan Ma & Robert N. McCauley, 2007. "Do China's capital controls still bind? Implications for monetary autonomy and capital liberalisation," BIS Working Papers 233, Bank for International Settlements.
  17. Jeffrey A. Frankel, 1999. "No Single Currency Regime is Right for All Countries or At All Times," NBER Working Papers 7338, National Bureau of Economic Research, Inc.
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