International Capital Flows and the Independence of China's Monetary Policy

This article estimates the quantitative relationship between international capital flows and China's monetary policy. A major innovation over most previous studies is taking into consideration the effects of changes in the reserve requirement ratio. Employing the method of the Federal Reserve Bank of St. Louis, this article translates the change in the reserve requirement ratio into the change in the monetary base, while the money multiplier remains unchanged. The change in the reserve requirement ratio is combined with the other monetary policies that directly affect the monetary base to construct an integrated measure of monetary policy. We then construct a modified offset and sterilization coefficients model. We find that the failure to take reserve requirement ratio changes into account leads to an underestimation of both the degree of sterilization and of capital mobility as measured by the offset coefficients. The results show that China's capital flows are quite limited, while China's monetary policy is able to almost completely sterilize monetary base fluctuations caused by international capital flows. Thus, we find that China has been able to maintain a great deal of domestic monetary policy independence despite a limited degree of exchange rate flexibility.