Sterilization in China: Effectiveness and Cost

China has experienced a large increase in its foreign exchange reserves since 2001, due to a continuous inflow of capital and the commitment to maintain a fixed rate against the dollar initially and then a crawling peg exchange rate regime. Among other things, the accumulation of foreign assets has an expansionary monetary effect and poses a challenge for domestic macroeconomic management. As a response, the People's Banks of China (PBC for short) sterilizes the increase in foreign assets by taking offsetting actions with domestic assets. This paper adapts a 2SLS method to estimate the extent of China's sterilization using quarterly data from 1995 to 2010. It also compares the sterilization cost with the central bank's income from investing foreign exchange reserves. I conclude that the sterilization has been highly effective to date. Moreover, so far the sterilization cost of the central bank can be fully covered by the income from foreign reserve investment. Projections into the future also show no sign of unsustainability, though the appreciation of the RMB may have a profound negative impact on the PBC's income from foreign reserves in domestic currency terms.