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Navigating the Trilemma: Capital Flows and Monetary Policy in China

  • Reuven Glick

    (Federal Reserve Bank of San Francisco)

  • Michael Hutchison

    (University of California, Santa Cruz)

In recent years China has faced an increasing trilemma¡Xhow 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 goods 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 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 lead to less inflation pressure even with a substantial buildup in international reserves.

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Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 252008.

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Length: 36 pages
Date of creation: Dec 2008
Date of revision:
Handle: RePEc:hkm:wpaper:252008
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  1. 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.
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  4. 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.
  5. Joshua Aizenman & Reuven Glick, 2008. "Sterilization, Monetary Policy, and Global Financial Integration," NBER Working Papers 13902, National Bureau of Economic Research, Inc.
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  18. M S Mohanty & Philip Turner, 2006. "Foreign exchange reserve accumulation in emerging markets: what are the domestic implications?," BIS Quarterly Review, Bank for International Settlements, September.
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