Empirical research has shown that China is moving towards the so-called ‘impossible trinity’, which states that a country can control only two of the following three variables at any one time: the exchange rate, the capital account and the interest rate.
Once the capital account is open, a country can only control one of the two other variables. Until recent years, China’s closed capital account enabled it to control both the exchange rate and the interest rate, so the ‘impossible trinity’ was not in play.
However, things have changed since the 2000s, when China started opening its capital account, albeit very slowly.
In particular, persistent capital inflows are cracking open the capital account and forcing China to choose between control of the interest rate (i.e. monetary autonomy) and the exchange rate (i.e. currency control).
Net foreign direct investment (FDI) inflows to China have never been disrupted in any major way by global events. Net portfolio and other investment inflows (including international bank lending, trade credits and miscellaneous flows) are more volatile because of their high sensitivity to external shocks, their short-term and speculative nature and their function as a conduit for ‘hot money’ to go into China. But overall, China has seen accelerating net capital inflows for more than 20 years (Chart 1).
Beijing has been using open market operations (OMO) and the reserve requirement ratio (RRR) as sterilisation tools to defy the ‘impossible trinity’ and retain both monetary and currency controls. However, sterilisation cannot go on forever, as its cost will eventually be unsustainable. The cost of sterilisation for the People’s Bank of China’s (PBoC) sterilisation arises mainly from the interest payments that the PBoC is required to make to banks, excess reserves, PBoC bills and ‘reverse repurchase agreements’ (reverse repos). Estimates based on official data from the PBoC show that its total interest expense on sterilisation has been rising at an annual rate of more than 13% a year, which is faster than China’s nominal GDP growth rate, making sterilisation unsustainable. This means that retaining both monetary autonomy and control on the exchange rate will become unsustainable too.
In the ‘impossible trinity’ context, Beijing’s policy preference has shifted from exchange-rate control to capital-account openness since 2005. This is seen in the widening of the renminbi’s trading band, a foreign exchange policy shift towards being more market-driven, expansion of use of the renminbi in international trade settlement and as a foreign direct investment currency, expansion of the QFII and RQFII quotas, and gradual progress in financial liberalisation.
Some have argued that China would follow Singapore’s managed float regime, which is based on the nominal effective exchange rate (NEER) framework due to the similarity between the behaviour of the Singapore dollar (SGD) NEER and the onshore-RMB (or CNY) fixing against the US dollar (USD). This may not necessarily be the case.
Both currency systems have a crawling fixing that has shown a remarkably similar trend since 2005. Both systems exhibit an appreciation bias that appears to be driven by the need to fight inflation, by large capital inflows and by a desire to maintain confidence in the currencies.
However, the similarity ends here. While the SGD NEER system operates with a +/-2% trading-band, the Monetary Authority of Singapore’s (MAS) fixing is adjusted only once every six months. But the CNY’s fixing is adjusted daily. The MAS is committed to an imputable six-month adjustment for the SGD’s NEER, although the trading band can be expanded to +/-3% periodically if and when the MAS deems it necessary to accommodate more volatility in response to market/economic needs. However, the PBoC has made no such commitment to a transparent adjustment process, and the CNY fixing is against the USD rather than against a basket of currencies, or the NEER.
As a small open economy with an open capital account, Singapore has decided to give up interest rate control and has opted instead for controlling the exchange rate. It is affected by many international forces, so its economy has an inherent tendency toward high volatility in the pace of economic growth. Domestic economic policy can do little to counteract the significant economic volatility trends in international growth inflict on Singapore. Anchoring its exchange rate to a basket of currencies is a practical measure to preserve confidence and reduce uncertainty caused by external forces.
Conversely, China’s economy is large with a high degree of domestic orientation. For this reason monetary autonomy is likely to be more effective than it would be for a small open economy in counteracting the effects of external shocks on the domestic economy. So it is more appropriate to relinquish currency control in favour of interest-rate control as a tool for domestic economic management. China’s capital account liberalisation, however unevenly implemented, will therefore need to go hand-in-hand with Beijing loosening its grip on the currency. This also suggests that the likely solution for China’s ‘Impossible Trinity’ is the combination of an open capital account and monetary autonomy; the renminbi exchange rate will have to be freed eventually.