Financial globalization and policy autonomy in China

2015 Money and Banking conference June 4 2015 Yu Yongding

Chinese Academy of social sciences

The Mundell trilemma

• Robert Mundell showed that a country can have two—but only two—of three features of international finance

– autonomy of monetary policy

– control of the exchange rate, and

– Free movement of cross border capital flows.

Exchange Rate

Stability

Freely floating exchange rate

with a fully open financial

market

Fixed exchange

rate with a

closed financial

market

Fixed exchange

rate with a fully

open financial

market

A

B

China’s choice in eyes of foreign observers

• China has chosen a different response to the trilemma. Its central bank conducts monetary policy and maintains tight control over the exchange value of its currency. But to accomplish these two goals, it has to restrict the international flow of capital, including the ability of Chinese citizens to move their wealth abroad. (position A)

The reality

• China’s exchange rate policy – Peg to the US dollar – Peg to a basket currency – Managed floating

• China liberalized inbound FDI more than 20 years ago and then a large number of sub-accounts in the capital account thereafter.

• Its controls over capital flows have never been very effective. – During the Asian Financial Crisis, China had to implement draconian measures to stop capital

flight. – Since the early 2000s, short-term capital started to flow into China persistently betting on the

yuan's appreciation. – From 2004 to 2006 capital inflow surged to speculate on China’s rising asset prices. – Since the launch of RMB internationalization in 2009, Yuan exchange rate arbitrage and carry

trade have become rampant – Since 2014 outflow has dominated

• Policy autonomy has been basically preserved • The position B, moving to the top of the triangle.

Long term trend of the RMB exchange rate

From peg to $ to a basket

A close-up: Fluctuation within a narrow band

March 2014, band expanded from 1% to 2% vis-à-vis the preset medium price of the USD of the day.

REER is rising due to dollar depreciation

Source:

www.conferenceboard.org © 2013 The Conference Board, Inc. | 1

China s capital account liberalization is still a long way off April 3, 2013

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Inward Direct Investment

Inward Securities Investment

Inward Other Investment

Outward Direct Investment

Outward Securities Investment

Outward Other Investment

Capital Account Balance¹

USD billion

Sources: SAFE, CEIC, The Conference Board

China’s capital account since 2000

China’s twin surpluses and accumulation of foreign exchange

reserves

Current account

Capital account

FX reserves

SOURCE: Guan, SAFE

Increase in foreign exchange reserves=newly created liquidity

HK’s lack of policy autonomy

Mainland China enjoys large policy autonomy

How has China juggled the trilemma?

• One may ask, with porous capital controls, how has China managed to maintain monetary policy independence and controls over exchange rate at the same time? The answer lies in China’s sterilization policy.

Sterilization in China

• Twin surpluses • To stabilize the RMB exchange rate—a prime monetary

policy objective • the PBOC intervenes heavily in the foreign exchange

market. • The liquidity created by the intervention is so large that

the PBOC has to engage in massive sterilization to mop up excess liquidity to avoid overshooting the targeted increase in the monetary base

• How large the autonomy of monetary policy depends on how much the liquidity created by foreign exchange market intervention has been sterilized.

China’s sterilization ratio

Robert Lavigne International Department Bank of Canada. NFA: net foreign assets

Instruments for sterilization

• The open market operations (OMOs) are the most frequently used monetary instrument in sterilization – From government bonds to CCBs repo – So far, the stock of CBBs held by banks has amounted to 5

trillion yuan.

• The reserve requirement ratio (RRR) is another important instrument for sterilization – Since 1998, the PBOC has changed the required reserve

ratio forty-two times in total – Each rise in the RRR freezes a large quantity of liquidity in

the banking system – At this moment, the required reserve ratio stands at 20

per cent.

the costs to sterilization

• First, maintain an undervalued real exchange rate and allow the buildup of FX reserves--the dollar trap. Facilitating the import of dark matter (creditor pays interests to borrower)

• Second, misallocation of resources

– While exporting enterprises get funding, small-and-middle sized enterprises that produce non-tradable products denied funds

• Third, bank profits squeezed. Hence more risky investment

How to discourage hot money

• The main concern of the PBOC has been carry trade. Interest rate policy since 2005 has been carried out under the shadow of carry trade. The Chinese government’s intention was to allow RMB to appreciate at an annual rate of 3%, so that enterprises could have enough time to make adjustment.

• To realize this goal, the government encouraged the formation of appreciation expectations of 3% in markets by repeatedly rejecting any suggestions of faster appreciation.

• Given US interest rate, the PBOC tried hard to adjust Chinese interest rate so as to maintain a 3% spread vis-à-vis LIBOR USD. As McKinnon noticed, “Investors in renminbi assets were willing to accept a lower return because they expected the renminbi to appreciate a little over 3%. This interest differential of 3% or so will continue as long as investors project that the renminbi will continue to appreciate by that amount”

• But to keep a given interest rate spread is a reflection of losing policy autonomy

To stop unwanted capital inflows

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8

Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06

China Central Bank Notes

LIBOR: USD

Interest Spread

Exchange Appreciation (% chg yoy)

%

July-06

5.7

2.6

After the QE, this strategy is no longer working.

Source: McKinnon

Changes after the global financial crisis

• Since the global financial crisis and the implementation of QE, the interest rate spread between China and the US has been reserved

• Cross-border capital flows liberalized greatly since the launch of the RMB internationalization since 2009

• And also because of low volatility of the RMB exchange rate

• Carry trade become rampant

A contributing factor: China’s Sharpe ratio is too high

China’s sharpe ratio vis-à-vis those of other key EM currencies

(3-month moving average)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

CNY KRW INR MXN BRL IDR

Source: Ma Guonan, BIS

China’s foreign bond issuance

Source: BIS, Sun Tao

“carry trade of the century”

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$bn

What is being repaid

Cumulative Trade FinancingGap ($bn)BIS Claims on Chinese Banks

2005.1

2015.5

Source: BIS

Capital outflows

• According to SAFE (state administration of foreign exchanges) in the first quarter of 2015

• Current account surplus: 78.9 billion USD

• Decrease in foreign exchange reserves: 80.2 billion USD

• This means that capital account deficit: 159.1 USD

• Net FDI inflows: 50.3 billion USD

• Short-term capital outflows:209.4 billion USD

• The magnitude of the quarterly short-term capital outflows is the largest China has never seen

Largest capital quarterly capital account deficit in the first quarter of 2015: 159 billion USD

Capital outflows + carry trade unwinding

• Following the narrowing of interest rate spread between China and US, and the renminbi depreciation, the carry trade unwinding is inevitable.

• The unwinding has already begun since 2014. • On the top of capital outflows, the carry trade unwinding

may create huge pressure on renminbi exchange rate, • Renminbi depreciation will in turn cause more capital

outflows. • The outflows-depreciation circle will worsen China’s

financial stability seriously • The fear of capital outflow will weaken China’s policy

autonomy

solution

• Speed up domestic financial reforms

• Make the exchange rate more flexible

• Slowdown the pace of capital account liberalization and taking measures (Tobin tax?) to discourage short term capital flows