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Research ArticleThe Effectiveness and Sustainability ofthe Sterilization Policy in China

Chien-Ping Chung,1 Jen-Te Hwang,2 and Chieh-Hsuan Wang1

1 Department of International Business, Shih Chien University, No. 70, Dazhi Street, Zhongshan District, Taipei City 104, Taiwan2Department of Banking and Finance, Kainan University, No. 1 Kainan Road, Luzhu, Taoyuan County 33857, Taiwan

Correspondence should be addressed to Chieh-Hsuan Wang; [email protected]

Received 29 April 2014; Accepted 4 June 2014; Published 20 August 2014

Academic Editor: Joao Ricardo Faria

Copyright © 2014 Chien-Ping Chung et al. This is an open access article distributed under the Creative Commons AttributionLicense, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properlycited.

The aim of this paper is to examine the sterilization policy in China. First, several indices are used to measure the status of China’smarkets and to determine effectiveness and sustainability of the sterilization policy and the possible impacts it may have induced.Second, within amicroeconomic framework, we incorporate the housing price variable into the target loss function of themonetaryauthority to explore its financial capabilities and evaluate the effectiveness and sustainability of China’s sterilization policy. Theempirical results show that Chinese monetary authorities sterilize almost all of the effects of international capital inflows andincrease foreign exchange reserves on the monetary base. That is, increased capital mobility does not sabotage the independenceof the Chinese monetary policy. Nevertheless, analyses of the sustainability of sterilization policy indicate that the sustainability ofthe monetary sterilization policy has been seriously challenged since March 2008, which suggests that Chinese monetary authorityhas endured tremendous pressure for unsustainable sterilization.

1. Introduction

Ever since the start of economic reforms in 1978, China’seconomic system has gradually shifted towards capitalismand globalization, with steady growth in the volume offoreign trade and a large number of foreign investments inthe country. In the beginning of the 1990s, China continuedto adjust the exchange rate of the RMB and adopted a dualexchange rate system in 1994, thereby effectively steering theeconomic system to become export oriented. After Chinaaccepted current account convertibility in 1996 in accordancewith an agreement with IMF, it joined theWorld Trade Orga-nization in 2001. The country has witnessed rapid increase inits foreign trade and inflows of foreign direct investments.

However, during the process of actual management of itseconomy, the monetary authority is usually forced to adoptconflicting currency policies in order tomaintain the stabilityof its currency’s internal and external value. In Krugman’stheory of impossible trinity, it is impossible simultaneouslyto have full capital mobility, fixed exchange rate, and anindependent monetary policy.1 In recent years, with RMB

appreciation expectation and anticipation of increase in valueof RMB denoted assets, inflows of short-term internationalcapital into China have risen steadily as the issue of theimpossible trinity looms over the nation.2

By the end of June 2012, China’s foreign exchange reserveshad reached USD 3,240.01 billion, equivalent to 70.84% ofPeople’s Bank of China’s total assets at that point of time.During substantial growth in foreign exchange reserves,China’s funds outstanding for foreign exchange have alsogrown steadily due to the government’s efforts to alleviate thepressure on the RMB’s appreciation. During the period from2003 to 2012, China’s funds outstanding for foreign exchangehave grown by as much as 10.61 times; the growth marginconstitutes 99.11% of the increase in narrow money M1 inthe same period.3 In order to stabilize money supply and toalleviate the risks of excess liquidity, inflation, and asset pricebubble, People’s Bank of China (PBC) has implemented vari-ous policies such as issuing central bank bills, raising reserverequirement ratio, and implementing loan allocations.

But as the Chinese government endeavored to alleviatethe impact of the steep growth in foreign exchange reserves

Hindawi Publishing CorporationEconomics Research InternationalVolume 2014, Article ID 509643, 14 pageshttp://dx.doi.org/10.1155/2014/509643

2 Economics Research International

on domestic currency demand and liquidity through varioussterilized intervention policies, the growing costs of steriliza-tion have also impacted the effectiveness and sustainabilityof the foreign exchange surplus sterilization policy. Startingfrom 2002, the scale of bill issuance by People’s Bank of Chinahas expanded drastically and the proportion of the monthlybalance of central bank bills against the Bank’s total debt sky-rocketed from 2.91% in 2002 to 22.11% in 2008.4 Although thescale of bill issuance slowed in 2011, the proportion was still at8.31%.5 The cost of interest paid by People’s Bank of China forsterilization (using bank bills) reached its peak at RMB 8,639billion in 2008. Despite having gradually decreased over time,the cost of such operations still reached RMB 2,761 billionin 2011. With the interest that People’s Bank of China has tocover for the reserve requirement, the costs of issuing centralbank bills and raising the reserve requirement ratio as toolsfor sterilization were RMB 3,005 billion in 2011 (equivalent to14.95% of China’s foreign exchange reserve for the same year).These serve as apparent signs that the sustainability of China’ssterilization policies faces tough challenges.6

The issues of effectiveness and sustainability of steriliza-tion policy have been the subjects of debates in differentcircles. Despite the fact that China has successfully sterilizedmost of the impact of its growing foreign exchange reserveson the domestic money supply, the effectiveness of capitalcontrols has been steadily declining and foreign exchangereserves have been constantly growing, resulting in risingcosts of sterilization which have made sustainability of steril-ization policies increasingly difficult. Inadequate sterilizationis resulting in excessive money supply and liquidity, causinginfluxes of funds into the asset market, thereby causingasset prices to rise steadily. As such, acquiring sufficientunderstanding of China’s sterilization policies has becomean issue that requires immediate attention. Therefore, thispaper aims to adopt microeconomic foundations for theconstruction of a model of sterilization and offset coefficientsthat fit China’s monetary stance to evaluate the effectivenessand sustainability of China’s sterilization policies. In additionto acquiring sufficient understanding of China’s currentlymonetary policies, we can deal with the issue of impropermodel configuration.

After introduction, the second section of this paper offersa brief overview of relevant research conducted on steriliza-tion policies, while the third section aims to shed light onthe current status of foreign exchange reserves accumulationand sterilization instruments used in recent years.The fourthsection focuses on empirical models, and the fifth sectioncovers the data and empirical results, followed by conclusionsof this paper.

2. Literature Review

Whether a nation adopts a fixed foreign exchange rate or amanaged floating exchange rate system, its monetary autho-rities must inevitably rely on foreign exchange market inter-vention as a means of maintaining exchange rate stability.When faced with a surplus in balance of payments, monetaryauthorities strive to maintain existing exchange rates by pur-chasing foreign exchange in the market while releasing high

power domestic currency of equivalent value. But in orderto achieve the target exchange rate and maintain domesticcredit stability, monetary authorities also implement ster-ilized intervention policies to offset the additional moneysupply that comes from the increase in funds outstandingfor foreign exchange. Starting from 1994, China’s foreignexchange reserve has grown rapidly due to a surplus inbalance of payment and as a result People’s Bank of Chinahas been searching and deploying new sterilization tools tomaintain stability of RMB exchange rate and domestic credit.Among the currency sterilization tools, including relend-ing (1994–2001) and national debt sterilization (1998–2002)adopted by the Bank, the twomost important tools frequentlydeployed by People’s Bank of China are central bank billsterilization (2002–present) and reserve requirement ratioadjustment (2006–present).

The key that determines the success of sterilized inter-vention made by a nation’s monetary authority for effectiveforeign exchange market adjustment and maintenance ofexchange rate stability lies in sustainability of the interven-tion. For nations that implement sterilized intervention, asthe volume of funds outstanding against foreign exchangegrows, the central bank faces increasing difficulty in imple-mentation of sterilized intervention due to the huge costsand the declining effectiveness of monetary policy decisionmaking process.7 In the discussion on the effectiveness ofsterilization manipulation, Frankel [1] analyzed four factorsthat can trigger capital inflows in developing counties andmaintained that sterilized intervention widens the interestspread between domestic and foreign markets, thereby accel-erating the growth of funds outstanding for foreign exchangeand money supply, making it even more difficult to achievethe given sterilization goal.8 Also, it affects the independenceof the nation’s monetary policies. Reinhart et al. [2] believethat sterilization manipulations drive domestic interest ratesfurther up and attract more foreign investments, therebymaking sterilization even more difficult and rendering theoperation extremely costly. And as such, governments shouldeither give up or reduce the scale of sterilization operations oreven opt to control capital mobility as an alternative solution.

Spiegel [3] developed an open-economy version of theBernanke-Blinder model which indicates that sterilizationefforts through increases in reserve requirements have lim-ited impact if viable financial alternatives to the commercialbanking sector exist. After having studied cases of steriliza-tion in seven emerging economies in Asia (Indonesia, Korea,Malaysia, Philippines, Singapore, Taiwan, and Thailand), hefound Korea to be in possession of the largest nonbankfinancial sector and that, in times of high international capitalinflows, the monetary authority in Korea had limited successwith its approach of sterilizing inflowing capital by openmar-ket manipulation and increased reserve requirement ratio.

Caballero and Krishnamurthy [4] constructed a the-oretical model to validate the ineffectiveness of currencysterilization and went one step further to discuss the oppositeeffect of short-term capital inflows as the consequence ofsterilization policies. Their research pointed out that when acountry lacks the connection with the international financialmarket, sterilization policies may elevate the risks of liquidity

Economics Research International 3

and result in continued inflow of short-term capital, whichleads to increase in money supply and overappreciation ofdomestic currency.

Glick and Hutchison [5] analyzed the impact of steriliza-tion of central bank bills on the base currency in China andthe empirical results revealed that the sterilization coefficientis within the interval from −0.6 to −1.5.9 However, startingfrom the fourth-quarter of 2006, due to China’s constantlygrowing foreign exchange reserve, the effectiveness of ster-ilization policies started to decline and this led to the rapidgrowth of reserve money. Zhang [6] surveyed the variousestimations about China’s sterilization coefficient from 1994to 2009. The estimate of sterilization coefficient after 2003 iswithin the interval from−0.996 to−0.852 (significant atmorethan 5%), which indicates that PBC’s sterilization has beenquite successful inmaintaining the independence of domesticmoney and credit growth after the introduction of centralbank bills and reserve requirement ratio.

With sterilized intervention policies growing in strength,sustainability of sterilization operations has become animportant issue. Calvo [7] pointed out that currency steril-ization causes a central bank’s domestic debt to grow rapidly.If the central bank’s domestic debt is not fully indexed tothe price level, sterilization policies trigger a vicious cycle ofinflation through massive accumulation of domestic debt. Inother words, sterilized intervention should not be sustained.Therefore, the government should issue domestic bonds atcorresponding price levels to alleviate inflationary pressures.Christensen [8] used a vector autoregression (VAR) modelthat incorporated domestic credit, foreign exchange reserve,domestic interest rate, foreign interest rate, and so forthfor analysis of correlation between massive capital inflowsand sterilized intervention in the Czech Republic from1993 to 1996. Results of this paper revealed that sterilizedintervention for neutralizing effects of capital inflows provedto be successful initially. But with the progression of time, ele-vated domestic interest rates eventually attract more capitalinflows, thereby raising the cost of sterilized intervention andultimately rendering the policy unsustainable.

Sterilization was virtually a game between Czech Repub-lic’s commercial banks and its central bank. The commercialbanks would borrow loans from international market at lowinterest rates and invest in domestic sterilization bonds thatoffered a higher rate of return. And thus, given the conditionsof significant interest rate spread between domestic andforeign market and limited controls on capital, the Czechmonetary authority was essentially encouragingmore inflowsof short-term capital with its sterilization operations.

Using simultaneous equations, Ouyang and Ramkishen[9] empirically validated the correlation between domesticnet assets and foreign net assets, in addition to an analysisof China’s foreign exchange reserves, structure of its sources,and the consequences of the nation’s currency policies inthe 1990s. Findings from the research showed that China’ssterilized intervention policies were unsustainable due tothe substantial burden on the nation’s treasury and actuallyproduced the opposite results due to escalation of capitalinflows and fragility of the financial system as time passed.Mohanty and Turner [10] indicated that, between 2000 and

2004, the central banks of Korea, the Czech Republic, andIsrael issued currency-stabilizing bonds of values equivalentto 300%, 200% and, 150% of their respective reserve moneyfor the purpose of sterilization operations. Issuance of centralbank bonds on such massive scale not only increases thedifficulty of currency management for the central bankbut also raises the expenditure on interest payment whendomestic interest rates go up, which renders sterilizationoperations too costly to last.

Based on the relevant international experience, mostmonetary authorities around the world that engage in steril-ization manipulation in the open market tend to drive up thelevel of domestic interest rates [2]. If a nation’s economy is notsynchronous with (or even goes against) foreign economiesin terms of trends of change, it can possibly attract moreinternational capital arbitrage, which can further widen thegap between domestic and international economic indicators.More space for arbitrage encourages more capital inflows andultimately creates a vicious cycle that renders sterilizationmanipulation measures unsustainable.

The existing literature mostly focuses on analysis ofsterilization coefficient estimation or sustainability of thesterilization policy. With the exception of the sterilizationmodel, little research is based onmicroeconomic frameworksin the circumstances of today. With sterilization policies thatare unsustainable and cannot be used to sterilize all of theeffects of international capital inflows and increasing foreignexchange reserves on the monetary base, the expectation ofthe RMB’s appreciation would trigger and attract more for-eign capital to China, thereby further impacting the currencypolicies, economy, and capital markets. In order to examinethe effectiveness of sterilization tools adopted by People’sBank of China, this paper has taken the approach proposedby Brissimis et al. [11] to adopt microeconomic foundationsfor the construction of a model of sterilization and offsetcoefficients that fit China’s monetary stance to evaluate theeffectiveness of China’s sterilization policies. Secondly, withanalysis of China’s sterilization policies completed, this paperhas modified Frenkel’s [12] basis of argument by using simpletheoretical models to discuss the sustainability of China’ssterilization policy.

3. Accumulation of Foreign Exchange Reserveand Sterilization Instruments in China

The PBC foreign exchange reserves have been increased con-tinuously since 1993, an increase of 188.69 billion USD by1997, at an average annual growth rate of 52.96%. Due toincessant current account surpluses and capital inflows from2003 until 2007, with an average annual increase of about194.67 billion USD in foreign exchange reserves, China over-took Japan to become the world’s largest holder of foreignexchange reserves in 2006. At the end of 2012, China’s foreignexchange reserves amounted to 3,311.59 billionUSD, account-ing for approximately 30.28% of the world’s total foreignreserves.10

The continuing accumulation of foreign exchange res-erves has substantially exacerbated pressure on RMB toappreciate. Driven by the expected appreciation of RMB,


Table 1: Funds outstanding for foreign exchange, reserve money, and the monthly balance of central bank bills.

Funds outstanding forforeign exchange

(1)

Reserve money(2)

Proportion(3) = (1)/(2)

(%)

Balance of centralbank bills

2000 1,429.11 3,649.15 39.16 —2001 1,785.64 3,985.17 44.81 —2002 2,322.33 4,513.82 51.45 148.752003 3,484.69 5,284.14 65.95 303.162004 5,259.26 5,885.61 89.36 1,107.902005 7,121.11 6,434.31 110.67 2,029.602006 9,898.03 7,775.78 127.29 2,974.062007 12,837.73 10,154.54 126.42 3,446.912008 16,843.11 12,922.23 130.34 4,577.982009 19,311.25 14,398.50 134.12 4,206.422010 22,579.51 18,531.11 121.85 4,049.722011 25,358.70 22,464.18 112.89 2,333.672012 25,853.35 25,234.52 102.45 1,388.00Source: People’s Bank of China, http://www.imf.org/external/index.htm.Unit: billion RMB.

large amounts of foreign direct investment (FDI) and short-term international capital have flowed into China, leadingto increases in foreign exchange settlement in the capitalaccount. In order for People’s Bank of China to stabilize itsforeign exchange rates, it continues to purchase excess supplyof foreign exchange in the foreign exchange market, resultingin excess liquidity in the domestic money market and risinginflationary pressure.

According to the trend of the effective exchange rateindex of RMB shown in Table 2, RMB showed depreciationcompared to other countries’ currencies before the reformof RMB exchange rate regime in June 2005. However, afterreforming the RMB exchange rate regime showed apprecia-tion over other currencies. In January 2002, the nominal andreal effective exchange rate indexes of RMB were 101.37 and100.14. In June 2005, the nominal and real effective exchangerate indexes of RMB dropped to 86.49 and 83.53; the rate ofdepreciation for each index during this period was 14.68%and 16.59%. Compared to June 2005, the nominal and realeffective exchange rate indexes of RMB in July 2005 were88.06 and 84.99. Each of the indexes rose to 114.21 and 118.79in December 2013; the rate of appreciation during the periodfor the nominal effective exchange rate index was 29.70% and39.77% for the real effective exchange rate index. Notably thedisparity between nominal and real effective exchange rateindexes began to increase in October 2010; the fluctuationof the real effective exchange rate index was significantlyhigher than the nominal effective exchange index, showingincreasing pressure of inflation in China.

Table 1 shows that funds outstanding for foreign exchangewere only 1,429.11 billion RMB in 2000, accounting for39.16% of the base money. However, the figure surged to25,853.35 billion RMB in 2012, accounting for up to 102.45%of the reserve money. This indicates that the independenceof monetary policy of Chinese monetary authorities has beenseverely challenged.

In the context of the constant buildup of China’s foreignexchange reserves, the PBC has undertaken a series ofsterilization operations to alleviate excessive liquidity andinflationary pressure resulting from huge funds outstandingfor foreign exchange. Owing to the small size of the marketfor treasury bonds, the PBC has started issuing central bankbills for sterilization, in addition to open market operationssuch as outright sales of government bonds and repurchaseagreements. The official launch of issuance of central bankbills by the PBC was on April 22, 2003. The central bankbills’ balance has progressively increased, from 303.16 billionRMB in 2003 to 4,577.98 billion RMB in 2008. While this hasgradually decreased in recent years, the balancewas still RMB1,388 billion by the end of 2012 (Table 1).

Faced with unceasing pressures of excessive liquidity dueto balance of payments surplus, the PBC has strengthenedliquidity management of the banking system as the mainobjective of its monetary policy in 2006, coupled withthe use of other sterilization instruments such as openmarket operations and reserve requirement ratio, in orderto suck the excess liquidity out of the banking system. Inaddition to issuance of central bank bills along with therepo operations for increasing the intensity of open-marketsterilization operations, the PBC, facing rapid growth indomestic credit, adjusted the reserve requirement ratios 41times between March 1998 and March 2012 (Figure 3). ThePBC lowered the reserve requirement ratios only seven timesduring this period, when facing the Asian financial crisis, theUS subprime mortgage crisis, and the problem of sluggisheconomy in 1998, 2008, and 2011, respectively.The PBC raisedthe reserve requirement ratios for rest of the period to dealwith the issue of excess liquidity. By the end of 2012, thereserve requirement ratios for large- and small- andmedium-sized financial institutions were 20% and 16.5%, respectively.

Relatively a huge proportion of the monetary base isreleased during the process of intervening in the foreign


Table 2: Variables and data sources.

Variable Data source

ΔNFA∗𝑡:Δ[NFA

𝑡−NFA

𝑡−1((𝑒

𝑡− 𝑒

𝑡−1)/𝑒

𝑡−1) − (𝑖TB𝑡/12)((NFA𝑡−1 + NFA

𝑡)/2)]

GDP𝑡

CEIC database

ΔNDA∗𝑡:ΔMB𝑡

GDP𝑡

− ΔNFA∗𝑡

CEIC database

Δmm𝑡: ln(

𝑀

2,𝑡

MB𝑡

) − ln(

𝑀

2,𝑡−1

MB𝑡−1

) CEIC database

Δ𝑝

𝑡−1: ln (CPI

𝑡) − ln (CPI

𝑡−1) CEIC database

𝐻

𝑐,𝑡−1:(Housing price)

𝑡−1− (Housing price trend)

𝑡−1

(Housing price trend)𝑡−1

CEIC database

𝑌

𝑐,𝑡−1:(GDP)

𝑡−1− (GDP trend)

𝑡−1

(GDP trend)𝑡−1

CEIC database

Δ𝐺

𝑐,𝑡: (fiscal deficit

GDP)

𝑡

− (

fiscal deficitGDP

)

𝑡−1

CEIC database

ΔREER𝑡−1

: (REER)𝑡− (REER)

𝑡−1TEJ database

𝐸𝑒

𝑡+1: the 3-month RMB/USD nondeliverable forward rate in logarithmic terms Bloomberg

𝑟

𝑡− 𝑟

∗

𝑡: the interest rate differential between People’s Bank of China and the US Federal Funds TEJ database

𝑟

𝑠,𝑡− 𝑟

∗

𝑠,𝑡: the stock return differential between China and the USA CEIC database and TEJ database

𝑖: interest rate on 3-month central bank bills PBC𝑟: the interest on required reserves PBC𝐿: the value of the current issuance of central bank bills minus the value of maturing central bank bills PBC

𝑅: the deposits with central bank from the balance sheet of other depository corporations PBC𝑅𝐸: the value of foreign exchange reserve expressed in RMB CEIC database𝑒: the rates of change in exchange rate CEIC database𝑟: the yield on 3-month US Treasury bills TEJ database

exchange market by the PBC. In order to achieve the goalsof its monetary policy and alleviate inflationary pressure, thePBC intervenes in the foreign exchange market and at thesame time actively adopts sterilization measures, for neutra-lizing the impacts of excess liquidity due to increasing for-eign exchange reserves through opposite changes in the netdomestic assets, therebymaintaining steady growth ofmoneysupply.

Figure 4 shows that the monetary base experienced rapidgrowth and fluctuations from 1998 to 2012, soaring to itshighest of 30.59% in 2007 from 2.29% in 1998. The broadmoney supplyM2 relativelymaintained a steady growth from1998 to 2008, at an average growth rate of 16.23%, and startedto experience significant fluctuations since 2008.

The steady growth of M2 proves that Chinese monetaryauthorities effectively sterilize the impacts of capital inflowsand increase foreign reserves on the domestic money supply.That is, large-scale foreign exchange market interventionand sterilization operations have significant influence on themoney supply in China. However, volatile fluctuations of M2after 2008 also pose challenges to the sustainability of China’ssterilization policy.

While sufficient foreign exchange reserves help stabilizethe economy, excessive foreign reserves may create tremen-dous pressure on themonetary authorities. In the case of lack-ing elasticity in exchange rates, the central bank opts to con-vert the external pressure on RMB to the internal momentumfor monetary expansion. Nonetheless, with expanding bal-ance of payments surplus, excessive foreign reserves held by

the PBC incur interest costs of sterilized intervention, oppor-tunity costs of inefficient allocation of capital, and exchangerate risk. Furthermore, as the problemof excessmoney can betemporarily avoided by sterilization measures, operations forsterilization in the medium-to-long term may still result inrisks such as overheating of the economy, inflation, and assetprice bubbles.

4. Empirical Model

The empirical model is divided into two parts. First, amodel of offset and sterilization coefficients that fits China’smonetary stance was constructed based on microeconomicfoundations to evaluate the effect of China’s sterilizationpolicy. Second, a simple theoreticalmodelwas used to explorethe sustainability of sterilization policy of People’s Bank ofChina and to determine whether the PBC can control domes-tic money supply without sacrificing the policy’s credibility.The following section describes each empirical model.

4.1. Effectiveness of the Sterilization Policy. Most of the studiesin extant literature have failed to provide solid microeco-nomic foundations when specifying models for offset andsterilization coefficient estimation, leading to less stringentchoices of control variables. The present paper aims toconstruct, with reference to themodel of Brissimis et al. [11], atheoretical framework to better reflect the working of China’seconomy to evaluate the effectiveness of the sterilizationpolicy in China.


0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000

Mill

ion

USD

Year

3,311,589

51,620 139,890 212,165

1,528,249

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Figure 1: Accumulation of foreign exchange reserve in China—2000 to 2012. Source: TEJ database.

80859095

100105110115120

REER indexNEER index

(%)

Time

April

200

2Au

gust

2002

Dec

embe

r 200

2Ap

ril 2

003

Augu

st 20

03D

ecem

ber 2

003

April

200

4Au

gust

2004

Dec

embe

r 200

4Ap

ril 2

005

Augu

st 20

05D

ecem

ber 2

005

April

200

6Au

gust

2006

Dec

embe

r 200

6Ap

ril 2

007

Augu

st 20

07D

ecem

ber 2

007

April

200

8Au

gust

2008

Dec

embe

r 200

8Ap

ril 2

009

Augu

st 20

09D

ecem

ber 2

009

April

201

0Au

gust

2010

Dec

embe

r 201

0Ap

ril 2

011

Augu

st 20

11D

ecem

ber 2

011

April

201

2Au

gust

2012

Dec

embe

r 201

2Ap

ril 2

013

Augu

st 20

13D

ecem

ber 2

013

Figure 2: Renminbi effective exchange rate index—January 2002to December 2013. Note: REER index represents the real effectiveexchange rate, and NEER index stands for the nominal effectiveexchange rate index. The base period for both indexes is 2010.Source: CEIC database.

Brissimis et al. [11] assumed that the central bank has anobjective function (a loss function), including the squareddeviation of the current exchange rate from its target, thesquared deviation of the logarithm of the price level from itstarget, the squared deviation of real income from its trend, ameasure of the volatility of interest rates, and ameasure of thevolatility of exchange rates.

Maintaining the stability of price level and economicgrowth is the priority for China’s monetary authorities.Considering China’s currently managed floating exchangerate system and interest rate policy, we assume that the targetloss function of China’s monetary authorities includes thesquared deviation of the price level from its target and thesquared deviation of real income from its trend. In addition,as real estate in China has been an important investmenttarget, China has recently taken a considerable number ofpolicy measures to maintain stable housing prices and toavoid economic impacts resulting from volatility of housing

0

5

10

15

20

25

Required reserve ratio

(%)

Time

Janu

ary

1996

Janu

ary

1997

Janu

ary

1998

Janu

ary

1999

Janu

ary

2000

Janu

ary

2001

Janu

ary

2002

Janu

ary

2003

Janu

ary

2004

Janu

ary

2005

Janu

ary

2006

Janu

ary

2007

Janu

ary

2008

Janu

ary

2009

Janu

ary

2010

Janu

ary

2011

Janu

ary

2012

21.5

17.5

6

13

Figure 3: Change of required reserve ratio in China. Source: thesame as in Figure 1.

05

101520253035

M2Reserve money

(%)

Year

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Figure 4: Growth rate of reserve money and M2—1998 to 2012.Source: the same as in Figure 2.

prices.Therefore, the target loss function of China’smonetaryauthorities is defined as follows:11

𝐿

𝑡= 𝛼 (𝑝

𝑡− 𝑝

𝑇

𝑡)

2

+ 𝛽 (𝑌

𝑡− 𝑌

𝑇

𝑡)

2

+ 𝛾 (𝐻

𝑡− 𝐻

𝑇

𝑡)

2

,

(1)

where 𝑝

𝑡, 𝑌𝑡, and 𝐻

𝑡denote inflation rate, gross domestic

product, and housing prices at period 𝑡, respectively; 𝑝𝑇𝑡, 𝑌𝑇𝑡,

and𝐻

𝑇

𝑡are the target and trend values of each variable.

In order to simplify the loss function in (1), we substitute𝑌

𝑐,𝑡and𝐻

𝑐,𝑡for𝑌𝑡−𝑌

𝑇

𝑡and𝐻

𝑡−𝐻

𝑇

𝑡, respectively, and subtract

𝑝

𝑡−1from both 𝑝

𝑡𝑝

𝑇

𝑡. Δ𝑝

𝑇

𝑡is assumed to be zero.12 We can

rewrite (1) in a slightly different form, as follows:

𝐿

𝑡= 𝛼 (Δ𝑝

𝑡)

2

+ 𝛽 (𝑌

𝑐,𝑡)

2

+ 𝛾 (𝐻

𝑐,𝑡)

2

,

(2)

where 𝐿𝑡is the loss function of the monetary authority at the

end of time 𝑡; Δ𝑝

𝑡is the change in the inflation rate at time 𝑡;

𝑌

𝑐,𝑡is the cyclical income at period 𝑡 and 𝐻

𝑐,𝑡is the cyclical

housing price at period 𝑡. The central bank has an objective


to minimize the loss function in (2) in order to obtain theoptimal foreign exchange market intervention rule ΔNFA

𝑡

and domestic money market intervention rule ΔNDA𝑡. The

constraints that reflect the working of the economy in Chinafor the monetary authorities’ loss function are analyzed inturn.13

Cyclical Income. For the specification of cyclical income, wefollow the theoretical formulation outlined in Brissimis et al.[11] and hypothesize that the cyclical income depends on thechange in money supply and the stance of the government’sfiscal policy. The equation takes the following form:14

𝑌

𝑐,𝑡= 𝜛

1[(ΔNFA

𝑡+ ΔNDA

𝑡)mm𝑡+MB

𝑡Δmm

𝑡]

+ 𝜛

2𝑌

𝑐,𝑡−1+ 𝜛

3Δ𝐺

𝑐,𝑡,

(3)

where 𝜛

1> 0, 0 < 𝜛

2< 1, and 𝜛

3> 0. Δmm

𝑡is the change

in money multiplier; and MB𝑡is the monetary base. Besides,

𝐺

𝑐,𝑡represents the stance of government fiscal policy, which

is measured by the budget deficit as percent of GDP.

Inflation. Since China trades with other countries frequently,inflation in China is hypothesized to depend not only on thechange in money supply and inflation of previous period butalso on the impacts of exchange rate volatility. China oftenuses deposit reserves and interest rate policy, influencing themoney multiplier through the liquidity of commercial banks,to affect money supply. As a result, the constraint for inflationis defined as follows:15

Δ𝑝

𝑡= 𝜏

1[(ΔNFA

𝑡+ ΔNDA

𝑡)mm𝑡+MB

𝑡Δmm

𝑡]

+ 𝜏

2Δ𝑝

𝑡−1+ 𝜏

3Δ𝑒

𝑡,

(4)

where 𝛾

1> 0, 0 < 𝛾

2< 1, and 𝛾

3> 0. Δ𝑝

𝑡−1and Δ𝑒

𝑡

are inflation rate in the previous period and change in theexchange rate at the current period. In addition to the abovespecification, we set the following constraint specifically forΔ𝑒

𝑡:16

Δ𝑒

𝑡= −𝑐𝜆

0+ (𝑐 + 𝑐𝜆

1𝜔

1mm𝑡) ΔNFA

𝑡

+ (𝑐𝜆

1𝜔

1mm𝑡) ΔNDA

𝑡+ (𝑐𝜆

1𝜔

1MB𝑡) Δmm

𝑡

+ (𝑐𝜆

1𝜛

2) 𝑌

𝑐,𝑡−1+ (𝑐𝜆

1𝜛

3) Δ𝐺

𝑐,𝑡

+ (𝑐𝜆

2) ΔREER

𝑡−1

+ Δ [𝐸𝑒

𝑡+1− (𝑟

𝑡− 𝑟

∗

𝑡) − (𝑟

𝑠,𝑡− 𝑟

∗

𝑠,𝑡)] ,

(5)

where REER𝑡−1

is the real effective exchange rate in time 𝑡−1;𝑒

𝑡is the exchange rate at time 𝑡;𝐸𝑒

𝑡+1is the expected exchange

rate at time 𝑡 + 1; 𝑟𝑡is the domestic interest rate; 𝑟∗

𝑡is the

foreign interest rate; 𝑟𝑠,𝑡

and 𝑟

∗

𝑠,𝑡are yields of domestic and

foreign investment, respectively.This equation includes a number of well-known propo-

sitions. First, an increase in foreign exchange reserves as aresult of intervention to sell the domestic currency causesΔ𝑒

𝑡

to increase. Second, an increase in the domestic component

of themonetary base causesΔ𝑒

𝑡to increase.Third, an increase

in themoneymultiplier causes the interest rate to decline andhence the domestic currency to depreciate. Next, an increasein cyclical income is likely to cause imports to increase andhence cause Δ𝑒

𝑡to increase. In addition, the higher fiscal

deficit indirectly decreases export and increases import andthus the domestic currency to depreciate.

Furthermore, the real effective exchange rate is calculatedas a weighted average of real exchange rates of the nationalcurrency to the currencies of its main trading partners.Generally speaking, the United States is the biggest tradepartner of China; thus, the change in the real effectiveexchange rate will lead Δ𝑒

𝑡to increase. Finally, an increase

in the expected rate of depreciation, a decrease in the interestrate spread, and a fall in the investment yield of stocks spreadwill cause Δ𝑒

𝑡to increase as capital flows out of domestic

assets.Substituting (5) into (4) obtains

Δ𝑝

𝑡= (𝜏

1mm𝑡+ 𝜏

3𝑐 + 𝜏

3𝑐𝜆

1𝜔

1mm𝑡) ΔNFA

𝑡

+ (𝜏

1mm𝑡+ 𝜏

3𝑐𝜆

1𝜔

1mm𝑡) ΔNDA

𝑡

+ (𝜏

1MB𝑡+ 𝜏

3𝑐𝜆

1𝜔

1MB𝑡) Δmm

𝑡+ 𝜏

2Δ𝑝

𝑡−1

+ (𝜏

3𝑐𝜆

1𝜛

2) 𝑌

𝑐,𝑡−1+ (𝜏

3𝑐𝜆

1𝜛

3) Δ𝐺

𝑐,𝑡

+ (𝜏

3𝑐𝜆

2) ΔREER

𝑡−1

+ 𝜏

3Δ [𝐸𝑒

𝑡+1− (𝑟

𝑡− 𝑟

∗

𝑡) − (𝑟

𝑠,𝑡− 𝑟

∗

𝑠,𝑡)] .

(6)

Cyclical Housing Price. For the specification of cyclicalhousing price, it is hypothesized that the cyclical housingprice depends on the change in money supply and thecyclical housing price in the previous period. Therefore, theconstraint for cyclical housing price takes the following formbased on the assumptions in footnote 12:

𝐻

𝑡= 𝜙

1[(ΔNFA

𝑡+ ΔNDA

𝑡)mm𝑡+MB

𝑡Δmm

𝑡]

+ 𝜙

2𝐻

𝑡−1.

(7)

Under a typical managed floating exchange rate system,we hypothesize that monetary authorities minimize theirloss function by altering domestic credit and undertakingexchange rate intervention. Consequently, the following twoequations can be derived by solving the partial derivatives𝜕𝐿

𝑡/𝜕ΔNFA

𝑡= 0 and 𝜕𝐿

𝑡/𝜕ΔNDA

𝑡= 0, subject to the

constraints in (3), (6), and (7):

ΔNFA∗𝑡= 𝜋

1+ 𝜋

2ΔNDA∗

𝑡+ 𝜋

3Δmm

𝑡+ 𝜋

4Δ𝑝

𝑡−1

+ 𝜋

5𝐻

𝑐,𝑡−1+ 𝜋

6𝑌

𝑐,𝑡−1+ 𝜋

7Δ𝐺

𝑐,𝑡

+ 𝜋

8ΔREER

𝑡−1

+ 𝜋

9Δ [𝐸𝑒

𝑡+1− (𝑟

𝑡− 𝑟

∗

𝑡) − (𝑟

𝑠,𝑡− 𝑟

∗

𝑠,𝑡)] ,

(8)


ΔNDA∗𝑡= 𝜃

1+ 𝜃

2ΔNFA∗

𝑡+ 𝜃

3Δmm

𝑡+ 𝜃

4Δ𝑝

𝑡−1

+ 𝜃

5𝐻

𝑐,𝑡−1+ 𝜃

6𝑌

𝑐,𝑡−1+ 𝜃

7Δ𝐺

𝑐,𝑡

+ 𝜃

8ΔREER

𝑡−1

+ 𝜃

9Δ [𝐸𝑒

𝑡+1− (𝑟

𝑡− 𝑟

∗

𝑡) − (𝑟

𝑠,𝑡− 𝑟

∗

𝑠,𝑡)] .

(9)

These two equations are used in the current regressionmodel to examine the effectiveness of the monetary author-ity’s sterilization policy. In order to be in line with theassumption of model stability and exclusion of irrelevantfactors from the original variables’ specifications, definitionsof the variables are modified.

In (8) and (9), ΔNFA∗𝑡is the change in the adjusted net

foreign assets scaled by GDP;17 ΔNDA∗𝑡is the change in the

adjusted net domestic asset scaled by GDP;18 Δmm𝑡is the

change of money multiplier for M2 in logarithmic terms;Δ𝑝

𝑡−1is the change of consumer price index in logarithmic

terms in time (𝑡 − 1); 𝐻

𝑐,𝑡−1is the cyclical housing price

index in time (𝑡 − 1); 𝑌𝑐,𝑡−1

is the cyclical income in time(𝑡−1);19 Δ𝐺

𝑐,𝑡is the change in government expenditure scaled

by GDP; ΔREER𝑡−1

is the change of the REER in logarithmicterms; 𝐸𝑒

𝑡+1is the expected nominal exchange rate (foreign

currency per US dollar) in logarithmic terms.20 (𝑟

𝑡− 𝑟

∗

𝑡) is

the interest rate differential between People’s Bank of Chinaand the US Federal Funds and (𝑟

𝑠,𝑡− 𝑟

∗

𝑠,𝑡) is the stock return

differential between China and the USA.𝜋

2in (8) is the offset coefficient of regressing capital flows

on the monetary policy.21 When 𝜋

2= 0, capital is immobile,

which means that the impact of a change in net domesticassets on the domestic money supply is substantial. When𝜋

2= −1, capital is perfectly mobile, indicating that the effect

of a change in net domestic assets on the domestic moneysupply can be completely offset by capital mobility and thusindependence of the monetary policy of the central bank isundermined. In general, capital is less than perfectly mobileand thus we expect that −1 < 𝜋

2< 0.

In addition to the offset coefficient, there are seven controlvariables in (8). Increases in inflation and cyclical housingprices lead to an expected currency depreciation; an increasein the money multiplier causes domestic money supply toincrease and hence the interest rate too declines; an increasein government deficit leads to a decrease in trade surplus;all of these four factors result in decrease in foreign capitalinflows.We thus expect𝜋

3,𝜋4,𝜋5, and𝜋

7to be smaller than 0.

Furthermore, an increase in cyclical income is likely tonot only cause imports to increase and thus the trade surplusand foreign exchange reserves to decrease but also boostthe confidence of foreign investors. This thereby encouragescapital inflows. The real effective exchange rate increases,causing the trade surplus and the foreign exchange reservesto decrease while at the same time the domestic currencyappreciates. This leads to inflows of foreign speculative cap-ital. Expectations of RMB’s appreciation increase the upwardpressure on RMB, which then attracts inflows of foreign cap-ital. A decrease in the interest rate spread, a fall in the invest-ment yield of domestic stocks, and a rise in the investmentyield of foreign stocks increase relative USD yields, negatively

affecting capital inflows. As a result, we expect these threecoefficients, 𝜋

6, 𝜋8, and 𝜋

9, to be either positive or nega-

tive.𝜃

2in (9) is the sterilization coefficient of the monetary

policy. When 𝜃

2= −1, it represents the fact that the PBC

can sterilize all effects of international capital inflows andincrease in foreign exchange reserves on the monetary base,meaning that a change in net foreign assets of central bankleads to a change of the same magnitude but in the oppositedirection in net domestic assets.The effect of capital mobilityon the monetary base is completely sterilized, resulting in nochange in the monetary base. 𝜃

2= 0 means the absence of

sterilization, indicating that the central bank does not changethe volume of domestic assets as a means of sterilization inresponse to a change in foreign assets. As China’s currentmonetary situation is usually somewhere in the continuumof these two extremes, we expect that −1 < 𝜃

2< 0.

In addition to the sterilization coefficient, there are sevencontrol variables in (9). The central bank usually implementsa tight monetary policy in response to a rise in the moneymultiplier and increase in inflation, the cyclical housing price,the cyclical income, and the government fiscal deficit. Wehence expect coefficients 𝜃

3, 𝜃4, 𝜃5, 𝜃6, and 𝜃

7to be smaller

than zero.Moreover, a stronger upward pressure on RMB will force

the monetary authorities to implement an expansionarymonetary policy to alleviate the pressure on RMB. A decreasein the interest spread between domestic and foreign markets,a decrease in the investment yield of domestic stocks, and arise in the investment yield of foreign stocks reduce foreigncapital inflows. The central bank then implements a tightmonetary policy in order to maintain a stable exchange rate.We therefore expect that 𝜃

9could be positive or negative.

4.2. Sustainability of Sterilization Policy. Generally speaking,sustainability refers to the capacity to maintain a process or astate. High costs of sterilization undermine the central bank’ssolvency, further affecting investors’ confidence in credibilityof the central bank, rendering the sterilization operationsunsustainable. Three methods have been often employed inthe literature to examine the effect of sterilization costs onsustainability of sterilization. The first method defines netsterilization cost as the interest on the central bank’s billsminus the US Treasury bill rate. This ignores the impact ofthe exchange rate on sterilization costs and uses only thedirect costs as an indicator of sustainability of sterilization.The second method is relatively stringent. It considers therelationship between the interest rate of the central bank’sbills and the growth rate of GDP. However, there is nodirect relationship between the credibility of the central bankand GDP growth. Hence the current study takes the thirdapproach to analyze sustainability of sterilization policy. Wediscuss the relationship between central bank’s sterilizationcosts and its holdings of foreign exchange reserves.

As nowadaysChinamostly depends on raising the reserverequirement ratios and issuing central bank bills as steril-ization instruments, only the third method is used [12] toexplore sustainability of sterilization bills. The present studyuses a simple theoreticalmodel to analyze the sustainability of


PBC’s sterilization by drawing on the methodology outlinedin Frenkel [12] and modifying its theoretical arguments.22

The credibility of monetary policy is based on the assetsheld by the central bank.When sterilization is a way of centralbank’s bills and reserve requirement ratios, the central bank’sprincipal assets include foreign exchange reserves, and itsprincipal liabilities include monetary base, interest paymentson its bills, and interest payments on deposit reserves. Weassume that the change of total central bank assets is asfollows:

𝑑𝐴 = 𝑑𝑅𝐸 = 𝑅𝑑𝐸 + 𝐸𝐶 + 𝐸𝑟𝑅, (10)

where 𝑑𝐴 is the change in total central bank assets and 𝑅,𝐸, 𝑟, and 𝐶 are the foreign exchange reserves, the exchangerate, the yield of foreign exchange reserves, and the foreigncurrency bought by the central bank as part of interventionfor maintaining stability of the exchange rate, respectively.𝑅𝐸 is the foreign exchange reserves denominated in domesticcurrency. Besides, the change in the foreign exchange reservedenominated in domestic currency includes 𝑅𝑑𝐸, 𝐸𝐶, and𝐸𝑟𝑅, which represent gains and losses due to exchange ratevolatility, new additions to foreign exchange reserves, andthe return earned on the original foreign exchange reserves,respectively.

Besides, we assume that the change of total central bankliabilities in response to the sterilization policy takes thefollowing form:

𝑑𝑃 = 𝑑𝐵 + 𝑑𝐿 + 𝑑

𝑅,(11)

where 𝑑𝑃 is the change in the total liabilities of the centralbank, 𝑑𝐵 is the monetary base released due to exchangerate intervention, and 𝐿 and

𝑅 are the debts incurred byissuance of central bank bills and reserve requirements astwo instruments of sterilization policy, respectively. 𝑖𝐿 and𝑟

𝑅 represent the interest on central bank bills and reserverequirements, respectively. When denominating these termsin domestic currency, (11) can be rewritten as follows:

𝑑𝑃 = 𝐸𝐶 + 𝑖𝐿 + 𝑟

𝑅.(12)

In order to avoid high sterilization costs thatmay threatenthe sustainability of sterilization operations and policy cred-ibility, we assume that sustainable sterilization is requiredwhen the increase of liabilities is smaller than or equal to theincrease of foreign exchange reserve:

𝐸𝐶 + 𝑖𝐿 + 𝑟

𝑅 ≤ 𝑅𝑑𝐸 + 𝐸𝐶 + 𝐸𝑟𝑅.(13)

Crossing out 𝐸𝐶 and then dividing by 𝑅𝐸 for both sides ofthe above equation yield

𝑖 (

𝐿

𝑅𝐸

) + 𝑟(

𝑅

𝑅𝐸

) ≤ (

𝑅𝑑𝐸

𝑅𝐸

) + (

𝐸𝑟𝑅

𝑅𝐸

) . (14)

Multiplying (𝑅𝐸/𝐿) gives

𝑖 + 𝑟 (

𝑅

𝐿

) ≤ (𝑒 + 𝑟) (

𝑅𝐸

𝐿

) , (15)

where 𝑒 = 𝑑𝐸/𝐸. Equation (15) represents the rule for su-stainability of the sterilization policy; the left-side of theequation can be viewed as the ratios of sterilization cost of thecentral bank; the right-hand side represents adjusted yieldsof foreign exchange reserves. Specifically, 𝐸 is the nominalexchange rate (foreign currency per US dollar); 𝑖 and 𝐿 areinterest rate on 3-month central bank bills and the monthlybalance of central bank bills; 𝑟 and 𝑅𝐸 are yield on 3-monthUS Treasury bills and the value of foreign exchange reserveexpressed in RMB, respectively, and 𝑟 and

𝑅 are the intereston required reserves and reserve requirements, respectively.

5. Data and Empirical Results

In this section, empirical analysis has been conducted withan offset and sterilization coefficient model to examine theprocess of international capital flows and the effectiveness ofmonetary policies. A framework that can be used to analyzesustainability of sterilization policies adopted by the PBCbased on the correlation between its sterilization costs andChina’s foreign exchange reserve is proposed.

5.1. Data Description and Unit Root Tests. There are twoparts in the empirical analysis. The empirical data in thefirst part contains a total of 134 observations from February2002 to March 2013. That in the second part has a totalof 103 observations from June 2003 to December 2011. Asthe smallest accounting frequency is quarterly for China’spublished GDP, the monthly GDP data employed in thepresent study is derived by decomposing the quarterly GDP,weighted by the ratio of monthly gross industrial output tothe quarterly gross industrial output.

Since there is no differentiation between the reserverequirements and excess reserves in the balance sheet of thePBC, it is difficult for us to calculate the exact amount ofinterest payments by the PBC on the reserve requirementsand excessive reserves. As a result, we use the depositswith central bank from the balance sheet of other deposi-tory corporations as an alternative variable representing thereserve requirements. We then use the corresponding ratiosof reserve requirement to obtain the approximate amount ofmonthly interest payments by the PBC. Table 2 summarizesthe measurement and sources of the various data used in theestimating equations.

This paper has adopted the augmented Dickey-Fuller(ADF) method of Dickey and Fuller [13] to test whether thetime series is stationary. The results are listed in Table 3. Theresults of ADF unit root tests reveal that all variables arestationary at the 5% level of significance.

5.2. Empirical Results

5.2.1. Effectiveness of the Sterilization Policy. Equations (8)and (9) are simultaneous equations. Simultaneous equationsystem is considered to be more theoretically stringent. Nev-ertheless, considering that China’s economy is in transition,sound market operations and transmission mechanism havenot existed among various economic variables. Simultaneous


Table 3: Unit root test for effectiveness of the sterilization policy.

Variable 𝜏 statisticΔNFA∗

𝑡−10.21∗∗∗

ΔNDA∗𝑡

−11.15∗∗∗

Δmm𝑡

−10.27∗∗∗

Δ𝑝

𝑡−1−5.22∗∗∗

𝐻

𝑐,𝑡−1−3.66∗∗∗

𝑌

𝑐,𝑡−1−2.27∗∗

Δ𝐺

𝑐,𝑡−4.07∗∗∗

ΔREER𝑡−1

−8.897∗∗∗

Δ[𝐸𝑒

𝑡+1− (𝑟

𝑡− 𝑟

∗

𝑡) − (𝑟

𝑠,𝑡− 𝑟

∗

𝑠,𝑡)] −12.05∗∗∗

Note: ∗∗ and ∗ ∗ ∗ denote that the 𝜏 statistic is significant at 5% and 1%levels, respectively.

Table 4: Granger causality test result.

Null hypothesis Chi-square ProblemΔNFA∗

𝑡does not Granger-cause ΔNDA∗

𝑡0.24453 0.9507

ΔNDA∗𝑡does not Granger-cause ΔNFA∗

𝑡0.31366 0.9189

equations cannot be used to analyze the functional rela-tionships among various economic variables representingstructural characteristics of the economic system. In addition,if the endogeneity problems of ΔNFA∗

𝑡and ΔNDA∗

𝑡are

not serious, results obtained from simultaneous equationestimation may not be necessarily better than those obtainedby using the generalized least squares method.23

In order to further confirm the correlation betweenΔNFA∗

𝑡and ΔNDA∗

𝑡, a causality test has been conducted

(Table 4). Based on the results in Table 3, there is no causalrelationship between ΔNFA∗

𝑡and ΔNDA∗

𝑡. Accordingly, we

use the generalized least squares method to estimate (7) and(8).24

Table 5 shows results of estimations of the empiricalmodel obtained through the use of the generalized leastsquares method. From Table 4, the offset and sterilizationcoefficients of international capital flows on monetary policyare −0.717 and −0.831, respectively.25 These indicate that 70%of the change in net domestic assets of the central bank wasoffset by a negative change in the net foreign assets and 80%ofthe change in net foreign assets of the central bank was offsetby a negative change in net domestic assets.This suggests thatimplementation of the large-scale sterilization by the PBCwas effective.

In addition, coefficients of money multiplier are statisti-cally significant and negative in all regressions. It is shownthat a rise in themoneymultiplier increases themoney supplyand pushes interest rate down, leading to outflows of foreigncapital. China’smonetary authority is inclined to adopt a tightmonetary policy to offset the increase inmoney supply causedby a higher money multiplier. The coefficients of the cyclicalincome in both equations are significantly negative, indicat-ing that the higher the real output exceeding the potentialoutput is, the larger the resulting negative impact on the cur-rent account surplus than on the attraction of foreign capitalis. The monetary authority also tends to implement a tight

Table 5: Parameter estimates.

ΔNFA∗𝑡

ΔNDA∗𝑡

Intercept 0.063∗∗∗ 0.045∗∗∗

ΔNFA∗𝑡

— −0.831∗∗∗

ΔNDA∗𝑡

−0.717∗∗∗ —Δmm

𝑡−3.479∗∗∗ −4.691∗∗∗

Δ𝑝

𝑡−12.506∗∗ 3.003∗∗

𝐻

𝑐,𝑡−1−0.055 0.070

𝑌

𝑐,𝑡−1−0.147∗∗ −0.124∗

Δ𝐺

𝑐,𝑡−0.051 −0.082∗

ΔREER𝑡−1

−0.550 −0.335Δ[𝐸𝑒

𝑡+1− (𝑟

𝑡− 𝑟

∗

𝑡) − (𝑟

𝑠,𝑡− 𝑟

∗

𝑠,𝑡)] 0.002 −0.021

𝑅

2 0.586 0.884DW 1.979 2.072Note: ∗, ∗∗, and ∗∗∗ denote that the 𝑧 statistic is significant at the 10%, 5%and 1% levels, respectively.

monetary policy to suppress excessive growth of the economy.Moreover, the effect of government budget deficit on the netdomestic credit is significantly different from zero. This indi-cates that, in order to maintain the stability of the social sys-tem, the central bank adopts a tighter monetary policy stancein response to increases in the government budget deficit.

Furthermore, the effects of previous inflation volatility onnet foreign assets and net domestic credit are not negative, asexpected.The possible reason is that China in recent years hasexperienced rapid economic growth, accompanied by risinginflation. Foreign investors who are optimistic about China’seconomic outlook go to seek investment opportunities inChina, leading to increases in net foreign assets. In order tomaintain a stable foreign exchange market, the central bankcannot help inject money in the domestic market, even ifcoupled with sterilization operations.

Therefore, coefficients of the change of consumer priceindex in logarithmic terms in time (𝑡 − 1) are statisticallysignificant and positive in all regressions. The other variablesare generally insignificant in the regressions and have incon-sistent signs. These findings, statistically insignificant or withincorrect signs of the variable coefficients, may be due to thefact that while the dependent variables are fairly volatile, theindependent variables are quite stable.26

We also apply LM test and ARCH test to each equationto ensure the accuracy of the empirical model. The resultsare presented in Table 6. LM and ARCH tests show that thenull hypotheses of no serial correlation andheteroscedasticitycannot be rejected at the 5% level of significance. Besides,CUSUM values fall within the two critical lines at the 5%significance level. Therefore, these equations are statisticallystable.

5.2.2. Sustainability of Sterilization Policy. From the perspec-tive of the central bank’s financial resources, sustainability ofsterilization operations depends on whether the central bankcan make a profit. If the central bank is in surplus, the profitfrom its role as issuer of the currency exceeds the cost ofsterilization operations, which are thus sustainable. On the


Table 6: Residual diagnostics.

ΔNFA∗𝑡

ΔNDA∗𝑡

Statistic Problem Statistic ProblemLM test 0.947 0.504 0.836 0.613ARCH test 0.444 0.942 0.118 0.999

0

5

10

15

Year

(%)

−5

−10

2003.6

2003.1

2004.2

2004.6

2004.1

2005.2

2005.6

2005.1

2006.2

2006.6

2006.1

2007.2

2007.6

2007.1

2008.2

2008.6

2008.1

2009.2

2009.6

2009.1

2010.2

2010.6

2010.1

2011.2

2011.6

2011.1

i + rr(RR/L)

(e + r)(RE/L)

Figure 5: Determination of sustainability of monetary sterilization.

contrary, if the cost of sterilization is too high and profitabilityof the central bank is compromised, sustainability of thesterilization policy is questionable.

As changes in the value of foreign assets due to exchangerate fluctuations do not correspond to the cash flow in thecurrent period, this does not bring substantial pressure on thecentral bank in the short term. If we specify the short-termmodel without including gains and losses from exchangerate volatility, operations of sterilization policies might besustainable. However, exchange rate volatility in the long runreduces the value of foreign exchange reserves relative to thedomestic assets. When considering changes in the value offoreign exchange reserves because of exchange rate volatility,it is likely that sterilization is unsustainable.

For an overview of the ratios of sterilization cost andadjusted yields of foreign exchange reserves, we examine thesustainability of China’s monetary sterilization policy basedon the estimation of (15) and the result is depicted in Figure 5.Figure 4 shows that the ratios of sterilization cost were lowerthan the adjusted yields of foreign exchange reserves untilMarch 2008. Afterwards, there are changes.The ratios of ster-ilization cost were higher than the adjusted yields of foreignexchange reserves betweenMarch and June, while the formerwas lower than the latter from July to September. Except forJanuary 2009 and August 2010, the ratio of sterilization costand the adjusted yields of foreign exchange reserves in the restof the periods do not meet the requirements of (15).27

There have been major changes in the balance sheet ofthe PBC in recent years. The growth of foreign exchangereserves is larger than the development of the economicsystem. Currency in circulation accounts for only a smallportion of the central bank’s liabilities; the major parts arethe domestic liabilities that require payment of interest. Thisadds to the financial burden of the PBC and also results inincreasing uncertainty of PBC’s surplus.

In addition, issuance of central bank bills only helpsease the problem of short-term excess liquidity. If the PBCcontinues to issue central bank bills as a sterilizationmeasurein the long run, it will further increase its financial burden.Furthermore, while the adjustment of reserve requirementratios strengthens the autonomy of PBC and effectivenessof sterilization policy, long-term sterilization activities pushup the interest rate in the financial market. This furtherencourages inflows of foreign capital which in turn neutralizethe effectiveness of the sterilization policy.The resultant costsincrease the difficulties in implementing themonetary policy.

Based on the foregoing analysis, sterilization operationsundertaken by the monetary authorities in China have beenincreasing in recent years. This not only pushes up themarket interest rate but also brings about imbalance in theasset structure of the monetary authorities, resulting in avicious cycle of monetary policies. The sterilization costsare positively related to the yield of central bank’s bills andthe required deposit reserve ratio and negatively related tothe yields of foreign investments. As a result, in the currentenvironment of economic downturn inwestern countries andlower yields of foreign investment, adoption of sterilizationpolicy further adds to burdens of the monetary authorities.Under the current international economic environment,sterilization will become unsustainable over a long period oftime, in the future. As a consequence, the imbalance in theinternational balance of payment will inevitably have to beadjusted.

6. Conclusion

To stabilize the exchange rate of the RMB and furtherrealize sustainable development of China’s economy in thecontext of persistent balance of payments surplus and theintensified upward pressure on the RMB, the PBC uses avariety of sterilizationmeasures and foreign exchangemarketinterventions to reduce excess liquidity and maintain thestability of RMB exchange rate and the monetary policyindependence.

Based on microeconomic foundations and with the per-spective of minimizing the target loss function of monetaryauthorities, this paper aims to construct a refined model foroffset and sterilization coefficient estimation to evaluate theeffectiveness of China’s sterilization policy. Besides, empiricaldata are used to further explore financial capabilities ofthe central bank in order to understand the sustainabilityof the sterilization policy. The empirical results show thatChinese monetary authorities sterilize almost all effects ofinternational capital inflows and increase in foreign exchangereserves on the monetary base. That is, increase in capitalliquidity does not sabotage the independence of the Chinesemonetary policy. Nevertheless, analyses of sustainability ofthe sterilization policy indicate that the sustainability of themonetary sterilization policy has been seriously challengedsince March 2008.

In the context of rising costs of sterilization, massive andpersistent international capital inflows have made it diffi-cult for the PBC to achieve its twin goals of currency sta-bility and monetary policy independence. In light of these


circumstances, themonetary authority should not only adjustthe maturity structure of the central bank bills to easethe pressure for making interest payments but also activelydevelop diversified sterilization tools to compensate forthe inadequate effects of sterilization measures. Moreover,the monetary authority should relax restrictions on capitaloutflows and adjust the imbalance in the balance of payments.Furthermore, this should help improve the exchange ratesystem and mechanism for adjusting the exchange rate toadjust the external imbalance of the economy and expand theratio of foreign reserves held by enterprises and for graduallyabolishing the provision on “allowable foreign exchangeworking position” for designated banks. These measures canalleviate pressure on the PBC for its passive role in the foreignexchange market interventions.

The persistent balance of payments surplus has erodedthe autonomy of the central bank. As a result the Chinesegovernment should focus on policy coordination. In additionto increasing the issuance of government bonds and raisingthe proportion of government bonds within the monetaryauthority’s assets, coupled with effective exchange rate man-agement to control for speculative foreign investment, thegovernment has to adjust the corresponding macroeconomicpolicy in order to effectively address the economic and assetbubbles due to excess liquidity.

Conflict of Interests

The authors declare that there is no conflict of interestsregarding the publication of this paper.

Endnotes

1. Refer to Krugman [14].2. In order to keep the value of the RMB stable, People’s

Bank of China has to constantly interfere with theforeign exchange market by making purchases, whichhas resulted in expansion of the monetary base. On theother hand, in order to suppress potential inflation thatmight accompany the overheated investment flows since2003, People’s Bank of China had to keep the speedof expansion of the monetary base and credit, therebyresulting in conflicting goals of maintaining RMB sta-bility and preventing overheating of the economy.

3. See the Chinese State Administration of Foreign Ex-change, http://www.safe.gov.cn/.

4. The monthly balance of central bank bills is defined asthe value of the current issuance of central bank billsminus the value of maturing central bank bills.

5. See People’s Bank of China, http://www.pbc.gov.cn/.6. Figures are calculated based on the statistics published

by People’s Bank of China.7. The huge costs of foreign exchange sterilization are

mainly due to the massive replacement of foreign cur-rency assets by domestic bonds caused by the centralbank’s sterilization operations in the open market. Thisraises the interest rates of domestic bondswhile lowering

the rate of return on foreign currency assets.The domes-tic and foreign interest rate spread results in substantialdeficit for the central bank and may even partially offsetthe bank’s sterilization efforts.

8. The four factors include (1) foreign interest rate reduc-tion; foreign capital would flow to developing nationsto ensure higher rates of return; (2) in order to alleviateinflationary pressure, nations with capital inflows raisedomestic interest rates that appeal to foreign capital;(3) increased domestic money demand due to variousreasons, thereby driving up interest rates, which appealsmore to foreign capital; and (4) changes in externalconditions that lead to improved trade balance, therebyincreasing domestic exports. As a result, total domes-tic demand increases and thereby creates pressure toincrease domestic interest rate.

9. The sterilization coefficients (i.e., how much domesticmoney creation responds to a change in internationalreserves) of international capital flow on monetarypolicy are the percentage of the change in net foreignassets of the central bank which is used to offset by anegative change in net domestic assets. For example,when the sterilization coefficient is −0.6 it means thatat least 40 percent of the growth in foreign reserves istranslating into reserve money growth.

10. See International Monetary Fund (IMF), http://www.imf.org/external/index.htm.

11. With a shortage of other viable channels of investmentin China, real estate market and stock market are mainasset markets in China. As China recently only tooka considerable number of policy measures to maintainstable housing prices but did not take any policy forstock market, therefore, the target loss function ofChina’s monetary authorities only contains the variableof cyclical housing price and puts the variable of yieldsof foreign investment in (5).

12. In order to simplify the analysis, after subtracting 𝑝

𝑡−1

from both 𝑝

𝑡and 𝑝

𝑇

𝑡, we can get that 𝑝

𝑡−𝑝

𝑇

𝑡equalsΔ𝑝

𝑡−

Δ𝑝

𝑇

𝑡.

13. ΔNFA𝑡and ΔNDA

𝑡are the changes in the net foreign

assets and net domestic assets, respectively.14. Since the volume of central bank’s net other assets and

equity capital are smaller, we assume thatMB𝑡= NFA

𝑡+

NDA𝑡to simplify the analysis.

15. We first assume that Δ𝑝

𝑡= 𝛾

1Δ𝑀

2𝑡+ 𝛾

2Δ𝑝

𝑡−1+ 𝛾

3Δ𝑒

𝑡,

where 𝑀

2𝑡= MB

𝑡⋅ mm𝑡is the money supply 𝑀

2at

time 𝑡.Δ𝑝

𝑡= 𝛾

1[(ΔNFA

𝑡+ΔNDA

𝑡)mm𝑡+MB

𝑡Δmm

𝑡]

+𝛾2Δ𝑝

𝑡−1+𝛾3Δ𝑒

𝑡, can be derived by using the speci-

fication in footnote 14.16. The exchange rate used in this paper is based on direct

terms (renminbis of per foreign currency unit).17. There is no correlation between changes in net foreign

assets and changes in the monetary base and capitalmobility due to nonpolicy factors such as interest ratevolatility and interest income. Therefore, the resulting


changes in asset values due to interest rate volatility andinterest income are excluded from the change in the netforeign assets.The change in the net foreign assets due toRMB exchange rate appreciation is 𝑅𝐸

𝑡= NFA

𝑡−1[(𝑒

𝑡−

𝑒

𝑡−1)/𝑒

𝑡−1], where 𝑒

𝑡is the monthly exchange rate (RMB

to USD) at time 𝑡. The interest income of the foreignexchange reserves is 𝛾

𝑡= (𝑖

𝑇𝐵𝑡

/12)⋅[(NFA𝑡−1

+NFA𝑡)/2],

where 𝑖

𝑇𝐵𝑡

is the US 10-year Treasury yield. Therefore,we specify the adjusted net foreign assets scaled by themonthly GDP as NFA∗

𝑡= (NFA

𝑡− 𝑅𝐸

𝑡− 𝛾

𝑡)/GDP

𝑡.

18. Using the specification in footnote 12, NDA∗𝑡

= (MB𝑡/

GDP𝑡) −NFA∗

𝑡is the adjusted net domestic asset scaled

by the monthly GDP.

19. 𝐻

𝑐,𝑡−1is calculated as the proportion of housing price

minus housing price trend against house price trend, and𝑌

𝑐,𝑡−1is calculated as the proportion of GDPminus GDP

trend against GDP trend. Hodrick-Prescott (HP) filtermethod is used to measure the trend of each variable inthis paper.

20. The 3-month RMB/USD nondeliverable forward rate(NDF) in logarithmic terms is used to substitute 𝐸𝑒

𝑡+1.

21. The offset coefficient is the effect of a change in centralbank net domestic assets on domesticmoney supply thatwas offset by the capital inflows.

22. In the context of China’s financial system, monetarypolicy is often different from the operations in the west-ern countries. Qunatitative instruments (reserves) arepreferred over price instruments (intereste rate). Chinahas raised the reserve requirement ratios several timesin recent years in an attempt to recover the funds out-standing for foreign exchange; therefore, the model spe-cification has to take into account the increases in centralbank liabilites due to the adoption of deposit reservepolicy.

23. The 𝑃 values of endogeneity test of ΔNFA∗𝑡and ΔNDA∗

𝑡

are 0.0853 and 0.4656, respectively.The test results showthat the null hypotheses of no endogeneity problems ofΔNFA∗

𝑡and ΔNDA∗

𝑡cannot be rejected at the 5% level

of significance.

24. Granger [15] defined causality among variables based ona “prediction” perspective. In addition to consideringpast values of 𝑥 variable when predicting 𝑥

𝑡, if past

values of 𝑦 variable help predict 𝑥

𝑡, then 𝑦 variable

Granger-causes variable 𝑥

𝑡. When the Granger causality

test shows that 𝑦 variable does not Granger-cause 𝑥

variable, it cannot be viewed as variable 𝑦 does not helpexplain𝑥

𝑡variable. It can only be used to determine lead-

lag relationship between variables.

25. The empirical result is similar to Glick and Hutchison[5] and Zhang [6] survey of the various estimates aboutChina’s sterilization coefficient from 2003 to 2009. Highlevels of sterilization indicate that PBC’s sterilization hasbeen quite successful in maintaining the independenceof domestic money and credit growth after the introduc-tion of central bank bills and reserve requirement ratio.

26. Since (8) and (9) are derived by the theoretical model,the control variables cannot be chosen completely arbi-trarily. Accordingly, we cannot use robust test to test therobustness of the model.

27. The financial crisis that began in 2007 spread andgathered intensity in 2008; the global response to thefinancial crisis began to take shape in late 2008s. OnOctober 8, 2008, the world’smajor central banks, includ-ing the Federal Reserve, the European Central Bank, theBank of England, and the PBC, lowered interest ratesin unison. Since the short/medium term foreign interestrate has dropped sharply, investment yields earned onforeign assets cannot cover PBC’s interest payments onthe outstanding PBC bonds and on the total (requiredand excess) reserves after late 2008s. Thus, a projectionof the sterilization cost and the income from foreignreserves investment also indicate that the sterilizationpolicy of PBC will become unsustainable in the future.

References

[1] J. A. Frankel, “Sterilization of money inflows: difficult or easy?”IMFWorking Paper 94/159, 1994.

[2] C. M. Reinhart, V. Reinhart, and M. Kahler, “Some lessons forpolicy markers who deal with the mixed blessing of capitalinflows,” in Capital Flows and Financial Crises, M. Kahler, Ed.,pp. 93–127, Cornell University Press, Ithaca, NY, USA, 1999.

[3] M.M. Spiegel, “Sterilization of capital inflows through the bank-ing sector: evidence fromAsia,” Economic Review (Supplement),vol. 31, no. 4, pp. 17–34, 1995.

[4] R. Caballero and A. Krishnamurthy, “International liquidityillusion: on the risks of sterilization,”NBERWorking Paper 8141.

[5] R. Glick and M. Hutchison, “Navigating the trilemma: capitalflows and monetary policy in China,” Journal of Asian Eco-nomics, vol. 20, no. 3, pp. 205–224, 2009.

[6] M. Zhang, “Chinese stylized sterilization: the cost-sharingmechanism and financial repression,” China &World Economy,vol. 20, no. 2, pp. 41–58, 2012.

[7] G. Calvo, “The perils of sterilization,” IMF Staff Papers, vol. 38,no. 4, pp. 921–926, 1991.

[8] J. Christensen, “Capital inflows, sterilization, and commercialbank speculation: the case of Czech Republic,” IMF WorkingPaper 04/218, 2004.

[9] A. Ouyang and R. Ramkishen, “Monetary sterilization in Chinasince the 1990s: how much and how effective?” CIES WorkingPapers 0507, 2005.

[10] M. S. Mohanty and P. Turner, “Intervention: what are thedomestic consequences?” BIS Papers 24, 2005.

[11] S. N. Brissimis, H. D. Gibson, and E. Tsakalotos, “A unifyingframework for analysing offsetting capital flows and steriliza-tion: Germany and the erm,” International Journal of Financeand Economics, vol. 7, no. 1, pp. 63–78, 2002.

[12] R. Frenkel, “The sustainability of sterilization policy,” CEPRPapers, 2007.

[13] D.A.Dickey andW.A. Fuller, “Distribution of the estimators forautoregressive time series with a unit root,” Journal of the Ameri-can Statistical Association, vol. 74, no. 366, part 1, pp. 427–431,1979.


[14] P. Krugman, “O Canada: A Neglected Nation Gets Its Nobel,”Slate Magazine, 1999, http://www.slate.com/articles/business/the dismal science/1999/10/o canada.html.

[15] C. W. J. Granger, “Investigation causal relations by economicvariables,” Econometrics, vol. 37, pp. 424–438, 1969.

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