China's dilemma in Mundell Triangle

Nobel laureate in economics Robert Mundell has noted an economy can only maintain two of three key features – independent monetary policy, fixed exchange rate and the free flow of cross-border capital. He said China is striving to maintain all three features, an effort encountered with increasing difficulty.

A preliminary review may show this saying is not quite correct. During the past three decades, the People's Bank of China (PBC), the central bank, has maintained the integrity of its monetary policies in most cases besides exercising active management over the yuan's exchange rate. People would naturally infer the Chinese government has strictly controlled the free flow of capital. However, China has lifted the ban on direct foreign investment (FDI) for more than 20 years, after which most capital accounts were also loosened.

Any attempt to control cross-border capital flows have been greeted with futility. Since the Chinese government started to internationalize the yuan in 2009, speculation on exchange rate and the corresponding arbitrage trading have been on a fast rise.

Despite the ostensible imperfections, the regulation of capital flow did increase the transaction cost for the money rushing in and out of China, thus easing the pressure on the appreciation of the yuan. In extreme scenarios, this would safeguard China's financial security, but cross-border capital flow did not cease to exist despite regulations.

Then, how could China simultaneously maintain all three objectives in defying Mundell's assertion? The answer lies in sterilization. During the past 30 years, China has maintained surplus in capital account, a fact that hasn't changed since 1993. The PBC has a tradition to intervene in the country's foreign exchange market in a bid to ensure its stability, which produced excessive liquidity. As a result, the authorities were forced to launch massive sterilization measures to prevent a mismatch between the currency increment and the monetary base.

Noticeably, China often implements the same method in monetary policy and sterilization policy. How China will relax its monetary policy is based on how much liquidity is sterilized in a government-controlled market intervention.

The most frequently-used monetary tool is open market operations. In 2003, the PBC sold all the government bonds accumulated in previous years, before selling central bank bills, which totaled 5 trillion yuan (US $812 billion).

The deposit reserve ratio is another tool. By raising the rate, the central bank can lock a huge amount of liquidity in the market. The current ratio, twice as much as major commercial banks in the United States, has been stable after 42 modifications since 1998.

Both mechanisms mean high costs in sterilization. Also, China is stuck in what is called the "dollar trap," in that China sacrifices itself to boost the U.S. dollar status, as Beijing wants to maintain the current, underestimated factual exchange rate.

But sterilization will result in the worst mismatch in resource allocations, with subsidies on the trade-oriented sector being a case in point. Such measures are likely to impact the entire economy, particularly on the non-trade oriented manufacturers, who will suffer from the lack of funds.

Further, higher reserve ratio in combination with administrative orders for central bank bill purchases has severely squeezed the profit margin of commercial banks. In an attempt to ensure earnings, all commercial banks have to make investments of higher risk.

Although there have been predictions that China would abandon the control on the exchange rate to boost the yuan's monetary autonomy, they have been proven inaccurate for the past decade. But now China may have to do so.

As China continues to loosen bank rates and allow the short-term capital free flow, it will meet even more difficulties in defying Mundell's "triangle theory." Hence, China will eventually allow the yuan to fluctuate while maintaining the current capital control.

The author is director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences.

The article was translated by Chen Boyuan. Its original version was published in Chinese.