The Open‐Economy Trilemma in China: Monetary and Exchange‐Rate Policy Interaction under Financial Repression

• Date: 01 March 2015
• Published date: 01 March 2015
• Author: Ying Wu
• DOI: http://doi.org/10.1111/1468-2362.12063

The Open-Economy Trilemma in

China: Monetary and Exchange-

Rate Policy Interaction under

Financial Repression



Ying Wu

Department of Economics and Finance, Franklin P. Perdue School of

Business, Salisbury University, Salisbury, MD, USA.

Abstract

This paper models China’s monetary-cum-exchange rate policy, in

which sterilization measures insulate base money from the full effects

of capital inflow while the accumulation of net foreign assets (NFAs)

limits exchange-rate appreciation. I find that the negative-risk premi-

um in the interest rate—which compensates NFA holders for exchange-

rate risk with a higher relative rate of return on their NFAs—plays a

pivotal role in influencing the mag nitude of sterilization and in induc-

ing endogenous change in the exchange rate. I show that a feedback

loop between the exchange rate and capital inflow exists in the form of

a multiplier mechanism that jeopardizes both monetary autonomy and

exchange-rate sta bility. The findings testify to the open-economy tri-

lemma challenging the effectiveness and sustainability of China’s

I wish to thank two anonymous referees for comments and sugges tions on earlier drafts and Andrew

Henderson for valuable editorial assistance. I am most grateful to Dr. Benn Steil, editor of

International Finance, for ver y insightful comments an d suggestions. Any remain ing errors are my

sole responsibility.

International Finance 18:1, 2015: pp. 1–23

DOI: 10.1111/1468-2362.12063

© 2015 John Wiley & Sons Ltd

monetary-cum-exchange rate policy and point to a flexible exchange

rate as a solution that can enhance monetary sovereignty, reduce

financial repression and improve economic efficiency.

I. Introduction

It is commonly acknowledged that an open economy cannot evade the ‘impossible

trinity’of a fixed exchange rate, an independent monet ary policy and th e free

movement of capital.

1

However, less understood is how this open-economy trilemma

can challenge policymakers in a transitional emerging economy, such as China, that has

a legacy of financial repression. As the Chinese borders become increasingly open to

capital movement, the country’s monetary authority is attempting to maintain an

independent monetary policy and control over a currency that does not float freely—a

combination that suggests the country faces significant challenges ahead.

As China attempts to i ntegrate further into the world economy, will its capital-

control measures and le gacy of financial repres sion enable it to avoid the chal lenges

imposed by the trile mma? In recent years, China has loo sened its control over

several domesti c and international economic pol icies. Cross-border capital flows into

and out of China have grown substantially, and interest rates have become more

sensitive to market conditio ns. However, while the People’sBankofChina(PBOC)

has begun allowin g market forces to play a role in determin ing the value of its

currenc y, the Renmin bi (RMB) , the centr al bank s till intervene s to stem its

appreciation. In an attempt to bal ance the three conflict ing macroeconomic pol icy

goals of the trilemm a, this intervention takes the form of a two-pronge d monetary-

and-exchange-rate policy, in which the PBOC (1) limits RMB appreciation by

accumulating net foreig n assets (NFAs) and (2) steriliz es this capital inflow to

insulate domestic b ase money. The difficulties of this two-pronged policy are fur ther

compounded because Chin a still lacks adequate market-oriented inst ruments with

which to conduct ste rilization, owi ng to the countr y’sfinancial repression. In this

study, I model the two prongs of China’s monetary-cum-exchange rate polic y with

an eye toward the sustaina bility of these m easures beyond the shor t run.

At first glance, China’s capital controls appear to provide i t with an exit from the

trilemma. However, these controls are not as bindin g as is commonly believed: t here

are numerous ways to move significant amounts of money across the countr y’s

borders in response to market conditions (Glick and Hutchison 2009).

2

China cannot

1

For the classical study of the inherent conflic t among these three macroeconomic polic y objectives,

see Mundell (1963).

2

For example, firms might br ing money into C hina through pseudo-t rade with exagg erated export

revenue or employ letters of credit to borrow low-co st funds from Hong Kong banks only to invest the

funds in various fin ancial products issued by Chine se banks. In addition, foreig n credit to China is

frequently routed through a currency carr y trade from Hong Kong and Singapore.

© 2015 John Wiley & Sons Ltd

2Ying Wu