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China's Fixed Exchange Regime and the Impossible Trinity

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Chase Ross

on 10 August 2013

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Transcript of China's Fixed Exchange Regime and the Impossible Trinity

Chase Ross
China's Fixed Exchange Regime and the Impossible Trinity
8 August 2013
Maurice Obstefeld with Alan Taylor hypothesized in 1997 that that there existed a “trilemma” for governments such that no government could simultaneously have free capital flows, a fixed exchange rate, and independent monetary policy.
The Impossible Trinity

Free capital flows allow capital to move towards the highest risk-adjusted returns.

Simple example: Foreign Direct Investment

Free capital flows allocate capital to those who need it most, regardless of country origins; allowing domestic investors a higher yield abroad but also giving domestic enterprises much needed investment

But investment from abroad can be dangerous; too much dependency on foreign investment looking for speculative and quick profits - hot money - can cripple an economy with its sudden departure
Free Capital Flows
Policymakers must balance investors' desires with
the volatility of foreign investment
Fixed Exchange Rate
Independent Monetary Policy
Capital Flows
The Impossible Trinity

The exchange rate between two countries' currencies reflects the difference in purchasing power between the currencies

Governments want to stabilize these exchange rates; it is costly for businesses with international transactions to hedge currency risks, and following this consumers expect prices of imports and exports to be stable

Countries, such as China, can intervene in markets to make their currency comparatively cheaper thus lowering the prices of their exports for consumers abroad. Hence, the exchange rate becomes "fixed."
Exchange Rate
The Impossible Trinity

Central banks manipulate money supply and liquidity to change interest rates

Typical central bank toolkit: discount window, open market operations, and reserve requirements

For example: Federal Reserve purchases US debt to increase money supply

In my opinion, the development of effective monetary policy is the greatest accomplishment of economics as a field yet - look at inflation in the U.S. in the past 50 years (the "Great Moderation").

Monetary Policy
The Impossible Trinity
USD:CNY, 1990-Present
USD:JPY, 1990-Present
Source: tradingeconomics.com
Useful to consider the IS-MP model to understand the importance of effective independent monetary policy:

IS-MP Model
IS curve represents every point where investment equals savings
MP Curve relates interest rates with output
Assumptions provide the following:
Key take away: Central bank can influence output, inflation, and unemployment with inflation expectations and targeted real interest rate (!)
Rearrange to:
Assumptions give:
Source: Romer (2012)
Source: FRED
Scenario: A central bank in a country with free capital flows, a fixed exchange rate, and independent monetary policy (supposedly) wants to lower interest rates.

An increase in money supply would drive down the deposit rate for domestic savers, and thus they would take advantage of free capital flows to move their money to opportunities with higher revenues abroad.

Thus the price of the foreign currency will appreciate relative to the domestic rate, but because there is a fixed exchange rate the central bank must act to buy the domestic currency and give back foreign currency in reserve.

Eventually, the central bank will run out of foreign reserves and will no longer be able to maintain the exchange, forcing a devaluing of the domestic currency.
The Impossible Trinity
Mexico 1994
As had been a sort of pseudo-tradition, the president of Mexico, Carlos Salinas de Gortari, embarked on an ambitious fiscal stimulus plan just before the 1994 election. On top of periods of hyperinflation in the late eighties, already high debt to GDP ratios, and cheap oil exports, the new spending was unwise.
As the Mexican government used a fixed exchange regime that would convert pesos to dollars, investors reacted quickly and harshly when the EZLN, an insurgent paramilitary organization, declared war on the government on 1 January, 1994 – the same day NAFTA went into effect.
When investors cash out for dollars the Mexican government slowly lost its reserve of dollars and by the end of 1994 the peso had to be devalued as the foreign reserves could not support the mass exodus any longer.
USD:MXN, 1990-1997
Source: tradingeconomics.com
Thailand 1996
Thailand was a stable performer in Southeast Asia in the early nineties, averaging 8% growth for the first five years of the decade.
The government acted to maintain the exchange rate in lieu of letting the currency depreciate. The central bank used foreign exchange reserves to prop up the price of the baht by purchasing baht with dollars. The central bank raised interest rates, encouraging foreign money to invest in the baht but also penalizing those who wish to sell baht speculatively.
The Thai central bank tied the currency – the baht – to a basket of inflation-adjusted currencies, including the dollar, the yen, and the German mark. This provided price stability that can be seen in relative low rates of inflation of 3.4 percent in 1993 and 5.9 percent in 1996.
USD:THB, 1995-2000
Source: tradingeconomics.com
China's Trinity
Chinese policymakers know well of the impossible trinity and have chosen, at least de jure, to control capital flows, allowing for a fixed exchange regime as well as independent monetary policy.
de jure versus de facto
Fixed exchange regime
Why does China want to devaule its currency relative to the dollar? Exports.
Cheaper RMB allows Chinese exports to sell at lower prices. Thus the PBOC effectively subsidizes exporters on the international stage
This is not without costs; the PBOC must use sterilization tools to remove excess liquidity in markets to prevent inflation at home (e.g. increased reserve requirements)
Source: tradingeconomics.com
With increased capital inflows escaping regulator's regulations, the fixed rate regime has become very expensive and unsustainable in the long term.
The People’s Bank of China uses four main tools to implement price stability through monetary policy; setting interest rates, open market operations, reserve requirement ratios, and loan targets.
As dictated by the impossible trinity, policy makers institute capital controls while enforcing a fixed exchange regime with effective monetary policy
Capital inflows have increased more than the letter of the law and policy changes would suggest
Example: to dampen speculative investment in real estate, is that foreigners can de jure only buy property if they have studied or worked within China for one year. But this can easily be circumvented.
Source: Han Jian (2011)
PBOC buys dollars each day in open markets, propping up demand for dollar and comparatively devaluing the renmibi
Must liberalize exchange rate, relax capital controls, or both.
Just opening capital flows would decrease current account surplus and create a costly appreciative pressure on the RMB
Only liberalizing the exchange rate would hurt exporters and, because of the reliance on exports, would damage growth in the standard of living for most Chinese
Best options: gradual transition to liberalize both.

The central bank will have little cost to sterilize amassed foreign reserves. The reduction in the current account surplus can be softened with expansionary monetary policy, increasing depreciation and inflation, and thus keeping nominal terms growing at expected rates.
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