Trilemma Challenges for the People’s - Recherche en IA spécialisée au MIT

Trilemma Challenges for the People’s
Republic of China
∗
MASAHIRO KAWAI AND LI-GANG LIU

This paper ﬁrst reviews recent developments in exchange rate regimes, capital
account liberalization, interest rate liberalization, and monetary policymaking in
the People’s Republic of China (RPC). It then observes that the PRC’s monetary
policy autonomy may have been reduced with falling capital control effectiveness
and a rigid exchange regime that is still tightly managed against the United States
(NOUS) dollar. This hypothesis is investigated empirically using both the Taylor
rule and a McCallum-like rule to test whether the PRC’s money market interest
rate and/or quantity of money supply are being increasingly inﬂuenced by the
US interest rate or reserve accumulation. The paper concludes that there is
considerable evidence suggesting diminishing monetary policy autonomy in the
RPC. To regain policy autonomy, the monetary authority needs to substantially
increase exchange rate ﬂexibility of the renminbi as long as it continues to pursue
capital account opening.

Mots clés: trilemma, exchange rate regime, capital controls, monetary policy
autonomy, interest rate liberalization, Taylor rule, McCallum rule
Codes JEL: E52, E58

je. Introduction

The People’s Republic of China (RPC) is facing trilemma challenges as it
continues to liberalize its capital account. The trilemma hypothesis claims that
a country’s monetary authority cannot achieve exchange rate stability, financier
marché (or capital account) openness, and monetary policy autonomy at the same
time.1 Thus, as ﬁnancial market openness has increased over time in the PRC, its
monetary authority must choose greater exchange rate ﬂexibility to retain a high
degree of monetary policy autonomy.

∗Masahiro Kawai (corresponding author, mkawai@pp.u-tokyo.ac.jp) is Professor, Graduate School of Public Policy,
University of Tokyo, and Li-Gang Liu (ligang.liu@anz.com) is Chief Economist, Greater China, ANZ Research,
Australia and New Zealand Banking Group Limited (ANZ). They thank two anonymous referees for constructive
comments.

1In the PRC, monetary policy is largely decided by the government (the State Council and the executive
branch), while its central bank—the People’s Bank of China (PBoC)—serves as a policy implementation agency
rather than a main policy decision maker. To reﬂect this reality, this paper uses the term “monetary authority” to refer
to a main monetary policy decision maker. The paper also uses the term monetary policy “autonomy” rather than
“independence” to avoid possible confusion with the issue of political and/or operational independence of a central
bank.

Revue du développement en Asie, vol. 32, Non. 1, pp. 49–89

C(cid:3) 2015 Banque asiatique de développement
et Institut de la Banque asiatique de développement
Publié sous Creative Commons
Attribution 3.0 IGO (CC PAR 3.0 IGO) Licence

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50 ASIAN DEVELOPMENT REVIEW

The PRC has been pursuing a policy of gradually opening its ﬁnancial mar-
kets. Since the 1980s, the authorities have liberalized inward and then outward
foreign direct investment (FDI). While strict controls used to be imposed on portfo-
lio investment ﬂows, these controls have also been relaxed in recent years to expand
the range of investors and the type of ﬁnancial assets permitted for cross-border
transactions. The authorities introduced the system of qualiﬁed foreign institutional
investors (QFII) for inward portfolio investment and that of qualiﬁed domestic
institutional investors (QDII) for outward portfolio investment. The policy of inter-
nationalizing the renminbi (RMB), launched in the wake of the global ﬁnancial crisis
(GFC), has also facilitated greater ﬁnancial market openness. Authorities now allow
ﬁrms to settle merchandise trade in RMB, permit non-residents to hold offshore
RMB deposits, and allow both PRC residents and non-residents to issue offshore
RMB bonds and equities.

The PRC used to peg the RMB tightly to the United States (NOUS) dollar, mais
exited from the dollar peg in July 2005. It began to engineer currency appreciation
against the US dollar by shifting to a crawling-peg regime, thus allowing a certain
degree of exchange rate ﬂexibility. Although the authority temporarily restored a
dollar-peg regime during August 2008–May 2010, it once again adopted a crawling-
peg-like regime in June 2010. En général, the degree of exchange rate ﬂexibility has
gradually increased over time but remains highly limited.

This paper argues that while the PRC’s ﬁnancial markets have become in-
creasingly integrated with external markets, particularly those in Hong Kong, Chine,
the degree of RMB exchange rate ﬂexibility has not risen much, and the combination
of greater openness of its ﬁnancial markets and lack of sufﬁcient exchange rate ﬂex-
ibility has constrained the ability of the monetary authority to pursue autonomous
monetary policy.

II. The Trilemma Hypothesis in International Finance

Achieving noninﬂationary, stable economic growth is one of the most im-
portant policy objectives for monetary authorities, particularly central banks, dans le
monde. Many authorities ﬁnd it desirable to have stable or even ﬁxed exchange rates,
as currency stability can help achieve price stability by establishing inﬂation anchors
and/or reducing macroeconomic and ﬁnancial volatility. Exchange rate stability can
also foster international trade and investment by lowering exchange rate uncertainty
and currency risk premiums.

Many authorities also ﬁnd it useful to have open ﬁnancial markets as they
allow countries to diversify economic and ﬁnancial risks and smooth consump-
tion, investissement, and/or output over time. Financial market openness enhances the
efﬁciency of ﬁnancial intermediation and savings and investment decisions of house-
holds and corporations.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 51

Chiffre 1. The Trilemma Triangle

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PRC = People’s Republic of China.
Source: Ito and Kawai (2014).

Enfin, many authorities ﬁnd it highly attractive to retain monetary policy
autonomy, c'est, the ability to set and implement monetary policy to offset other
countries’ monetary shocks and monetary policy changes, without being constrained
by their choice of exchange rate regime. Monetary policy autonomy signiﬁcantly
helps contribute to economic stabilization in the sense of achieving low inﬂation
and stable economic growth.

Conceptually, higher levels of exchange rate stability, ﬁnancial market open-
ness, and monetary policy autonomy would all be useful and attractive for any
monetary authority. But no authority can retain all three at any one time. This is
the fundamental hypothesis—the “impossible trinity” or the “trilemma”—that dom-
inates monetary policymaking in any open economy (Mundell 1963). The PRC is
no exception.

The trilemma is often illustrated using a triangle as shown in Figure 1, avec
the three sides representing the three desirable properties: exchange rate stability,
ﬁnancial market openness, and monetary policy autonomy (Ito and Kawai 2014).
While it is possible to achieve desired levels of two out of the three attributes, it is
impossible to achieve desired levels of all three. Par exemple, a country’s authority
may choose to stand at one of the three corners in the triangle, but it is impossible
to achieve all three simultaneously. As only two out of three can be achieved to their

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52 ASIAN DEVELOPMENT REVIEW

full extent (or any extent), we often observe three distinctive policy combinations:
(je) a ﬁxed exchange rate regime and full monetary policy autonomy (with closed
ﬁnancial markets, as in the case of the lower left-hand corner—representing, pour
example, the Bretton Woods system and the PRC in the pre-1990s); (ii) a ﬁxed
exchange rate regime and fully open ﬁnancial markets (while giving up monetary
policy autonomy, as in the case of the lower right-hand corner—representing, pour
example, the gold standard system, a currency board system similar to Hong Kong,
China and small eurozone countries); et (iii) fully open ﬁnancial markets and full
monetary policy autonomy (while adopting a freely ﬂexible exchange rate regime, comme
in the case of the top corner—representing, Par exemple, Australia, Canada, Japan,
and the United Kingdom).

While history is full of episodes of systems that represent such “corner
solutions,” monetary authorities can also adopt an intermediate combination of the
three properties, c'est, a “dot” inside the triangle. There are an inﬁnite number of
such combinations. The reason a monetary authority may select such a dot is that
it may wish to compromise in selecting the level of attainment of each of the three
properties. Par exemple, a monetary authority may wish to have some exchange rate
stability, some ﬁnancial market openness, and some monetary policy autonomy. Or,
if a monetary authority wishes to retain full monetary policy autonomy, it needs to
strike a good balance between some exchange rate stability (or ﬂexibility) and some
ﬁnancial market openness (or some capital controls). In many developing countries,
monetary authorities often limit ﬁnancial market openness as it would make the
economy vulnerable to external ﬁnancial shocks and capital ﬂow volatility, creating
boom and bust cycles and, potentiellement, crises financières.

The PRC’s monetary authority used to peg the RMB exchange rate to the
US dollar while maintaining tight capital controls (the lower left-hand corner of the
triangle in Figure 1). This enabled the authority to retain monetary policy autonomy.
Cependant, as it began to gradually open its ﬁnancial markets over time, its position in
the triangle in Figure 1 started to shift from the lower left-hand corner toward the side
of ﬁnancial market openness. If the authority continues to maintain exchange rate
stability, this shift will take place horizontally along the bottom of the triangle, thus
compromising monetary policy autonomy. On the other hand, if the PRC authority
wishes to maintain monetary policy autonomy, the shift will take place upward along
the left side, thus allowing greater exchange rate ﬂexibility.

The choice of exchange rate regime therefore must be made in the context
of the trilemma hypothesis, c'est, in conjunction with the choices on monetary
policy autonomy and ﬁnancial market openness. For a large economy like the PRC,
maintaining monetary policy autonomy is an important requirement for effective
macroeconomic management. So as ﬁnancial market (or capital account) openness
increases over time, the authority needs to choose greater exchange rate ﬂexibility
to retain a sufﬁciently high degree of monetary policy autonomy.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 53

III. Exchange Rate Policy and Rate Flexibility

UN.

Renminbi Exchange Rate Behavior since 2005

Sur 21 Juillet 2005, the PRC authority de-pegged and revalued the RMB ex-
change rate against the US dollar by 2.1%, from CNY8.28 to CNY8.11 per US
dollar. Accompanying the revaluation, the authority also announced a set of mea-
sures to shift the exchange rate regime to a more ﬂexible “managed ﬂoat” system.
The RMB’s valuation from that point onward would be determined with reference to
a basket of currencies. Prior to this change, the RMB had been on a ﬁxed exchange
rate system pegged to the US dollar with occasional devaluations.2

The new RMB exchange rate regime gave the authority a new policy tool
to manage its economy. The authority announced a daily reference trading spot
rate, called the central parity rate (CPR), for the RMB to trade against the US
dollar. The PRC launched a steady appreciation immediately following the RMB
revaluation in July 2005. Until January 2006, the authority would set the CPR for
the next trading day at the previous trading day’s market close. In January 2006, un
new pricing mechanism was introduced to set the CPR using a weighted average
scheme.3 Currency weights were determined by the China Foreign Exchange Trading
System according to the previous day’s transaction volumes of individual market
participants. En outre, other indicators, such as quoted prices from the automatic
price matching system, could be used in principle as a reference. Cependant, tel
information was often not available in real time. Ainsi, it was difﬁcult for the market
to determine how a daily CPR was set and whether it would be subject to various
external political pressures and internal economic objectives (Liu and Pauwels
2012).

The steady appreciation of the RMB against the US dollar was temporarily
halted toward the end of July 2008 with the eruption of the GFC. The peg lasted for
presque 2 years until June 2010 at a rate of CNY6.83 per US dollar before resuming a
steady path of appreciation. During this re-peg period, the PRC authorities prevented
the RMB from appreciating vis-`a-vis the dollar in order to help exporters cope with
the sharp drop in demand from the US and the rest of the world.

Dans le passé, once the CPR was determined against the US dollar, the exchange
rate was then set against the euro, the yen, and the Hong Kong dollar using the
market cross rates of these currencies with the US dollar. Since 2012, RMB direct
trading has been allowed for the yen, Australian dollar, New Zealand dollar, pound

2In January 1994, the RMB was devalued from CNY5.35 to CNY8.28 per US dollar, after which the rate

stayed at the same level for more than 10 années.

3The new CPR had three distinct features: (je) over-the-counter (OTC) trading was introduced as the main
form of currency trading; (ii) more CPR pairs of the RMB against the US dollar, the euro, the yen, and the Hong
Kong dollar were announced at 9:15 am Beijing time of each business day; et (iii) the CPR was calculated using a
weighted average based on trading volume.

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54 ASIAN DEVELOPMENT REVIEW

Chiffre 2. The Renminbi Exchange Rate with a Widening Band

Source: Bloomberg.

sterling, euro, and Korean won. Par conséquent, Shanghai market liquidity for these
currencies has become a factor affecting these currencies’ onshore rates against the
RMB, in addition to their market cross rates calculated against the US dollar.

The RMB trading band vis-`a-vis the US dollar was initially set at a tightly
controlled range of ±0.3%, which was later widened to ±0.5% in May 2007, ±1%
in April 2012, and then to ±2% in March 2014. En effet, the RMB’s exchange
rate ﬂexibility has increased progressively with an enlarged trading band over time
(Chiffre 2).

Although the RMB exchange rate band has been widened over time, RMB
volatility has been limited in comparison to the volatility of other freely ﬂoating
currencies such as the euro, yen, and Australian dollar. Using an option-based
currency volatility measure, Chiffre 3 shows that 1-month at-the-money implied
volatility of the euro, yen, Australian dollar, and New Zealand dollar ﬂuctuated at
an average of 10%–20% during the GFC period of September 2008–June 2010.
Afterward, the average volatility of these currencies still ﬂuctuated at around 10%.
In contrast, the option price implied volatility of the RMB reached only 5% avec
the eruption of the GFC and has since settled down to less than 2%. Ainsi, RMB
exchange rate volatility has remained limited.

Exchange Rate Policy after the 2005 De-pegging

After the RMB’s exit from the dollar peg, its exchange rate was supposed to
reference a basket of currencies, with its exchange rate reform strategy being to take

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 55

Chiffre 3. Option Price Implied Volatility of Major Currencies and the Renminbi

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AUD = Australian dollar, CNY = renminbi, EUR = euro, JPY = yen, NZD = New Zealand dollar, USD = US
dollar.
Note: The chart displays the 1-month at-the-money implied volatility of the various currencies.
Source: Bloomberg.

an approach marked by “self-initiative, controllability, and gradualism” to improve
the RMB exchange rate formation mechanism (PBoC 2009).

Whether the RMB has actually been referenced to a basket of currencies
can be examined empirically using two approaches. One is to construct a currency
basket that reﬂects enough of the PRC’s trade with the rest of the world and see
whether the RMB exchange rate has actually followed the valuation derived from
this basket of currencies. The other approach is to use the Frankel and Wei (1994)
model to econometrically identify major international currencies and estimate their
weights in an RMB currency basket.

Basket of a Large Number of Currencies?

D'abord, en utilisant 11 currencies that make up 70% of the PRC’s trade with the rest
of the world, we constructed a currency basket for the RMB and expressed it as an
implied RMB exchange rate against the US dollar.4 The basket-based RMB rate is
depicted in Figure 4 together with the market RMB spot rate against the US dollar.

4The methodology closely follows the usual calculation of a nominal effective exchange rate (NEER)—that
est, constructing a geometric average of the 11 currencies’ exchange rates against the US dollar and then expressing
the value of this currency basket as an exchange rate against the US dollar rather than as an index. The currency
basket assigns large weights to the US dollar (34.2%), euro (22.5%), Japanese yen (14.9%), and Korean won (10.2%),

56 ASIAN DEVELOPMENT REVIEW

Chiffre 4. Basket-based Renminbi Rate versus Market Renminbi Rate

CNY = renminbi, USD = US dollar.
Source: Authors’ computations using data from Bloomberg.

The ﬁgure shows that from July 2005 to September 2008, the movement of the
market RMB spot rate followed that of the basket-based RMB rate reasonably well,
with a correlation coefﬁcient of 0.91, although the basket-based rate was stronger
in value than the market rate vis-`a-vis the US dollar. Beginning in September
2008, the basket-based RMB rate started to show more volatile movements than the
market spot rate due to sharp changes in the exchange rates of the PRC’s trading
partners during the height of the ﬁnancial crisis and the RMB’s re-pegging to the US
dollar. Between October 2008 et juin 2010, the correlation coefﬁcient between
the two rates was 0.49. Entre juin 2010 and August 2014, the correlation even
turned negative to –0.39. The ﬁgure clearly shows that in 2012 the market and the
basket-based RMB rate began to diverge, with the market rate appreciating and the
basket-based rate depreciating against the US dollar, both as a trend.

Frankel–Wei Estimation of a Currency Basket

The second approach is to examine the major international currencies that
have a large inﬂuence on the observed movements of the RMB exchange rate and
determine the weights assigned to these major currencies using the Frankel–Wei

followed by the Singapore dollar, pound sterling, Malaysian ringgit, Australian dollar, Thai baht, Canadian dollar,
and the Russian Federation ruble, with their weights ranging from 2% à 3%.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 57

Tableau 1. Changes in Observed Exchange Rate Regimes for the Renminbi

Estimation Period

Pound Sterling R-squared

US Dollar
0.999∗∗∗
(0.000)
0.934∗∗∗
(0.009)
0.970∗∗∗
(0.006)
0.940∗∗∗
(0.008)

0.999

Post-AFC period
(3 January 2000–30 June 2005)
Pre-Lehman period
(21 July 2005–21 July 2008)
GFC period
(1 August 2008–31 May 2010)
Post-GFC period
(1 June 2010–31 March 2014)
AFC = Asian ﬁnancial crisis, GFC = global ﬁnancial crisis.
Remarques: The values in parentheses are the estimated robust standard errors. ∗∗ = 5% level of statistical signiﬁcance,
∗∗∗ = 1% level of statistical signiﬁcance.
Source: Kawai and Pontines (2015).

−0.000
(0.000)
−0.017
(0.013)
0.003
(0.005)
0.002
(0.008)

0.996

0.979

0.985

Yen
0.000
(0.000)
0.028∗∗∗
(0.007)
0.003
(0.004)
0.011∗∗
(0.005)

Euro
0.000
(0.000)
0.044∗∗∗
(0.013)
0.023∗∗∗
(0.008)
0.034∗∗∗
(0.007)

model. Tableau 1 summarizes the estimation results reported by Kawai and Pontines
(2015). The table clearly indicates that the US dollar is still assigned the largest and
predominant weight throughout the sample period, while other major international
currencies such as the euro and the yen only have limited, occasional inﬂuence on
the RMB exchange rate.

Ainsi, the post-2005 RMB exchange rate regime has not truly referenced a
basket of a wide range of currencies in setting the value of the RMB exchange rate.
The RMB exchange rate has relied and continues to rely heavily on the US dollar
as its anchor currency, with limited exchange rate volatility.

Accumulation of Foreign Exchange Reserves

Limited exchange rate volatility, together with a prevailing one-way bet on
the RMB’s continued appreciation against the US dollar, led to signiﬁcant capital
inﬂows into the PRC, which required the PRC’s monetary authority to engage in
massive currency market interventions. Chiffre 5 shows that the pace of foreign
exchange reserve accumulation had been rapid until the outbreak of the GFC. After
the crisis, the rate of growth decelerated, with reserves hardly growing during Q2
2011–Q4 2012. But the reserves began to rise once again in 2013, albeit at a lesser
pace than in the pre-crisis period.

As a share of gross domestic product (PIB), foreign exchange reserves
increased from 14% dans 2000 à 48% during 2009–2010, and then declined somewhat
à 40% dans 2013. As the PRC’s current account surplus as a ratio of GDP declined
sharply after the GFC, from its peak at 10% dans 2007 to only 2% dans 2014, the pace
of reserve accumulation naturally slowed down. As will be shown later, reserve
accumulation has been accompanied by a rapid increase in the PRC’s monetary
base. This suggests that the PRC’s monetary policy has been increasingly inﬂuenced
by external conditions.

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58 ASIAN DEVELOPMENT REVIEW

Chiffre 5. Foreign Exchange Reserves of the People’s Republic of China

GDP = gross domestic product.
Source: CEIC.

IV. Effectiveness of Capital Controls

UN.

Renminbi Internationalization and Rising Arbitrage Opportunities

The PRC started to encourage international use of the RMB for trade purposes
in September 2009. This led to rapid increases in the number of RMB offshore
trading centers such as in Hong Kong, Chine; Singapore; Taipei,Chine; and London.
Among these offshore trading centers, the RMB market of Hong Kong, Chine,
commonly referred to as the CNH market, remains the largest and most active. Total
RMB deposits in the banking system of Hong Kong, Chine, including certiﬁcates
of deposit, exceeded CNY1.2 trillion in the ﬁrst half of 2014, a sizable amount
comparable to the value of the PRC’s new loans extended per year before 2005. Le
main drivers of the rapid rise of RMB deposits in Hong Kong, China have been
trade settlements invoiced in RMB. Total trade settlements using RMB between
Hong Kong, China and the PRC reached CNY3.8 trillion in 2013.

Entre-temps, offshore capital markets for the RMB have also developed rapidly.
The RMB bond market of Hong Kong, Chine, nicknamed the “dim sum” market,
experienced a surge with a total outstanding amount of CNY310 billion in 2013 et
CNY374 billion in Q3 2014. The bonds raised in the RMB market of Hong Kong,
China could be repatriated to the PRC via an approval from the State Administration
of Foreign Exchange or via an RMB QFII scheme.

Since July 2013, commercial banks have been allowed to transfer their RMB
deposits outside the PRC to their domestic branches, making RMB repatriation to

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 59

Chiffre 6. Onshore and Offshore Renminbi Interest Rate Differentials
(%)

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PRC = People’s Republic of China.
Note: Offshore refers to Hong Kong, Chine.
Sources: Bloomberg, CEIC.

the PRC easier. The linking of the Shanghai and Hong Kong, China stock markets,
launched in late 2014, has allowed investors in both markets to buy each other’s
listed shares and is another step toward a more open capital account.

The rapid RMB internationalization process also means that the PRC’s capital
account is opening at a faster pace, allowing market participants to arbitrage away
exchange rate and interest rate differentials between markets in Hong Kong, Chine
and the PRC. Donc, it is natural to assume that the existing capital control
measures will become less effective.

Cependant, casual observations suggest that RMB assets of the same maturity in
both onshore and offshore markets still enjoy large yield differentials. Par exemple,
3-month RMB savings deposits onshore obtain a return of 2.6% per annum, alors que
3-month time deposits in Hong Kong, China only offer a return of around 0.5% (voir
Figure 6A). Entre-temps, 3-month Ministry of Finance bonds from the PRC issued in
Shanghai and Hong Kong, China still have yield differentials, with the shorter-dated
bonds having larger yield differentials (Figure 6B).

These observations appear to suggest that the PRC’s capital controls are still
effective or binding. It is these control measures that drive a wedge between onshore
and offshore yields by limiting arbitrage activities in the form of capital ﬂows. These
straightforward yield comparisons could be misleading, cependant, as they do not take

60 ASIAN DEVELOPMENT REVIEW

Chiffre 7. Errors and Omissions in the Balance of Payments of the People’s Republic
of China and the Rate of Renminbi Appreciation

BOP = balance of payments, RMB = renminbi.
Source: IMF, International Financial Statistics.

into account factors such as interest rate controls, transactions costs, and the risk of
arbitrage due to capital controls.

One sign of this is the fact that the PRC’s unaccounted capital ﬂows have
started to grow over time. Chiffre 7 shows that until 2008, errors and omissions in the
PRC’s balance of payments had been around $10 billion–$20 billion, mostly in the
form of unaccounted inﬂows, coinciding with the expectation of RMB appreciation.
Since 2009, errors and omissions have become large outﬂows, at an average of
close to $55 milliard. Errors and omissions numbers became even larger during 2012–2013 to around $82 milliard, suggesting that the leakage from capital controls
has become larger over time, even when the RMB exchange rate has been on a
steady appreciation.

B. Measuring Capital Control Effectiveness

A useful benchmark for comparing yield differentials in two markets is to rely
on the covered or uncovered interest rate parity (IRP) conditions or some modiﬁed
IRP conditions that can capture distortions caused by capital controls. Under free
capital mobility, the IRP condition states that investors should be indifferent to
nominal interest rate differentials in two countries because the exchange rate between
the two currencies is expected to adjust in a way that offsets nominal interest rate
differentials, thus removing any arbitrage opportunities.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 61

Using the IRP approach, Ma and McCauley (2007) found that the PRC’s
capital controls remained effective in driving a wedge between onshore and off-
shore interest rates of the same type of assets for the period before the RMB’s
circulation offshore. A more appropriate approach to investigate the PRC’s capi-
tal control effectiveness would be to follow a seminal study by Otani and Tiwari
(1981), who looked at Japanese bond yield differentials in both the Tokyo and Lon-
don markets at the early stage of Japan’s capital account liberalization in the late
1970s.

Following their approach, we present two calculations of the IRP condition
to investigate deviations from IRP in both the Hong Kong, China and Shanghai
marchés. D'abord, we look at the Hong Kong, China CNH market, which is not subject
to many controls or market distortions. Deuxième, we look at cross-border investments
involving onshore RMB (CNY) and offshore CNH transactions. The difference
between the two deviations can be viewed as a capital control effectiveness measure
that addresses transaction costs and other distortions in both markets.5

The deviation from the IRP condition in the Hong Kong, China CNH market

can be deﬁned as follows:

DeviationC N H 1 =

(1 + rC N H ) SC N H
(1 + rU S D) FC N H

− 1,

(1)

where rCNH is the 3-month offshore RMB (CNH) interbank interest rate; rUSD is the
3-month US dollar interbank rate in Hong Kong, Chine; SCNH is the CNH spot rate
against the US dollar; and FCNH is the CNH deliverable forward rate. Since we use
the 3-month interest rates, the annualized interest rate is divided by a factor of 4 et
the results should be interpreted as percentage points.

De la même manière, the deviation from the IRP condition in cross-border investment

can be expressed as follows:

DeviationC N Y 1 =

(1 + rC N Y ) SC N Y
(1 + rU S D) FC N H

− 1,

(2)

where rCNY is the 3-month onshore RMB (CNY) interbank interest rate; rUSD is the
3-month US dollar interbank rate in Hong Kong, Chine; SCNY is the onshore RMB
(CNY) spot rate against the US dollar; and FCNH is the CNH deliverable forward
rate. Note that this IRP condition uses the Hong Kong, China CNH forward rate,
rather than the onshore RMB (CNY) forward rate, which has not been fully developed
in terms of depth and liquidity.

5Detailed technical derivation of these equations can be found in Otani and Tiwari (1981).

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62 ASIAN DEVELOPMENT REVIEW

Alternativement, investors may use the offshore non-deliverable forward (NDF)
rate also quoted in Hong Kong, Chine, FNDF, rather than FCNH, as the RMB NDF
market in Hong Kong, China is larger and more liquid at this stage. Many investors
still use this market to hedge their onshore RMB exposures. Donc, the above
expression can be changed to:

DeviationC N H 2 =

DeviationC N Y 2 =

(1 + rC N H ) SC N H
(1 + rU S D) FN D F

− 1

(1 + rC N Y ) SC N Y
(1 + rU S D) FN D F

− 1

(1)'

(2)'

Enfin, capital control effectiveness (CCE) measures can be derived by com-
paring Equations (1) et (2) and Equations (1)’ and (2)'. The difference between
onshore and offshore deviations from IRP means that after adjusting for interest rate
differentials and forward premiums, the distortion remaining can be attributed to
capital controls. Speciﬁcally, the CCE measures can be expressed as:

CCE1 = |DeviationC N Y 1 − DeviationC N H 1|

CCE2 = |DeviationC N Y 2 − DeviationC N H 2|

(3)

(3)'

Using data from 2010 to the present, we can calculate the deviations from
IRP for Equations (1) et (2), and Equations (1)’ and (2)'. Figure 8A depicts the
deviations from IRP based on Equation (1), which indicates that despite limited
liquidity and market depth, deviations in the Hong Kong, China market have be-
come smaller over time. Since March 2012, the deviations have become on average
negligible (within ±1%) and are not far from parity. This means that the Hong Kong,
China CNH market has quickly become an efﬁcient market, with limited arbitrage
opportunities between offshore transactions in US dollars and CNH.

Cependant, this is not the case for cross-border investment involving onshore
RMB (CNY), as we do observe large deviations in Equation (2). Figure 8B shows
that using the onshore RMB (CNY) interbank rate and onshore RMB (CNY) spot
rate, we ﬁnd the deviations from IRP can be as large as 6%–7% on average before
Septembre 2011. This means that if the same amount of RMB were to have been
shifted from offshore to onshore markets, the arbitrage returns would have been
6%–7%. From November 2011 to September 2014, we observe a fall in arbitrage
opportunities of an average of 1%–3%. Though this is a sharp reduction from
the pre-September 2011 period, deviations from IRP for cross-border investment
involving onshore RMB (CNY) have remained much larger than those in the Hong
Kong, China CNH market.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 63

Chiffre 8. CNH Deviation from Interest Rate Parity
(%)

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CNH = renminbi market of Hong Kong, Chine.
Source: Authors’ computations using data from CEIC and Bloomberg.

Declining Capital Control Effectiveness

The two charts in Figure 9 are constructed using Equations (3) et (3)’ and
provide two CCE measures, one based on the CNH forward rate and the other
the NDF rate. Over the period 2010–2014, it appears that the PRC’s capital control
regime, in general, has remained effective despite the rapid RMB internationalization
process and the accelerated pace of capital account opening.

Examining the calculations more carefully, we observe that CCE has been
declining since September 2011, when the CNH market in Hong Kong, China began
to grow larger, became more liquid, and was better regulated. While this structural
break has yet to be tested statistically, the decline has been sizable. We ﬁnd that there
is no signiﬁcant difference between CCE1 (Hong Kong, China CNH investment
using the CNH forward rate) and CCE2 (onshore RMB [CNY] investment using the
NDF rate). Both measures declined from an average of 5.2% in the period before
Septembre 2011 to an average of 2.5% in the period after September 2011.6

6It may be noted that while the CCE measures saw sharp declines in 2012, they started to rise in the second
half of 2013, reaching as high as 5.9% in February 2014, before falling again back to the range of 0%–2% in the
second half of 2014. The rise of the CCE in the ﬁrst half of 2014 could be largely attributed to rising exchange rate
volatility as well as a sharp exchange rate depreciation engineered by the PRC’s monetary authority. Once the RMB
returned to a one-way bet for appreciation with little volatility in the second half of 2014, the CCE measures dropped
again.

64 ASIAN DEVELOPMENT REVIEW

Chiffre 9. Capital Control Effectiveness Measures
(%)

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CNH = renminbi market of Hong Kong, Chine.
Source: Authors’ computations using data from CEIC and Bloomberg.

This ﬁnding suggests that the de jure capital controls adopted by the PRC
authority may no longer be successful in preventing proﬁt-driven capital ﬂows
between Hong Kong, China and the PRC. The large and growing trade integration
of the PRC with Hong Kong, China may have contributed to the de facto ﬁnancial
integration of the PRC with Hong Kong, China over time, for a given degree of
de jure capital controls, through an expanded use of the current account for capital
account purposes such as trade mis-invoicing.

En effet, the RMB’s role as a trade settlement currency has facilitated de facto
capital ﬂows through trade transactions. Par exemple, the PRC’s export ﬁgure in Q1
2013 was abnormally large. The anomaly could be explained by the round-tripping
of goods between Shenzhen and Hong Kong, Chine, an international entrepˆot, comme
well as the over-invoicing of exports from Shenzhen.

These trade activities intend to seek ﬁnancial gains on large onshore and
offshore interest rate differentials (voir la figure 10), leading to large capital inﬂows,
which pose challenges to the PRC’s monetary policy while adding appreciation
pressures to the RMB exchange rate. The authorities have had to engage in peri-
odic crackdowns and sudden foreign exchange market interventions to slow such
activités.

Recent policy developments allowing ﬁrms located in the Shanghai Free
Trade Zone to experiment with further capital account liberalization by tapping into
offshore markets for funding will make the existing capital control measures even

TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 65

Chiffre 10. 3-Month SHIBOR, CNH HIBOR, and LIBOR
(%)

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HIBOR = Hong Kong, China Interbank Offered Rate (for offshore renminbi [CNH]), LIBOR = London Interbank
Offered Rate (for the US dollar), SHIBOR = Shanghai Interbank Offered Rate (for onshore renminbi [CNY]).
Source: Bloomberg.

less effective. If the current trend of de facto ﬁnancial market opening continues,
the PRC’s de jure capital controls will lose effectiveness faster than expected. Ce
will also mean that its capital account could be opened (de facto) much faster than
is currently expected by 2020.

V. Monetary Policy Challenges in the People’s Republic of China

The PRC authority is facing signiﬁcant challenges in its pursuit of monetary
politique. This section discusses the impact of incomplete interest rate reform, le
spread of shadow banking, and rising signs of monetary policy ineffectiveness.

UN.

Interest Rate Reform

The PRC has used ﬁnancial repression in the form of controlled interest
rates and credit allocation with an aim to support investment and economic growth.
Interest rate controls and other ﬁnancial repression measures have also led to the
underdevelopment of the ﬁnancial sector, inefﬁcient allocation of savings, excessive
investissement, and overcapacity in certain sectors of the economy.

Dans 1996, the PRC embarked on an interest rate reform by gradually liberalizing
interbank lending rates. Since then, various reform measures have been completed,
including the abolishment of the upper limit on interbank lending rates in 1996, le

66 ASIAN DEVELOPMENT REVIEW

Chiffre 11. Timeline of the People’s Republic of China’s Interest Rate Liberalization

CAD = Canadian dollar, CHF = Swiss franc, GBP = pound sterling, RMB = renminbi.
Source: People’s Bank of China.

liberalization of foreign currency lending rates in 2000, the removal of lending rate
ceilings for most ﬁnancial institutions in 2004, the launch of the Shanghai Interbank
Offered Rate (SHIBOR) dans 2007, the abolishment of the lending rate ﬂoor in 2013,
and the launch of interbank negotiable certiﬁcates of deposit (NCDs) dans 2013, comme
shown in Figure 11.

Among the recent policy changes, one of the most signiﬁcant was the removal
of the bank lending rate ﬂoor in July 2013, which allowed banks to freely set their
own lending rates. While this was a big step in interest rate reform, the actual impact
on the real economy has been quite limited. Before the reform, although commercial
banks had been allowed to offer a discount of up to 30% of the benchmark lending
rate, banks in practice had rarely done so.7 Only about 11% of loans were offered
below the benchmark rate through most of 2013. The average weighted 1-year
lending rate actually increased from 6.7% in March to 7.2% by the end of 2013.

After the removal of the lending rate ﬂoor, the monetary authority launched
a system for a prime loan rate (PLR) in October 2013. This is an indicative interest
rate at which commercial banks lend to their prime customers. The PLR is calculated
as the weighted average of a panel of banks’ lending rates that they charge their best
clients. This was also seen as a step toward further interest rate liberalization, as the
PLR could replace the current benchmark policy lending rate and be gradually used
as a new market-driven benchmark for lending rates.

7With the loan rate discount, the minimum loan rate banks could charge on 1-year loans became 4.2% quand

the 1-year benchmark loan rate was 6%.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 67

Chiffre 12. Deposit Interest Rate, Wealth Management Product Rate of Return, et
Consumer Price Index Inﬂation Rate (year-on-year)
(%)

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CPI = consumer price index, WMP = wealth management product.
Sources: CEIC, WIND.

The PRC’s deposit rate remains controlled. To add some ﬂexibility to the
controlled deposit ceiling rate, the authority has been taking a gradual approach to
liberalizing bank deposit rates. Commercial banks were allowed to charge a deposit
rate premium, increasing the rate by up to 10% from the benchmark deposit rate
dans 2012, and up to 30% in November 2014.8 En outre, commercial banks were
allowed to issue interbank NCDs from December 2013, which were priced with
reference to the SHIBOR. This reﬂects the actual supply and demand conditions
of the interbank market since interbank NCDs are tradable. This means that large
deposits are now priced according to market demand and supply. These policy
measures have made deposit rates less binding over time.

En outre, commercial banks have used off-balance-sheet activities to evade
the controlled deposit ceiling rate via wealth management products (WMPs). Close
à 45,000 WMPs were issued in 2013 amounting to CNY10 trillion, autour 10%
of the PRC’s total deposits. En moyenne, WMPs offer a rate of return of around
5.5%, which is much higher than traditional deposit rates (Chiffre 12). Financial
nouveautés, such as internet-based ﬁnancial products, have been competing with
the banking system for deposits, thus putting further pressure on banks to offer
higher deposit rates and more attractive WMP yields to compete for bank funding.

8With the deposit rate premium, the maximum deposit rate banks could offer on 1-year deposits became 3.9%

as the 1-year benchmark deposit rate was 3%.

68 ASIAN DEVELOPMENT REVIEW

Spread of Shadow Banking Activities

Shadow banking refers to credit intermediation involving entities or activities
by nonbanks, particularly ﬁnancial intermediation outside the regulated banking
système (IMF 2014). To apply this concept to the PRC, its shadow banking consists
of ﬁnancial institution business (off-balance-sheet assets by banks not subject to
regulation), trust products, and underground banking. We estimate that the shadow
banking activities in the PRC could be at least CNY30 trillion, equivalent to 52%
of GDP in 2013 ou 19% of total bank assets in the PRC.

Commercial banks are subject to tight regulations, such as a limit on the
deposit rate ceiling, le 75% loan-to-deposit ratio requirement, and the capital
adequacy requirement. Given the rising demand for credit, commercial banks in
the PRC began to evade such tight regulations through various measures. These
include: (je) ﬁnancial institution business, c'est à dire., channeling large amounts of deposits
to other ﬁnancial institutions (both banks and nonbank ﬁnancial institutions) lequel,
unlike corporate lending business, is not subject to the 75% loan-to-deposit ratio
requirement or the high capital requirement; (ii) trust products, c'est à dire., collecting quasi-
deposits (trust funds, WMPs, etc.) from the public to ﬁnance off-balance-sheet
activités;9 et (iii) underground banking, c'est à dire., undertaking informal banking in the
form of directly intermediating private funds among enterprises and individuals,
which is not subject to the normal regulations of the formal banking system.

Internet ﬁnancial products and money market funds have also developed
rapidly to evade formal banking regulations. Yu’e Bao, the biggest internet ﬁnancial
product, is an investment product offered by Alipay, users of which can put their
money into the product with no minimum amount requirement and withdraw their
cash anytime, akin to an open-end money market fund. Money market funds put
plus que 90% of their money as ﬁnancial institution deposits in commercial banks.
Financial institution deposit rates are negotiable, and not subject to the banks’ reserve
requirements.

The shadow banking system has posed regulatory challenges to the PRC’s ﬁ-
nancial stability. D'abord, its rapid development could force the regulated banking sector
to expand its off-balance-sheet activities in order to compete with nonbank ﬁnancial
institutions for deposits, internet ﬁnancial products, etc.. Large off-balance activities
could make commercial bank deposits more short-term, thus exacerbating maturity
mismatches and destabilizing the overall banking system. Deuxième, certain ﬁnancial
institutions are not subject to the same prudential regulations as deposit-taking in-
institutions. Par conséquent, they could increase their ﬁnancial leverage, magnifying both

9With regard to quasi-deposits, in addition to borrowing among themselves, banks normally issue WMPs to
ﬁnance off-balance-sheet products. Dans l'ensemble, ﬁxed-rate WMPs provide much higher yields than regulated deposits.
Typiquement, commercial banks set up a “capital pool” which consists of bonds, trust products, loan-like claims, et
interbank loans. Based on this pool, commercial banks issue short-tenor WMPs to match long-term assets, much like
what an asset management company (within a bank) does.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 69

proﬁts during a boom year and losses during a downturn. Troisième, the formal banking
sector has the incentive to provide loans to nonbank ﬁnancial institutions because
such loans are subject to only a quarter of the regulatory capital requirement. Ce
would increase ﬁnancial links between banks and nonbank ﬁnancial institutions.
Ainsi, the expansion of shadow banking could pose ﬁnancial risks to the formal
banking sector because of its rising interconnectedness with potentially unstable
shadow banking activities.

Rising Signs of Policy Ineffectiveness

Since the eruption of the GFC, the PRC’s monetary authority has adjusted
its monetary policy stance in response to changing prospects of GDP growth and
consumer price index (CPI) inﬂation. Facing the GFC in the ﬁnal quarter of 2008,
the monetary authority quickly loosened policy by lowering the benchmark deposit
and loan rates as well as the reserve requirement ratio. Together with its large ﬁscal
stimulus package, monetary policy easing seemed to have had a stabilizing impact.
With the recovery of the economy and rising CPI inﬂation during 2010–2011, le
monetary authority shifted its monetary stance from ﬁghting against the crisis to
combating inﬂation by raising the benchmark deposit and loan rates and the reserve
requirement ratio. The reserve requirement ratio was raised 12 times, tandis que le
interest rate was adjusted 5 times during this period. When the European ﬁnancial
crisis deepened in the second half of 2011 et 2012, the monetary authority gradually
eased its policy.

From “Cash Crunches” to “Quantity Swings”

From May 2012, the monetary authority seemed to have avoided the use of
its traditional policy toolkit, such as adjusting the reserve requirement ratio and the
benchmark interest rate to conduct monetary policy. Plutôt, it began to rely on open
market operations intensively via repos and reverse repos to inject and withdraw
liquidity from the banking system. Par conséquent, large swings of interest rates and
loan quantities were observed during June–July 2013.

In mid-June 2013, a sudden repricing of counter-party risk brought about a
surge in the short-term interest rate and thereafter, signiﬁcant volatility in the money
marché. The 7-day repo rate, a reliable indicator measuring market liquidity condi-
tion, surged to almost 12% from less than 4% in a day, with the high rate lasting for
2 weeks. The market panic created “cash crunches” in the PRC’s interbank markets.
The authority ﬁnally injected liquidity into the banking system 2 weeks later via the
short-term lending facility (SLF), which eased market liquidity conditions in July
2013. The 7-day repos remained quite volatile until January 2014 after the authority
engaged in “double interventions,” i.e., interventions in both the foreign exchange

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70 ASIAN DEVELOPMENT REVIEW

and money markets via unsterilized interventions, leading to RMB depreciation and
money market rate declines.

Since the June 2013 “cash crunches,” the authority appears to have become
more proactive in managing money market liquidity conditions. Cependant, the quan-
tity of loans provided has become less stable than before. The PRC’s new RMB loans
were only CNY385 billion in July 2014, much lower than the market consensus of
CNY780 billion. For the same month, the PRC’s aggregate ﬁnancing, including new
loans, also surprised the markets on the downside. This was also the lowest level
since the September 2008 Lehman collapse.10

Such large swings, in terms of money market rates or loan quantities, pourrait
create signiﬁcant shocks to the ﬁnancial system and raise risk premiums sharply,
thereby causing large swings in real GDP growth.

Changing Monetary Policy Environments

While the monetary authority has not adjusted its policy stance in a signiﬁcant
way since July 2012, the global ﬁnancial environment and domestic economic con-
ditions have changed. Domestically, the PRC’s growth has moderated from around
9% à 7.5%. As the output gap narrowed sharply, the risk of deﬂation has risen. Le
PRC’s producer price index (PPI) has experienced persistent deﬂation since March
2012. Externally, the US Federal Reserve System (Fed) expanded asset purchases
quantitative easing (QE), ended QE, and is now heading toward monetary policy
normalization; the European Central Bank (ECB) cut interest rates thrice; et le
Bank of Japan began an aggressive quantitative and qualitative easing program under
the banner of Abenomics.

Some key central banks in Asia and Oceania (the Reserve Bank of Australia,
the Bank of Korea, and the Bank of Thailand) have cut their own policy rates in order
to reduce interest rate differentials in an attempt to prevent currency overvaluation
for competitiveness reasons. The PRC’s authority, on the other hand, refrained from
using its traditional policy toolkits, such as changes in the benchmark interest rate and
the reserve requirement ratio, because of the need to nurture a policy target interest
rate. Plutôt, it has relied on open market operations to manage liquidity conditions.
As shown in the previous section, the large interest rate differential between onshore
and offshore markets with little exchange rate volatility led to large capital inﬂows
(Chiffre 7). Dans 2013 alone, net capital inﬂows into the PRC were close to $500 milliard. For the ﬁrst 2 quarters of 2014, net capital inﬂow was more than $200
milliard.

10Undiscounted bank bills declined by CNY416 billion in July 2014, following a CNY144 billion increase in
the previous month, largely owing to the crackdown on commodity ﬁnancing following the Qingdao port fraud case.
Trust and entrusted loan growth also softened, indicating that shadow banking activities have slowed down sharply,
with further negative implications for the property sector.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 71

Chiffre 13. Monetary Base and Net Foreign Assets Purchased by the People’s Bank of China
(CNY trillion)

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CNY = renminbi, PBoC = People’s Bank of China.
Source: WIND.

While the PRC has taken irreversible steps to progressively open the capital
account, its exchange rate policy has remained rigid, steadily appreciating against
the US dollar. This condition has drawn large capital inﬂows on sizable interest
rate differentials and expectations of RMB appreciation, thus potentially limiting
monetary policy effectiveness and autonomy.

Rising Signs of Asset Price Bubbles

Corporate loans as a percentage of the PRC’s aggregate ﬁnancing have contin-
ued to decline and PPI inﬂation has remained negative for nearly 2 années, suggérant
that demand for credit from the real sector has remained weak. Entre-temps, banks’
reserve money has risen on large capital inﬂows that have led to a rapid accumulation
of foreign exchange reserves (Chiffre 13). To meet their proﬁt growth target, com-
mercial banks have created new ﬁnancial vehicles to expand their balance sheets for
ﬁnancial activities. Such activities have resulted in a surge in money supply without
signiﬁcant ﬁnancial intermediation in the real sector.

Money has bypassed the real sector and has been channelled to high-return,
high-risk sectors such as the property market. Dans 2013, the PRC’s property prices
soared again, led by ﬁrst-tier cities. While the stock market has remained depressed,
other asset markets, such as for art collections and physical gold investments, have
become buoyant, reﬂecting a simmering asset price bubble.

72 ASIAN DEVELOPMENT REVIEW

VI. Empirical Evidence on Diminishing Monetary Policy Autonomy in the

People’s Republic of China

The previous section considered the various challenges facing the PRC’s
monetary policy. Much documented data suggest that monetary policy effectiveness
has declined in the PRC and its policy autonomy has eroded with rapid RMB inter-
nationalization and a limited, yet increasingly open, capital account. The problem
seems to stem from the fact that the PRC’s capital controls have become less ef-
fective over time, while its exchange rate regime has remained rigid despite recent
efforts to make it more ﬂexible. Dans cette section, we examine the PRC’s monetary
policy effectiveness and autonomy using a set of econometric analyses.

UN. Monetary Policy Framework of the People’s Republic of China

The objective of the PRC’s monetary policy is to maintain price stability so as
to promote economic growth under the mandate of the law of the People’s Bank of
Chine (PBoC). To achieve these dual policy objectives, the monetary authority may
use various policy instruments such as reserve requirement ratios, benchmark in-
terest rates, re-discounting, central bank lending, open market operations, et autre
administrative or window guidance measures. When pursuing policy mandates, le
monetary authority encounters some practical constraints. Given the less devel-
oped ﬁnancial markets, it also has the responsibility to promote ﬁnancial market
liberalization and reforms.

It may be argued that the PRC’s authority applies both quantity and price
instruments to conduct monetary policy while being constrained by the less efﬁcient
ﬁnancial system. Laurens and Maino (2007) describe the process of setting the
monetary policy framework in the PRC in the following way: the monetary authority
ﬁrst sets numerical targets for the quantity of money supply and credit growth as its
intermediate quantity targets at the beginning of each year, and then monitors these
intermediate targets closely during the course of the year and ﬁne-tunes deviations
from these targets by a number of policy instruments such as reserve requirements,
open market operations, policy interest rates, and window guidance measures. Liu
and Zhang (2010) argued that the use of short-term interest rates alone would be
inadequate in the PRC, due to the weak interest-rate transmission channel, partly
reﬂecting the dominance of state-owned commercial banks with a penchant to lend
to state-owned enterprises (SOEs). They also demonstrated that neither a standard
Taylor rule (Taylor 1993) nor a quantity of money rule in the spirit of McCallum
(1988, 2000) would track the PRC’s policy rate or M2 growth well. Kwan (2013)
estimated the Taylor rule for the PRC during the post-Lehman period and found that
the interest rate policy did not play a role in stabilizing the PRC’s macro economy.
On the other hand, Fan, Yu, and Zhang (2011) found that the McCallum rule was
able to explain the movement of real money supply well.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 73

Dans cette section, we attempt to identify the PRC’s monetary policy rule and
examine whether the rule that used to work well under the rigid capital control system
has become loose and increasingly constrained by its own exchange rate regime
and/or external monetary developments.11 If we ﬁnd that a major monetary policy
instrument, such as the policy interest rate and growth of monetary aggregates, était
used successfully to achieve domestic policy objectives (price stability and economic
growth) without being signiﬁcantly constrained by foreign monetary policy changes
or its own exchange rate regime, then we can conclude that the PRC authority retains
monetary policy autonomy. And if the policy instrument is inﬂuenced by the foreign
interest rate (in the case of the policy interest rate as a policy instrument) or by
the pace of foreign exchange reserve accumulation (in the case of the growth of
monetary aggregates as a policy instrument) rather than by the consideration of
domestic economic stabilization, we can conclude that the PRC authority does not
have policy autonomy.

Empirical Models for Testing Monetary Policy Autonomy

Short-Term Interest Rate as a Policy Instrument

D'abord, following Ito and Kawai (2014), we propose using the following equa-

tions to test the PRC’s monetary policy autonomy:

+ ut

+ φ1y ˜yt + φ1π ˜πt + wt ,

it = α0 + β0i ∗
t
it = φ0 + φ0y ˜yt + φ0π ˜πt + vt
it = α1 + β1i ∗
where it is the policy interest rate the PRC authority sets and i ∗
is the US dollar
t
London Interbank Offered Rate (LIBOR).12 In the Taylor rule of Equation (5), ˜yt is
the growth rate of industrial production and ˜πt is the inﬂation gap, c'est à dire., the difference
between the actual and target inﬂation rates.13 Equation (6) is a combination of
Equations (4) et (5).

(6)

(5)

(4)

11We do this despite the claim made by the PBoC that the monetary authority has multiple policy targets (tel
as employment, price stability, balance of payments, and promoting ﬁnancial reform) and that neither price-based
(interest rate) rule nor quantity-based (money supply) rule is suitable to the PRC.

12For i ∗

t , Ito and Kawai (2014) use the synthetic foreign interest rate from the point of view of a country,
which is the weighted average of the foreign interest rates, with the weights being estimated from the Frankel and
Wei (1994) model. Given that the RMB exchange rate has assigned a weight of over 94% to the US dollar, we use the
US dollar LIBOR as the foreign interest rate.

13The Taylor equation typically includes the GDP gap, c'est à dire., the difference between actual GDP and potential
GDP as well as the inﬂation rate gap on the right-hand side of Equation (5). One might argue that the right-hand
side of the equation should also include the exchange rate gap, in the case of the PRC, as the country has been
stabilizing the exchange rate. We simplify our analysis by ignoring this possibility. As GDP data are available at most
on a quarterly basis, its use would limit the number of observations in our sample. Ainsi, we have decided to use the
monthly growth rate of industrial production in estimating Equations (5) et (6) as this would allow us to have a
larger number of observations.

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74 ASIAN DEVELOPMENT REVIEW

Ito and Kawai (2014) then use the overall estimation performance of Equa-
tion (4), (5), et (6) to judge the degree of monetary policy autonomy. Si le
PRC’s monetary policy closely follows the monetary policy of the base country, le
coefﬁcient β0 is signiﬁcantly positive and close to unity, and the goodness of ﬁt
of Equation (4) is high. Dans ce cas, the PRC has no monetary policy autonomy.
If the PRC authority follows the Taylor rule to achieve domestic objectives, alors
φ0y ≥ 0, φ0π ≥ 0, and the goodness of ﬁt of Equation (5) is high. Dans ce cas, le
PRC authority has full monetary policy autonomy. When the authority follows both
the foreign interest rate and domestic objectives, then β1 ≥ 0, φ1y ≥ 0, φ1π ≥ 0,
and the goodness of ﬁt of Equation (6) is high. Dans ce cas, the PRC authority has
quelques, but not full, monetary policy autonomy. We need to pay attention to the signs
and statistical signiﬁcance of the estimated coefﬁcients as well as the size of the
adjusted R-squared in judging the degree of monetary policy autonomy.

2. Monetary Aggregates as a Policy Instrument

We next consider the possibility that monetary aggregates, ranging from
narrow to broad deﬁnitions of the money supply (M0, M1, and M2), are used as
policy tools.14 For this purpose, we consider the following three equations:

(cid:6)M/Mt = μ0 + γ0(cid:6)FXR/FXRt + εt

(cid:6)M/Mt = θ0 + θ0y ˜yt + θ0π ˜πt + νt

(cid:6)M/Mt = μ1 + γ1(cid:6)FXR/FXRt + θ1y ˜yt + θ1π ˜πt + ωt .

(7)

(8)

(9)

Équation (7) states that when an economy’s exchange rate regime is rigid
and prevents the exchange rate from changing in the face of balance of payments
imbalances, the monetary authority will intervene in the currency market to accu-
mulate or reduce foreign exchange reserves. Unless fully sterilized, the effect of a
payment imbalance will be to change the economy’s monetary aggregates ((cid:6)M/M),
so γ0 ≥ 0. If γ0 is unity, the monetary authority has no policy autonomy.

In contrast, the monetary authority may follow a rule similar to that of
McCallum (1988, 2000) by setting the monetary aggregates to achieve its objectives
of price stability and economic growth.15 The McCallum-like rule, as postulated in

14The deﬁnitions of M0, M1, and M2 are as follows. M0 is currency in circulation. M1 is the sum of M0
and demand deposits. M2 is the sum of M1, household savings deposits, and corporate time deposits. En outre,
M2 began to include securities company customer margin deposits in June 2001, RMB deposits of foreign-funded
and joint ﬁnancial institutions in 2002, and deposits of the Housing Provident Fund Management Center and deposits
of non-depository ﬁnancial institutions in depository ﬁnancial institutions in October 2011. It is noted that M0 is a
narrower concept of money supply than the monetary base.

15In his formulation, McCallum (1988, 2000) attempts to explain the rate of change in the monetary aggregate
variable in terms of the growth rate of nominal GDP. Our formulation is a variant of his original formulation and,
thus, we call it a McCallum-like rule.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 75

Équation (8), sets the quantity of money in reaction to industrial production growth
and the inﬂation rate gap. The equation states that when the actual inﬂation rate is
higher than the target inﬂation rate, and when industrial output expands, the money
supply should decrease to contain the overheating or inﬂationary pressure in the
economy, and vice versa. Ainsi, we expect θ0y ≤ 0 and θ0π ≤ 0. Équation (9) is a
hybrid of Equations (7) et (8).

As in the case of the Taylor rule, we consider the signs of the estimated
coefﬁcients and the size of the adjusted R-squared of Equations (7), (8), et (9)
to judge the extent of monetary policy autonomy. If the monetary authority is
constrained by its choice of ﬁxed exchange rate regime and thus has no policy
autonomy, then γ0 ≥ 0 and the goodness of ﬁt of Equation (7) is high. If the monetary
authority follows the McCallum-like rule to achieve domestic objectives and thus
has full monetary policy autonomy, then θ0y ≤ 0, θ0π ≤ 0, and the goodness of ﬁt
of Equation (8) is high. When the monetary authority is partially constrained by
reserve accumulation while partially trying to achieve domestic objectives, alors
γ1 ≥ 0, θ1y ≤ 0, θ1π ≤ 0, and the goodness of ﬁt of Equation (9) is high.

In what follows, we ﬁrst test the PRC’s monetary policy autonomy by using
Equations (4), (5), et (6) under the assumption that the short-term interest rate is a
policy instrument. If we ﬁnd evidence that the PRC’s monetary policy followed the
Taylor rule in earlier years, but not as closely in later years, we may conclude that
monetary policy autonomy has diminished. Suivant, we test monetary policy auton-
omy by examining Equations (7), (8), et (9) under the assumption that monetary
aggregates are the policy instruments. De la même manière, if we ﬁnd that the PRC authority
followed the McCallum-like rule in the past, but not as closely as before in more
recent years, we can conclude that the authority has lost at least partial monetary
policy autonomy.

As the speciﬁcation of Equations (7) et (9) may be subject to simultaneity
problems, we use the generalized method of moments (GMM) procedure to obtain
consistent estimators for the model parameters. Lagged values of foreign assets
purchased by the PBoC and the trade balance are used as instrumental variables
when carrying out GMM estimations.

Testing Monetary Policy Autonomy with the Interest Rate
as a Policy Instrument

We ﬁrst examine whether the PRC’s monetary policy autonomy has eroded
under the assumption that its primary policy instrument is the short-term interest
rate. This involves the estimation of Equations (4), (5), et (6). We use monthly
averages of the 7-day repo rate and 7-day China Interbank Offered Rate (CHIBOR)
as the PRC’s policy interest rates. See Appendix for data used in the empirical
analysis and their sources.

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76 ASIAN DEVELOPMENT REVIEW

Tableau 2. Estimation of the Short-Term Interest Rate of the People’s Republic of China
Using the Foreign Interest Rate

(cid:2)i t
(7-day repo rate)

(cid:2)i t
(7-day CHIBOR)

Sample period

(cid:6)i ∗
t

Constant

Non. of observations
F-statistic

Oct 2004– Oct 2004–
Dec 2008
Oct 2014
0.141∗∗
−0.089
(0.257)
(0.108)
0.165
0.175
(0.204)
(0.168)
51
1.315
(0.257)
0.006

2.629
(0.108)
0.013

121

Jan 2009–
Oct 2014
0.841∗∗∗
(0.000)
0.541
(0.004)
70
21.084∗∗∗
(0.0000)
0.225

Sep 2001–
Sep 2014
0.146∗∗∗
(0.018)
0.172∗∗
(0.068)

157

5.731∗∗∗
(0.018)
0.029

Sep 2001–
Dec 2008
0.013
(0.741)
0.077
(0.278)
88
0.110
(0.741)
−0.010

Jan 2009–
Sep 2014
0.886∗∗∗
(0.000)
0.583∗∗∗
(0.003)
69
21.863∗∗∗
(0.000)
0.235

Adjusted R-squared
CHIBOR = China Interbank Offered Rate.
Remarques: The values in parentheses are p-values. ∗∗ = 5% level of statistical signiﬁcance, ∗∗∗ = 1% level of statistical
signiﬁcance.
Source: Authors’ computations.

Impact of the Foreign Interest Rate

In Equation (4), i and i∗ refer to the short-term rates of 7-day repo or 7-day
CHIBOR and the same maturity LIBOR, respectivement. In estimation, we take ﬁrst
differences in interest rates (c'est à dire., 1-month changes in rates) in order to avoid the
noise or volatility that may cause the problem of nonstationarity, and thus affect
both the coefﬁcient estimates and adjusted R-squared.
We conducted unit root tests on (cid:6)it and (cid:6)i ∗

t , with both test statistics indicating
stationary. We also tested for structural breaks in our sample. Chow’s multiple
breakpoint test identiﬁed several structural breaks in the years 2008, 2011, 2012,
et 2013 on unexpected shifts in the time series, for which the F-statistics are larger
than the critical values. Dummy variables were added to the ﬁrst difference version
of Equation (4) to take into account that major events may have caused structural
breaks and affected the interest rate policy choices.16 However, the results have not
indicated much difference.

The regression results of the ﬁrst difference version of Equation (4) for the
two short-term interest rates (7-day repo and 7-day CHIBOR) are summarized in
Tableau 2. We separate the sample (October 2004–October 2014 in the case of the
7-day repo, and September 2001–September 2014 in the case of the 7-day CHIBOR)
into two subperiods— that is, the period before the GFC and the period after—to
consider the signiﬁcant changes in the global ﬁnancial environment.

The results indicate that in the case of the 7-day repo for the full sample,
the US dollar LIBOR rate appears to have a positive and statistically signiﬁcant

16The US Fed’s quantitative easing takes the value of 1 during the period November 2008–September 2014

as QE3 ended in October 2014.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 77

inﬂuence on the PRC’s short-term interest rate. Cependant, the explanatory power
measured by the adjusted R-squared is low at 0.013. For the pre-GFC subsam-
ple period (October 2004–December 2008), the LIBOR rate does not have much
inﬂuence on the PRC interest rate, as the coefﬁcient of (cid:6)i ∗ is negative though
statistically insigniﬁcant. The adjusted R-squared is low at 0.006. For the most re-
cent subsample period (January 2009–October 2014), the PRC’s short-term interest
rate appears to be signiﬁcantly inﬂuenced by the LIBOR rate. The coefﬁcient is
as high as 0.84, suggesting a 1 percentage point change in LIBOR could cause a
0.84 percentage point change in the PRC’s interest rate. Entre-temps, the adjusted
R-squared is 0.225, much higher than the pre-GFC sample result. This suggests
that the PRC’s short-term interest rate is highly inﬂuenced by LIBOR rates in the
most recent period, indicating less autonomous monetary policy in the post-GFC
period.

The estimation results for the 7-day SHIBOR are generally similar to those

of the 7-day repo rate.

Taylor Rule Estimation

Suivant, we estimate a Taylor rule as speciﬁed in Equation (5), which describes
the response of the policy interest rate to changes in industrial production and the
inﬂation rate gap. The rule stipulates to raise the interest rate (introduce tighter
monetary policy) when industrial production grows or the actual inﬂation rate is
above the target rate, and vice versa. The coefﬁcient estimates of φ0y and φ0π are
expected to be positive.

D'abord, stationarity and stability tests were conducted. The time series are
generally stable but the stability test identiﬁed several structural breaks among
the variables. Year dummies are included in Equation (5) to control for structural
changes in the estimating equation.

The regression results are summarized in Table 3 with the 7-day repo rate
and the 7-day CHIBOR used as the policy interest rates. The sample period is again
divided into two subsample periods, c'est à dire., before and after the GFC.

Looking at the 7-day repo rate in the pre-GFC period (October 2004–
Décembre 2008), the PRC’s monetary policy appears to have followed the Tay-
lor rule, with the estimated coefﬁcients of both industrial production growth and the
inﬂation gap being statistically signiﬁcant and positive. This suggests that the PRC’s
monetary policy took domestic economic conditions into consideration. The result
is consistent with the results reported in Table 2 where the PRC’s policy rate was
not affected by the US LIBOR rate in the pre-GFC period.

In the post-GFC period, the estimated coefﬁcient of industrial production
growth has become statistically insigniﬁcant, though the inﬂation rate remains sta-
tistically signiﬁcant and positive. This means that the PRC’s monetary policy has
responded to the inﬂation rate gap but not to real economic activity. It appears that

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78 ASIAN DEVELOPMENT REVIEW

Tableau 3. Estimation of the Taylor Rule

(cid:2)i t
(7-day repo)

(cid:2)i t
(7-day CHIBOR)

Sample period

˜yt

˜πt

Constant

Non. of observations
F-statistic

Oct 2004– Oct 2004–
Dec 2008
Sep 2014
0.091∗∗∗
0.068∗∗∗
(0.043)
(0.032)
0.164∗∗∗
0.409∗∗∗
(0.020)
(0.000)
0.191∗∗
0.134
(0.305)
(0.056)
51
3.652∗∗∗
(0.033)
0.096

120
28.149∗∗∗
(0.000)
0.313

Jan 2009–
Sep 2014
0.036
(0.324)
0.663∗∗∗
(0.000)
0.417∗∗∗
(0.001)
69
46.501∗∗∗
(0.000)
0.572

Sep 2001–
Sep 2014
0.056∗∗∗
(0.020)
0.385∗∗∗
(0.000)
0.134∗∗
(0.081)

157
36.899∗∗∗
(0.000)
0.315

Sep 2001–
Dec 2008
0.044∗∗∗
(0.038)
0.157∗∗∗
(0.000)
0.050
(0.436)
88
8.098∗∗∗
(0.001)
0.140

Jan 2009–
Sep 2014
0.038
(0.319)
0.683∗∗∗
(0.000)
0.420∗∗∗
(0.002)
69
44.976∗∗∗
(0.000)
0.564

the PRC’s monetary authority followed the Taylor rule in the pre-GFC period, alors que
only partially following the Taylor rule in the post-GFC period.17

The results for the CHIBOR are largely the same as those for the 7-day repo

rate.

Hybrid Taylor Rule Estimation

We then explore the sensitivity of the short-term policy interest rate to the
foreign interest rate as well as the domestic economic conditions. The regression
results of Equation (6) are summarized in Table 4. In both the pre- and post-GFC
period, the PRC’s short-term interest rate did not respond to the US interest rate
in a statistically signiﬁcant way. In the pre-GFC period, the PRC’s interest rate did
respond positively to domestic output growth and the inﬂation gap, particularly when
the 7-day CHIBOR was the policy interest rate. This further supports the view that
the PRC’s monetary policy was autonomous prior to the GFC.

In contrast, in the post-GFC period, the PRC’s short-term interest rate contin-
ued to have positive responses to the inﬂation rate gap, but did not have a signiﬁcantly
positive response to domestic output growth. The results for the CHIBOR clearly
indicate that there is less support for the Taylor rule in the post-GFC period than in
the pre-GFC period.

17Even though the short-term interest rate has signiﬁcantly positive responses to both output growth and the
inﬂation rate gap in the pre-GFC period, it should be noted that the estimated coefﬁcient on the inﬂation rate gap
is only 0.16. This suggests a weak response of monetary policy. The reason is that when the inﬂation rate rises by
1%, the short-term interest rate rises by only 0.16%, which is not sufﬁcient to raise the real interest rate and possibly
contain inﬂation.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 79

Tableau 4. Estimation of the Hybrid Taylor Rule

(cid:2)i t
(7-day repo)

(cid:2)i t
(7-day CHIBOR)

Dec 2004– Dec 2004–
Dec 2008
Sep 2014

0.170∗∗∗ −0.094
(0.401)
(0.019)
0.106∗∗∗
0.062∗∗∗
(0.030)
(0.047)
0.415∗∗∗
0.118
(0.189)
(0.000)
0.210∗∗∗
0.194
(0.196)
(0.033)
51
2.660
(0.059)
0.091

120
21.395
(0.000)
0.340

Jan 2009–
Sep 2014
−0.225
(0.284)
0.027
(0.465)
0.742∗∗∗
(0.000)
0.346∗∗∗
(0.016)
69
31.468
(0.0098)
0.573

Sep 2001–
Sep 2014
0.123∗∗∗
(0.017)
0.050∗∗∗
(0.037)
0.378∗∗∗
(0.000)
0.181∗∗∗
(0.021)

157
27.326
(0.000)
0.336

Sep 2001–
Dec 2008
0.033
(0.370)
0.040∗∗
(0.061)
0.163∗∗∗
(0.043)
0.059
(0.369)
88
5.657
(0.001)
0.138

Jan 2009–
Sep 2014
−0.221
(0.317)
0.030
(0.45)
0.760∗∗∗
(0.000)
0.350∗∗∗
(0.019)
69
30.332
(0.000)
0.564

Sample period

(cid:6)i ∗
t

˜yt

˜πt

Constant

Non. of observations
F-statistic

The results for the 7-day repo rate are less clear, but do not suggest ris-
ing monetary policy autonomy in the post-GFC period. The overall results for
Équation (6) again support the view that the PRC’s monetary policy was more
autonomous in the pre-GFC period than in the post-GFC period.

To summarize, the PRC’s short-term interest rate in the pre-GFC period
responded positively to both output growth and the inﬂation rate gap, without being
constrained by the foreign interest rate. This suggests that the PRC’s monetary
policy was relatively autonomous. In contrast, in the post-GFC period, the PRC’s
interest rate responded positively only to the inﬂation rate gap. This suggests eroding
monetary policy autonomy in the post-GFC period.

Testing Policy Autonomy with Monetary Aggregates as a Policy Instrument

We next examine whether the PRC’s monetary policy autonomy has been
reduced under the assumption that its primary policy instrument is one of the
monetary aggregates, such as M0, M1, and M2. This involves the estimation of
Equations (7), (8), et (9).

Impact of Foreign Exchange Reserve Accumulation

Équation (7) tests whether changes in the monetary aggregate variable are
inﬂuenced by changes in foreign assets purchased by the monetary authority. Le
coefﬁcient on the change in foreign assets purchased is expected to be positive

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80 ASIAN DEVELOPMENT REVIEW

and close to unity if the PRC authority adopts a rigid exchange rate regime and,
as a result, gives up monetary policy autonomy. The monetary aggregate variable
represents year-on-year growth of M0, M1, or M2.18 As changes in the monetary
aggregate variable can also cause changes in foreign exchange reserves, Équation
(7) potentially involves the problem of simultaneity and could result in inconsistent
estimates. To address this problem, the GMM procedure has been employed.

The regression results of Equation (7) are summarized in Table 5. The esti-
mated coefﬁcient on (cid:6)FXR/FXRt is signiﬁcantly negative in the pre-GFC period,
while that for the post-GFC period is signiﬁcantly positive regardless of the deﬁ-
nition of monetary aggregates. The size of the adjusted R-squared is larger in the
post-GFC period than in the pre-GFC crisis. These results suggest that the PRC’s
monetary policy autonomy was reduced in the post-GFC period.

2. McCallum-like Rule Estimation

We next examine whether the McCallum-like rule explains monetary policy
in the PRC. The McCallum-like rule states that the quantity of money set by the
authority reacts negatively to changes in industrial production and the inﬂation rate
gap. Équation (8) postulates that when output grows and the inﬂation rate is higher
than the target rate, the money supply should decline, and vice versa.

Regression results are summarized in Table 6. The results indicate that the
PRC’s monetary policy does not appear to have followed the McCallum-like rule
in the case of M0 or M1, but may have followed the rule in the case of M2 in
the post-GFC period. D'abord, M0 had a signiﬁcantly negative response to output
growth and a signiﬁcantly positive response to the inﬂation rate gap (in contrast
to the prediction of the McCallum-like rule) in the pre-GFC period, while it did
not respond signiﬁcantly to domestic economic conditions in the post-GFC period.
Deuxième, M1 had a signiﬁcantly positive response to output growth (in contrast to the
prediction of the McCallum-like rule) and a statistically insigniﬁcant response to the
inﬂation rate gap during the pre-GFC period, while it did not respond to domestic
economic conditions in the post-GFC period.

Enfin, in the case of M2, the McCallum-like rule seems to be observed in the
post-GFC period but not in the pre-GFC period. C'est, M2 responded positively to
output growth (in contrast to the prediction) and negatively to the inﬂation rate gap
in the pre-GFC period, while it responded negatively to both output growth and the
inﬂation rate gap (as expected by the McCallum-like rule) in the post-GFC period.
Ainsi, we have mixed results on monetary policy autonomy in the post-GFC period.
We observe no evidence of policy autonomy based on M0 or M1, but we observe
some evidence of rising policy autonomy based on M2.

18We use year-on-year growth to avoid the problem of nonstationarity as monetary aggregate variables and

foreign exchange reserves are usually nonstationary.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 81

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 83

Hybrid McCallum-like Rule Estimation

The estimation results of Equation (9) suggest that the PRC’s monetary ag-
gregate variable did not respond to domestic economic conditions, but did respond
positively and signiﬁcantly to foreign assets purchased in the post-GFC period
(Tableau 7). D'abord, M0 responded negatively to foreign exchange reserve accumulation
and negatively to output growth in the pre-GFC period, while it responded positively
to foreign exchange reserves and the inﬂation rate gap (in contrast to the prediction
of the McCallum-like rule) in the post-GFC period. Deuxième, the results for M1 and
M2 are similar. C'est, M1 and M2 responded negatively to foreign exchange re-
serves and positively to output growth (in contrast to the prediction of the rule) dans le
pre-GFC period. They responded positively to foreign exchange reserves and output
growth (in contrast to the prediction of the rule), but negatively to the inﬂation rate
gap (as expected by the rule) in the post-GFC period.

Ainsi, the McCallum-like rule does not explain the M0 and M1 behavior
in the pre-GFC or post-GFC period. The McCallum-like rule explains the M2
behavior to some extent in the post-GFC period. Cependant, there is strong evidence
that the PRC’s monetary policy in the post-GFC period is positively affected by
foreign exchange reserves, whether M0, M1, or M2 is used. Ainsi, there is not much
evidence of increasing monetary policy autonomy in the post-GFC period relative
to the pre-GFC period, even when M2 is used.

Empirical results presented so far do not clearly show that the PRC’s monetary
policy fully follows either the Taylor rule or the McCallum-like rule. The estimation
results of Equations (5) et (6) summarized in Tables 3 et 4 suggest that the
PRC’s monetary policy likely followed the Taylor rule in the pre-GFC period, mais
not in the post-GFC period. The estimation results of Equation (8) as reported in
Tableau 6 suggest the possibility that the PRC’s monetary policy, using M2, followed
the McCallum-like rule in the post-GFC period, but this is not the case when M0
or M1 is used. PRC’s money supply, including M2, also responded positively and
signiﬁcantly to changes in foreign assets purchased during the post-GFC period.
In this sense, the PRC’s monetary policy autonomy seems to have increasingly
eroded over time. Our interpretation of this is that the diminishing monetary policy
autonomy has been due to the rising ineffectiveness of the PRC’s de jure capital
control system—in the face of gradual capital account liberalization and RMB
internationalization—and a highly managed exchange rate regime that prevents
sufﬁcient exchange rate ﬂexibility.

VII. Policy Implications

The above analysis suggests that the PRC’s monetary policy has become
less effective and autonomous over time with the progress on capital account

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84 ASIAN DEVELOPMENT REVIEW

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 85

liberalization and the spread of shadow banking. Donc, the authorities should
review their current monetary policy framework, ﬁx the fundamental root issues,
and establish supporting infrastructure to improve the monetary policy transmission
mechanism and the ﬁnancial stability framework. The PRC should also accelerate
interest rate liberalization. Par exemple, the authorities could set up a deposit insur-
ance system, introduce a short-term policy interest rate, and develop a deep, liquid
bond market to help form stable yield curves.

UN.

Greater Exchange Rate Flexibility

To cope with the trilemma constraint, the ﬁrst priority is to address the
rigid exchange rate system. C'est, the PRC must adopt a more ﬂexible exchange
rate regime in order to regain policy autonomy. At this stage, the PRC’s capital
control regime is unevenly enforced. Capital inﬂows have had limited controls,
while capital outﬂows are still under severe restrictions. Donc, large interest rate
differentials with small exchange rate volatility have attracted large capital inﬂows,
which have forced the authority to engage in larger currency market interventions
and accumulate foreign exchange reserves. A one-way bet on the RMB’s continued
appreciation has led to even larger capital inﬂows. For this purpose, the authority
may enlarge the RMB–US dollar trading band further so as to facilitate greater
exchange rate ﬂexibility.

En outre, to offset exchange market pressure due to capital inﬂows, le
PRC authorities must encourage capital outﬂows. This could be achieved by allow-
ing private ﬁrms and residents to invest abroad using both the RMB and foreign
currencies, particularly the US dollar. The two-way ﬂow of capital will naturally
lead to greater volatility of the RMB exchange rate against major currencies.

A Short-Term Policy Interest Rate for the People’s Republic of China

As the PRC’s lending and deposit rates are becoming increasingly liberalized
de facto, the monetary authority must choose a short-term benchmark interest rate
as its policy instrument and help create a market-driven yield structure of interest
rates. The authority can carry out its monetary policy by adjusting its short-term
policy interest rate and employing a new short-term liquidity facility. This policy
rate will be used as the basis for banks to set reference rates, which then will be used
to price ﬁnancial derivatives and products.

According to the Bank for International Settlements (BIS 2013), reference
rates based on unsecured interbank term lending and borrowing are the dominant
types of reference rates used in the world. BIS found that:

(je) Plus que 50% of all syndicated loans signed in 2011 were linked to either

the LIBOR or the Euro Interbank Offered Rate (EURIBOR).

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86 ASIAN DEVELOPMENT REVIEW

Tableau 8. The Shanghai Interbank Offered Rate and Repo Rate

SHIBOR

Bond Repurchase Agreement

Tenor

Overnight, 1-week, 2-week, 1-month,
3-month, 6-month, 9-month, et
1-année
Credit Line Need to set up credit line
Credit risk
Risk
Collateral
Credit-based
PBoC = People’s Bank of China, SHIBOR = Shanghai Interbank Offered Rate.
Source: People’s Bank of China.

1-day, 7-day, 14-day, 21-day, 1-month, 2-month,
3-month, 4-month, 6-month, 9-month, 1-année

No need to set up credit line
Risk-free, secured transaction
Government bonds, PBoC bills, and credit bonds

(ii) A large portion of bonds in the world—to the tune of at least $10 trillion—were

referenced to one of these two rates.

(iii) A signiﬁcant share of mortgages and other retail loans were linked to them,
and the use of these reference rates in derivatives markets was also widespread.

For central banks, the reference rate (such as the overnight rate) also serves
as an operational target. Different from the actual policy rate, this operational target
is used to guide monetary policy. It is an important component of the monetary
policy transmission mechanism because the central bank can inﬂuence the ﬁnancial
system through the reference rate and then affect interest rates for loans, money
market rates, and interest rate derivatives. Donc, the PRC’s monetary authority
should work closely with market participants and review the reference rate setting
processus.

Before the LIBOR scandal, the SHIBOR was considered a natural candidate
for the reference rate for the PRC. As the SHIBOR is an interest rate that partici-
pating banks report but do not have to transact using the reported rates, the system
could lead to the over ﬁxing or under ﬁxing of the reference rate, especially in a
stressed environment. Such problems could lead to a loss of market conﬁdence in
the SHIBOR. Par conséquent, the repo rate has become a more viable alternative for the
PRC’s future reference rate (Tableau 8).

Looking at major international central banks, the monetary operational target
rates used by the US Fed and the Bank of Japan (BOJ) are both overnight rates. Le
Fed conducts its monetary policy by inﬂuencing the federal funds rate (FFR), le
rate at which banks lend to each other overnight. After the Federal Open Market
Committee (FOMC) sets the FFR target, the Fed then uses tools, such as open market
opérations, reserve requirements, and the discount window, to change the supply
and demand of funds in the market, thus inﬂuencing the FFR.

De la même manière, the BOJ publishes and controls the uncollateralized overnight call
rate, which is the rate charged for overnight loans between banks. The BOJ sets this
rate through open market operations to inﬂuence banks’ current account balances
with the BOJ, which in turn affects the overnight call rate.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 87

The ECB meanwhile acts as the calculation agent for the Euro Overnight
Index Average (EONIA), which is also an interbank overnight rate. Ofﬁcially, le
EONIA is not a reference rate or operational target for the ECB, but it plays a similar
fonction (BIS 2008).

C. Market Infrastructures

Rapid interest rate liberalization without the necessary market, legal, regu-
latory, and supervisory infrastructure can lead to failures and crises in the banking
système. The conventional interest rate liberalization sequencing, based on these con-
cerns, is to liberalize short-term rates ﬁrst and then to liberalize long-term interest
rates.

In addition to interest rate liberalization, the PRC must deepen and broaden
the local-currency bond, foreign exchange, and related derivatives markets to allow
ﬁrms and investors to diversify the risks; facilitate the use of market-driven prices to
price risks; and provide tools for ﬁnancial institutions and corporations to manage
their risk exposures.

Enfin, the PRC’s monetary authority will also need to make monetary policy
forward looking to reﬂect changes in both domestic and external ﬁnancial markets
and economic conditions. Against this backdrop, the authority should better com-
municate with the market and adjust the interest rate proactively to anchor market
expectations.

VIII. Conclusion

This paper ﬁnds that the de facto degree of ﬁnancial market openness is sur-
prisingly high in the PRC despite the presence of de jure capital controls. Nonethe-
less, the authority still maintains a tightly managed RMB exchange rate regime
and continues to accumulate foreign exchange reserves. Par conséquent, the authority’s
ability to set autonomous monetary policy has been constrained. This could lead
to the accumulation of domestic macroeconomic and ﬁnancial imbalances, lequel
could eventually lead to ﬁnancial crises in the future.

To avoid such consequences, the PRC authority faces several options. Un
is to reverse policies to open ﬁnancial markets and limit international capital ﬂows.
This would allow the authority to achieve both exchange rate stability and monetary
policy autonomy, but would require the process of RMB internationalization to
slow down. En outre, reversing policy direction could reduce the PRC’s growth
prospects by sending a negative message to ﬁnancial markets.

The other more reasonable option would be to increase RMB exchange rate
ﬂexibility and thereby restore monetary policy autonomy. Two-way ﬂexibility can
be achieved by substantially liberalizing capital outﬂows, as capital inﬂows have

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88 ASIAN DEVELOPMENT REVIEW

already been substantially liberalized and large capital inﬂows have been pushing
up the RMB value. This option presents the risk of excessively large RMB exchange
rate volatility, but the authority can contain this through smoothing interventions in
the currency market.

Cependant, to continue to pursue ﬁnancial market opening, the PRC would
need to make its ﬁnancial markets deeper and more liquid and strengthen ﬁnancial
market supervision and regulation. The interest rate needs to be determined in the
market through the demand and supply of funds, which would help create stable
yield curves and strengthen the transmission mechanism of monetary policy.

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TRILEMMA CHALLENGES FOR THE PEOPLE’S REPUBLIC OF CHINA 89

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Variables
(cid:6)it

(cid:6)i ∗
t
˜yt
˜πt
(cid:6)FXR/FXRt
(cid:6)M/Mt

Appendix: Data Description

Description

Period

7-day Repo
7-day CHIBOR
3-month SHIBOR
3-month US dollar LIBOR
Industrial production (réel) growth rate
CPI inﬂation gap
Foreign currency assets purchased by PBoC
M0
M1
M2

Oct 2003–Oct 2014
Sep 2000–Oct 2014
Oct 2006–Oct 2014
Jan 1990–Oct 2014
Jan 1995–Oct 2014
Jan 1990–Oct 2014
Dec 1999–Oct 2014
Dec 1997–Oct 2014
Mar 1997–Oct 2014
Mar 1997–Oct 2014

Source

CEIC

Bloomberg
CEIC
CEIC
CEIC
CEIC

CHIBOR = China Interbank Offered Rate, CPI = consumer price index, LIBOR = London Interbank Offered Rate,
PBoC = People’s Bank of China, SHIBOR = Shanghai Interbank Offered Rate.

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