Confronting China’s policy trilemma

The fall in China’s forex reserves below the $US3 trillion mark in January – its lowest level in six years - in itself is not an issue for the Asian giant. China still has adequate levels of reserves.

Based on the International Monetary Fund’s (IMF) metric for assessing reserve adequacy for emerging market economies, under a fixed or managed exchange rate regime (as in China’s case), the adequate level of reserves is between $US1.8 trillion and $US2.9 trillion depending on whether there are capital controls.

" Allowing the RMB to weaken further is the more appropriate path to take."
Khoon Goh, Head of Asia Research, ANZ

As China has some restrictions on the capital account, the appropriate level of reserves likely falls somewhere within that range. But the pace of decline in both reserves and in the adequacy metric suggests this trend cannot continue for long.

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There are many reasons for capital outflows from China in recent years, ranging from exchange rate expectations, interest rate differentials and repayment of foreign currency debt, to a desire for residents and corporates to diversify their assets overseas.

The most comprehensive measure of capital flows is from the balance of payments, which shows China experienced net capital outflows totalling #US654bn or equivalent to 5.8 per cent of gross domestic product (GDP) in 2016. But the decline in FX reserves is purely a policy decision in response to the outflows.

In short, China is facing the policy trilemma whereby it cannot have an open capital account, independent monetary policy and a fixed exchange rate at the same time. It has to choose two out of the three.

It can either choose to have:

  • A fixed exchange rate and an open capital account, giving up control of interest rates (which is the path Singapore and Hong Kong chose);
  • An open capital account and independent monetary policy, in which case it has to allow the exchange rate to be freely floating (the path chosen by the G10 economies); or
  • A fixed exchange rate and independent monetary policy, but maintaining a closed capital account (China pre-2005 peg).


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Given China is a large economy and exports are no longer a major growth driver, it makes more sense for policymakers to maintain an independent monetary policy.

The People’s Bank of China (PBoC) has been liberalising the interest rate market and we believe they are on their way towards establishing a formal policy rate.

The Chinese authorities ultimately want to open up the capital account, and this is where the friction is with their desire to maintain stability in the RMB exchange rate.

When the CFETS RMB Index was allowed to weaken over the January to June 2016 period, China’s FX reserves stabilised. But since the RMB Index had been held within a narrow side-range since July 2016, the decline in FX reserves resumed.


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China has tightened some administrative measures in order to reduce outflow pressure. There has been some success in this, most obviously in the area of net RMB outflows, which shrank in December following increases for most of the year.

Despite this outflows have persisted. The risk is new measures will raise concerns of more restrictions or actual imposition of capital controls, prompting an acceleration of outflows.


Maintaining further stability in the RMB Index would mean further declines in China’s FX reserves, or more stringent measures to curb outflows. Either that or allow the RMB to adjust more freely, which would mean letting it weaken further. This is a choice policymakers need to make.

In our view, allowing the RMB to weaken further is the more appropriate path to take. Chinese residents and corporates need to learn to adapt and live with greater volatility in their currency.

In any case, as a net creditor to the world (with China’s net international investment position at $US1,747 billion at the end of the third quarter of 2016, or 15.7 per cent of GDP) a weaker RMB boosts the value of the country’s foreign assets.

Allowing further erosion of FX reserves or introducing more administrative measures runs the risk foreign investors lose confidence in RMB as a global currency.

Khoon Goh is Head of Asia Research at ANZ

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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