‘Impossible Trinity’ Ends in China as PBOC Allows Freer Yuan

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'Impossible Trinity' at End on PBOC Move

In giving markets a greater say in setting the yuan’s level, Zhou Xiaochuan is bowing to Nobel-prize winning economist Robert Mundell’s maxim that a country can’t maintain independent monetary policy, a fixed-exchange rate and free capital borders all at the same time.

The policy trilemma, or impossible trinity, is illustrated by Asia’s experience in the 1990s. When some countries violated the dictum, their pegged currencies, high interest rates and open capital borders attracted a flood of foreign investment that quickly reversed along with their trade balances, triggering the Asian financial crisis of 1997-98.

The People’s Bank of China’s surprise shift to a more market-driven exchange rate mechanism a week ago was largely interpreted as a way to boost exports and improve chances of winning reserve currency status from the International Monetary Fund. The policy trilemma suggests a third motivation: moves to open the capital account and the desire for more monetary policy flexibility meant a freer currency was needed.

“The PBOC is shifting priorities,” said Li Jie, head of the foreign-exchange reserve research center at the Central University of Finance and Economics in Beijing. “By freeing the exchange rate, it is focusing on domestic monetary policy independence and paving the way for freer capital flows.”

Until last week, here’s how it worked: the PBOC each day would set a reference rate for the yuan against the U.S. dollar and limit moves to 2 percent on either side. It also bought and sold the currency to influence the exchange rate -- having knock on effects on the liquidity situation at home.

Printing Yuan

For most of the past decade, that meant printing and selling yuan and buying dollars to keep a lid on the currency’s strength, resulting in a foreign exchange hoard of almost $4 trillion and a broad money supply of 135 trillion yuan ($21 trillion), almost double the U.S.’s level. To offset the resulting liquidity surge, the central bank would lock away funds by raising the ratio of deposits that lenders had to park at the PBOC as reserves.

That all changed over the past year. As yuan appreciation pressure shifted to depreciation pressure, and as more capital began moving out, the PBOC found itself on the defensive: Reserves dropped, it lowered banks’ reserve ratio requirements and tried to prop up the yuan to discourage outflows and maintain stability as it pushed for reserve currency status.

Verbal Support

Last Tuesday, the PBOC decided enough was enough, announcing the biggest devaluation in two decades and adopting a more market-based methodology to determine the yuan’s daily fixing rate. Verbal support and assertions it would step in when there are excessive swings helped stabilize the yuan by the end of the week, as did reports of ongoing intervention.

“For the last decade, the central bank’s job was to soak up excessive liquidity, and in the future, its job will mainly become providing liquidity,” Huang Yiping, an academic adviser to the central bank, said in an interview last week. “It’s possibly an easier job for the central bank.”

Governor Zhou could do with a lighter load. The 67-year-old central banker, in office since 2002 when Alan Greenspan was still Federal Reserve chief, is trying to press on with moves to open the economy while adding monetary stimulus to keep growth from slowing too fast.

“Exchange rate flexibility means that they can conduct an independent monetary policy going forward,” said David Dollar, a senior fellow at the Brookings Institution in Washington who previously worked for the U.S. Treasury in Beijing. “In the short run, that probably means monetary stimulus.”

Policy Options

China may cut banks’ required reserve ratio amid tightening liquidity and expectations the yuan will remain weak, the official China Securities Journal said in a front-page article, citing unidentified analysts.

Stocks tumbled the most in three weeks as traders reduced stimulus bets and speculated the government will pare back efforts to prop up equities. The Shanghai Composite Index sank 6.2 percent to 3,748.16 at the close Tuesday.

To offset any further capital outflows, the central bank could also inject more liquidity into chosen lenders. Benchmark interest rate cuts can lower borrowing costs, while a weaker currency should help boost exporters, who had been loosing competitiveness.

“The central bank is gaining a kind of automatic stabilizer,” said Zhou Hao, an economist at Commerzbank AG in Singapore. “It’s in line with the PBOC’s overall goal of building up a more market-oriented central banking mechanism.”

A flexible exchange rate will increase room for the central bank to adjust monetary policy, PBOC Deputy Governor Yi Gang said at a briefing in Beijing last week. Ma Jun, chief economist at the central bank, said a more market-oriented pricing mechanism will help avoid excessive deviations from the equilibrium level and reduce the chance of sudden fluctuations.

Letting market forces decide the exchange rate has “untied the hands of the PBOC somewhat so that it can focus more on domestic economic activities when making monetary policy,” said Liu Li-Gang, head of Greater China economics at Australia & New Zealand Banking Group Ltd. in Hong Kong. “It will help align China’s monetary policy objectives.”

— With assistance by Xin Zhou, and Kevin Hamlin

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