China gets cornered by \'Impossible Trinity\'

Overall, macro and financial conditions in the world's second largest economy turned darker last year. Growth slumped to a 25-year low while deflationary risks  intensified. Trade growth languished in negative terrain for much of the year. The bursting of an equity bubble and property market downturn definitely did not help. Foreign reserves were rapidly burnt up to stem the Renminbi's slide amid high capital outflows. Credit growth, by and large, remained subdued. Fiscal and monetary stimulus has not been particularly successful in improving domestic conditions.

One bright spot for China- in an unenviable year - was receiving the IMF's 'Reserve Currency' status. We all understand this new stamp will enhance China's influence in the international monetary system. On the other hand, fulfilling the status of a global reserve currency requires steps that policy-makers in Beijing have traditionally been reluctant in taking - letting markets do the talking. Reserve currency holders generally need to allow a floating exchange rate and unhindered flow of financial capital (full capital openness). Historically, China has carefully managed its exchange rate to keep it at a depreciated level to support its export-led growth model. Similarly capital and financial account transactions - which typically deal with foreign direct investment, portfolio investment, derivatives and foreign loans -have been subject to varying degrees of restrictions. The biggest restrictions today are on currency exchange for individuals (no resident is allowed to buy more than US$ 50,000 worth of foreign currency each year) and portfolio investment. Beijing maintains that it is undertaking reforms to allow a more flexible exchange rate and open capital account. For instance, the authorities recently announced they would start tracking the value of the country's currency against a basket of many other currencies and not just the US Dollar. Against this background, the following questions arise: (i) What risks will a more flexible Renminbi create? and (ii) If a true floating exchange rate is not feasible in the short-term, can the government push through with further capital account liberalisation?
For the purposes of this write-up, it is important to recognise that Beijing is increasingly facing the confinements of the 'Impossible Trinity', also known as the 'Trilemma'. This age-old concept, introduced by economists Robert Mundell and Marcus Fleming, shows that no government can control both exchange rate and interest rates while allowing free capital flows. They can at best target two of these variables, with the third left to market forces. Essentially, governments have the following options:
(i) If capital flows are liberalised, the government can pursue a stable or pegged exchange rate policy and forgo an independent monetary policy as domestic interest rates will have to follow global interest rates.
(ii) What if capital account is open and the government wants to set interest rates on its own accord as well as maintain exchange rate stability?
If interest rates were lower (higher) than world markets, capital would flow out (in), compelling the government to sell (buy) foreign currency to maintain exchange rate stability. If exchange rate is facing depreciation pressure, the central bank - through sale of foreign currency - depletes domestic money supply, hampering monetary policy targets. When foreign reserves reach critically low levels, the central bank has to let go of the peg. Conversely, if exchange rate is facing appreciation pressure, the central bank - through purchase of foreign currency - injects excess liquidity in the domestic system, again contradicting monetary programmed targets. Sterilising these flows will increase the government's expenditure, hampering core fiscal objectives. This unsustainable strategy means the central bank has to sacrifice exchange rate stability if it wants monetary policy autonomy and free capital flows. The interest rate differential between domestic and world markets will then drive capital flows and determine equilibrium exchange rate.
(iii) Finally, the government can control both interest rate and exchange rates but forgo free capital flows, by imposing capital controls.
Historically, Beijing has opted for the third option outlined above. Now the onus is on policy-makers to shift towards the second option, but such transitions require careful assessment of risks and economic feasibility. For instance, would a flexible Renminbi appreciate or depreciate in an environment of greater capital openness? Given subdued growth prospects, dented confidence in China's policy credibility, large stock market sell-offs and US interest rate hike, the Renminbi is expected to depreciate if only markets decided its fate. We only need to look at the offshore Renminbi exchange rate for evidence. The offshore market (based in Hong Kong) provides a truer reflection of the currency's value given the absence of frequent central bank intervention. The chart below shows the offshore exchange rate weakened more than the onshore rate since the authorities devalued the Renminbi in August, 2015. So there is little doubt that the onshore Renminbi would depreciate further in the absence of central bank intervention.  
Now the question arises how further depreciation (associated with a more flexible Renminbi) will affect China. Analysts may argue that it will improve China's trade performance. Yet, given persistently weak global demand, it is doubtful whether depreciation will substantially revive China's fledgling exports. For instance, currency depreciation in South Korea and Singapore last year did little to revive their exports. Even if we assume exports will improve with a lag, such macro benefits should be balanced against any costs imposed upon the economy due to depreciation. The most pressing concern in this regard is China's massive pile of dollar-denominated corporate debt. According to the Bank for International Settlements, this figure is around US$ 800-850 billion. While China's reserve is still much higher, it will not necessarily protect exporters (specifically whose foreign currency income is less than foreign currency liability) and non-exporters from exchange rate risks.
Depreciating exchange rates will raise the cost of servicing unhedged debts, reducing profits or depleting capital buffers. This is likely to impede future growth, business expansion plans and ultimately China's transition to a more consumption-driven economy. Additionally, episodes of sharp depreciations will no doubt create panic in global markets and raise possibilities of 'competitive devaluation' by neighbouring economies. Competitive devaluation or 'currency wars' stem from countries' motivation to protect their own export competitiveness.  In all likelihood, China would want to avoid such geopolitically-sensitive scenarios if it wants to maintain goodwill, protect its growing strategic role in the international financial system and promote the Renminbi's reserve currency status. These underlying exchange rate risks imply that Beijing will retain significant control over the Renminbi in the short-term and utilise its foreign reserves to prevent sharp depreciation.
With one hand still on the exchange rate, Beijing faces a tough policy choice. Recall from the 'Impossible Trinity' that if an economy has a (relatively) fixed exchange rate regime, it cannot maintain both unrestricted capital flows and monetary policy autonomy. It should be noted that the central bank has been aggressively pumping liquidity into the economy in recent months to offset monetary contraction caused by capital outflows. But its foreign exchange intervention is directly undermining liquidity-injection policy. When the central bank sells foreign currency (to curb depreciation), the Renminbi it receives in exchange are drained from domestic money supply. Here lies the constraint of the 'Impossible Trinity' that China is facing - as long as it has porous financial borders, it cannot hope to control both exchange rate and monetary policy. Greater capital account liberalisation amid a managed exchange rate regime will further reduce effectiveness of monetary policy. So Beijing has to choose between capital openness and an independent monetary policy (assuming it retains control over the exchange rate).
It is unlikely that policy-makers will allow further loss of monetary policy autonomy at a time when the domestic economy is attempting to transition towards a consumption-driven growth model. The central bank recently shifted towards benchmark interest-rate targeting (through open market operations), away from administrative control of interest rates and quantitative targets of bank lending and monetary aggregates. The motivation behind this is simple - as bond markets develop and take on greater role in the domestic financial system, targeting the price of credit (interest rates) and not its volume strengthens monetary policy transmission. The authorities certainly would not have undertaken this painstaking initiative if they planned on relinquishing control over monetary policy. So if it wants to control both interest rates and exchange rate, Beijing cannot move towards greater capital account liberalisation just yet. In fact, the authorities could even consider temporarily dialling back its existing level of financial openness and resume liberalisation initiatives once global markets settle down and capital outflows decrease. There is evidence that some capital account 'de-liberalisation' is already happening in China. Tightening purchases of overseas insurance products, restricting companies' foreign exchange purchases and suspending selected international banks' foreign exchange business are notable examples.    
To cut a long story short, China's predicament offers a valuable lesson in macroeconomic policy for developing countries considering greater integration with international financial markets. If monetary policy autonomy is a priority, capital account liberalisation should come after a country transitions to a flexible exchange rate -not before it. Otherwise, restrictions of the 'Impossible Trinity' will come knocking on the government's doors.
The writer currently works as a Macroeconomic Analyst for an organisation in Washington D.C. He is a Fellow for the Asian Center for Development in Dhaka.  
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