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The RMB exchange rate and monetary sterilisation in China.

In contrast to previous economy-overheating episodes, foreign capital inflow among other factors constitutes one of the fundamental causes for the recent investment boom and economic overheating in China. The foreign reserves component in the monetary base has overtaken the domestic credit component in exerting a dominant influence on the money supply. Nevertheless, the conventional course of sterilisation implemented by the monetary authorities has not been sufficiently effective in mopping up the extra credit that foreign capital inflow brings in. Monetary sterilisation in China has been only partial and incomplete.

China's exchange rate reform has attracted a great deal of interest from academics as well as policy and business practitioners. Various measures to realign the yuan have been developed accordingly. (1) The recent (21 July 2005) revaluation of the RMB came as much of a surprise to some people as it was an anticipated event to others. The move symbolises a big stride towards China's eventual internationalisation of its currency. The Chinese currency's exchange value is now market-determined with reference to the exchange value of a basket of currencies. The 2 per cent revaluation vis-a-vis the dollar represents an end to the old dollar-peg regime and a starting point for the newly established RMB exchange rate mechanism.

The new system labelled "managed floating exchange rate system" will provide a great deal of flexibility for macroeconomic management, monetary policy independence and real economic performance. Therefore, it is certainly an over-simplification (if not a misperception) to construe the exchange rate reform as simply a RMB revaluation of 2 per cent against the US dollar.

Under the RMB-US dollar peg, robust rising net exports and incoming foreign direct investment (FDI) in recent years, plus the influx of speculative financial capital driven by an anticipated RMB revaluation, led to significant increases in China's foreign exchange reserves and expansions in the monetary base and aggregate money supply. The massive foreign capital inflow constitutes one of the causes of the recent economic overheating in China.

Although when and how the reform of the Chinese yuan exchange rate should be tackled had long been an unsettled issue until the recent currency move by the People's Bank of China (PBC), there was no question that China should realign its currency exchange rate in some way. Besides all the existing reasons why the yuan revaluation is necessary, two additional considerations in favour of a yuan revaluation are: (1) the yuan/dollar peg distorted market forces through overinvestment so that the resulting moderate overall current account surplus hid the necessity for the anticipated exchange rate adjustment. Hence, simply examining the size of the current account balance per se can be misleading; (2) a related distortion of an undervalued yuan was probably reflected in the overvaluation of the euro and yen vis-a-vis the dollar relative to the two economies' long-term fundamentals. It is argued in this study that the yuan overvaluation, among other factors, has been responsible for China's recent investment boom and overheated economy. In this regard, the degree of economic overheating in China can be underestimated partially because China's current consumer price index (CPI) inflation to some degree may still reflect repressed inflation due to existing price controls in the areas of economic shortage such as energy and transportation. (2) Furthermore, there exists a dual structure of prices in China: high inflation in the prices of real estate, energy and key raw materials coexists with low inflation in the prices of finished products such as typical consumption products. The duality stems from the biased aggregate demand structure that relies heavily upon capital investment funded by both domestic and foreign funds (capital formation or fixed asset investment accounted for 45 per cent of China's GDP in 2004). (3) Particularly, the inflow of foreign exchange reserves has recently played a dominant role in stimulating investment demand and creating overcapacity which depresses the prices of finished products. Hence, under the circumstances, the CPI per se turns out to be an inadequate measure for the investment-rooted economic overheating.

A larger picture in understanding the roots of China's cyclical overheating involves the so-called revived Bretton Woods system, said to be a counterpart to the original Bretton Woods system that existed from the end of World War II until the early 1970s. (4) In the revived system, with the Chinese yuan (and some other Asian currencies) pegged to the dollar at artificially low rates, Asian economies keep their exports competitive and create jobs for underemployed workers. Both China and the US benefit from the system. Specifically, China compensates the US economy in two ways: allowing foreign firms to invest in Chinese factories and use cheap labour to earn fat profits, and to invest a large chunk of export earnings in T-bonds, thus helping finance America's current account deficit and keep American interest rates low and consumer spending high. And, in turn, the US has facilitated Chinese economic growth through two channels: low American interest rates encourage capital flooding into China, fuelling China's investment boom, and American consumers' buying large quantities of Chinese exports have backed economic growth in China.

In the aforementioned revived Bretton Woods system, China's foreign exchange reserves grow with the economy unconditionally. The readily increasing foreign exchange reserves, up to nearly USD660 billion by the end of the first quarter in 2005, constitute an important source of increases in the money supply. Under these circumstances, can the Chinese Government maintain effective control over the money supply? In particular, China, no longer a country with complete control on international capital mobility, has recently made great strides towards eventual free capital mobility. With a well-designed sequence, China has chosen to relax capital inflows before outflows, and long-term inward FDI before short-term portfolio investment. Such a structure of partial capital control implies that foreign capital inflow can impose constraints on China's monetary autonomy and the resulting pressure on the domestic currency is more biased towards a yuan appreciation than depreciation. Indeed, the PBC has been trying to reduce the impact of foreign exchange operations on the domestic money supply through PBC bill issuance and sale of government securities in a process called sterilisation, i.e., equal foreign and domestic asset transactions in opposite directions to nullify the impact of their foreign exchange operations on the domestic money supply. Nevertheless, this study shows that this sterilisation measure has been partial and incomplete in China and thus has not been effective in mopping up extra liquidity. Hence, the yuan is systematically undervalued in the foreign exchange market, which has become an inherent source for foreign capital inflow and associated monetary overheating.

This study first reviews some current macroeconomic indicators and examines the effectiveness of the recent macroeconomic austerity measures. It then focuses on the evolution of two components of the monetary base: the domestic credit and foreign exchange reserves. The evidence of macroeconomic data and the empirical analysis of monetary aggregates in particular suggest that the sterilisation in China falls short of being effective in neutralising the expansionary impact of foreign exchange reserve accumulation. The cointegration analysis strongly supports the finding of incomplete sterilisation obtained from the preliminary analysis, indicating that sterilisation applies effectively to only about two-fifths of the inflow of foreign exchange reserves. It is also argued here that maintaining an undervalued currency for too long could be costly and possibly disastrous. In particular, it is not wise to implement the exchange rate reform when the economic overheating is over. A gradualist approach to exchange rate reform appears to be preferable to the big-bang method.

Challenges during China's Soft Landing

About two years have elapsed since the Chinese Government started its campaign to cool down the overheated economy. Notwithstanding the signs of progress in achieving a soft landing, such as the slowdown of broad monetary aggregates and bank lending from their breakneck pace in 2003 and the first quarter of 2004, the GDP growth rate rose to 9.5 per cent in 2004 from 9.3 per cent in 2003, and remained at an annualised rate of 9.4 per cent in the first quarter of 2005. Fixed asset investment growth in the first quarter of 2005 even surpassed its earlier figure registered in the fourth quarter of the previous year. It is evident that the desired soft landing of the Chinese economy had not yet been achieved by that time. (5) In particular, China's industrial output gathered momentum with an increase of more than 16 per cent in May 2005 while urban fixed-asset investment had been rising. (6)

Driven by strong foreign capital (FR) inflow in anticipation of a possible yuan revaluation, the money supply measured as M2 (an aggregate money measure that includes currency, demand deposits, saving deposits and time deposits) grew at 14 per cent from March 2004 to March 2005, which in turn had caused loans (LOAN) to expand at 11 per cent (see Figures 1 and 2). As the real estate sector is highly sensitive to bank loans, the flood of credit also triggered asset price inflation characterised by increases of nearly 10 per cent in the house-selling price index (HSELLI) and 8 per cent in the land rent price index (LANDRI) based on 4-quarter change indexes. Compared with the first quarter of 1999, the percentage increases in HSELLI and LANDRI are about 19 and 13 per cent respectively, as shown in Figure 3, and the recent percentage increase in the purchasing price index of major raw materials, fuels and power (PRAW) is 27 per cent, as in Figure 4. High energy and housing prices created latent inflation risks.


Unlike the consumption-driven US economy, China's economy is investment-export driven. It will probably take several years to undo an unsustainable investment overhang and rectify the resulting imbalances. Therefore, it is foreseeable that a soft landing for China's economy could be a long process. In fact, as depicted in Figure 5, following China's economic overheating in 1993, it took about four years of investment declines.


Root of Overheating: The Larger Picture

As indicated in the introductory section, the recent investment overheating in China is closely related to the special inter-dependent relationship between the American and Chinese economies. Such a relationship is dubbed the "Revived Bretton Woods System" in which the Chinese yuan is pegged to the US dollar at an artificially low rate, enabling China to keep its exports competitive and to accumulate dollar assets. (7) Since the mid-1980s, US-China trade has exhibited a uniform deficit pattern in which the US has negative net exports (USNX), while China imports asset-price inflation and suffers from money excess as a result of the US lax monetary policy (see Figure 6).


Strong US imports of Chinese goods have fuelled China's economic growth, and the low American interest rates have bolstered capital inflow into China and led to China's investment boom. In return, China allowed foreign firms to invest in Chinese factories and earn fat profits using its cheap labour, while it invested a large chunk of export earnings in low-yield US Treasury bonds to help finance America's current account deficit, keeping American interest rates low and consumer spending high. The booms in the two economies have reinforced each other and powered the world economy.

The aforementioned interrelations between the two super economic powers also impact monetary statistics. Figure 7 exhibits the time dynamics of two components of the monetary base: domestic assets (DA) and foreign assets (FA). Although the role of foreign assets was rather limited before the mid-1990s, foreign exchange reserves have risen remarkably since 1994 when a merged exchange rate replaced the two-tier exchange rate regime. Likewise, domestic credit has also steadily increased in exchange for inward foreign exchange reserves so that the pegged yuan/dollar exchange rate can be maintained. In particular, the foreign exchange reserves have overtaken the domestic credit since the fourth quarter of 2002. Therefore, the challenge for the PBC to control domestic credit constitutes a dilemma: monetary liquidity conditions could be "too tight" to peg the exchange rate or "too loose" to sustain a low-inflation growth. Because of the quandary, foreign exchange reserves flood in so that changes in FA (DFA) are almost uniformly positive as shown in Figure 8, while variations in the domestic credit (DDA) exhibit an alternate up-and-down pattern.


Incomplete Monetary Sterilisation in China: Facts

As a result of the "Revived Bretton Woods System", China has become a large capital-importing country whereas the US has become a large goods-importing country. Figure 9 shows the share of foreign exchange reserves in China's monetary base (FSHARE). In its last economic overheating (1993-4), the foreign exchange reserves share accounted for only about 25 per cent of China's high powered money (high powered money is another label for the monetary base) while the same share rose close to 70 per cent at the end of 2004 even after the monetary authority's monetary tightening.


The aforementioned mechanism for economic overheating hinges upon the leading role that foreign exchange reserves play in the determination of the money supply, which further depends on what the PBC will do with respect to the increase in foreign exchange reserves. Suppose that the PBC sells government securities to nullify the impact of foreign exchange operations on the domestic money supply. Then, the question is: How complete has China's sterilisation been?

Table 1 reports the quarterly data of changes in the domestic asset component of the monetary base (DDA), changes in the foreign asset component of the monetary base (DFA) and two other derived monetary statistics. Summing DDA and DFA gives net changes in the monetary base, denoted as UNSTEZ, to reflect the degree of sterilisation. An alternative measure of the degree of sterilisation is obtained through dividing DDA by DFA, and the resulting ratio (RATIO) is listed in the last column of the table. UNSTEZ and RATIO listed in Table 1 are two characteristics or latent series in that their numerical values characterise the basic properties of a sterilisation policy, including the degree, magnitude and direction of sterilisation. With the algebraic signs and magnitude of UNSTEZ and RATIO being determined by those of DDA and DFA, there are four distinctive cases, as summarised in Table 2. It is found that sterilisation in China has been rather incomplete. Specifically, 15 quarters from 1995Q1 to 2005Q1 experienced incomplete sterilisation, 20 quarters had no sterilisation at all and only six quarters went through over-sterilisation. Therefore, the quarters with incomplete sterilisation or no sterilisation accounted for 85 per cent of the 40 quarters in the period. As far as the case of incomplete sterilisation is concerned, only about 24 per cent of foreign exchange reserve inflow is sterilised per quarter on average. In particular, 32 per cent of foreign exchange reserve inflows were sterilised in 2004. As for over-sterilisation, it clustered at the end of the 1990s, characterising the deflation episode in which foreign exchange reserve inflows slowed down under devaluation pressures.

Figure 10 shows that the unsterilised portion of foreign-reserve inflow (UNSTEZ [equal to] DFA+DDA) is significant and getting increasingly large over time, and UNSTEZ has predominantly caused monetary expansion in the past 10 years except for the deation episode in the late 1990s. In retrospect, over-sterilisation during the deflationary period suggests that money was excessively tightened. Otherwise, the monetary policy would have played a more active role in stimulating aggregate demand and relieving the government of the deficit-spending burden in that period.


Econometric Evidence for Incomplete Monetary Sterilisation

The previous section describes stylised facts and preliminary evidence for incomplete monetary sterilisation in China. This section turns to a more rigorous analysis to support the observations. Unlike some existing literature, the findings in this section show that for every yuan of foreign exchange reserve inflow, the domestic credit falls by only about 40 cents on average from 1995:Q1 to 2005: Q1. (8) Such a long-run equilibrium relationship indicates that China's sterilisation efforts are way below the par of full or complete sterilisation, i.e., a one-to-one negative relationship between the movements in the domestic credit and foreign exchange reserves. Factors that explain the incomplete sterilisation could be sterilisation costs or even the policymakers' deliberation to use unsterilised foreign capital inflow to counter the long-lasting deficient domestic private absorptions and thus sustain economic growth. (9)

This section presents a cointegration analysis of how much net domestic credit changes in response to a change in net foreign assets by estimating a monetary reaction function in terms of the two components of the monetary base. This approach differs both from the simple OLS method, which suffers from the problem of spurious regression and the resulting estimation bias, and from the VAR model that can yield only the lagged rather than contemporary relationship among variables due to the identification issue. (10) Given that DFA is stationary after first-order differencing according to the conventional unit root test, the cointegration test is run and the results are summarised in Table 3.

Table 3 shows that there is strong statistical significance, at the one per cent level, that DDA and DFA have a long-run equilibrium relationship over the sample period: DDA falls by 0.41 yuan for every yuan of foreign exchange-reserves inflow, suggesting that sterilisation is incomplete in China. It follows that money in China is rather endogenous. (11)

In addition to the estimated cointegration equation, the cointegration and error-correction analysis also provide the results of variance decomposition to support the observed incomplete sterilisation and monetary endogeneity. The consistent results are summarised in Table 4. The graph in each of the four panels represents the proportion of the forecast error variance of a variable explained by the shocks to the other variable. The larger the proportion, the more endogenous the variable whose variance is being explained. The panel at the upper-right corner gives the most interesting outcome. Unlike the series of DFA, which is totally exogenous or non-endogenous as shown in the two panels in a lower row, the series of DDA is partially endogenous. Following a shock to the series of DFA, the variance of DDA due to the shock to DFA monotonically increases and it reaches 45 per cent at the 20th quarter after the shock to DFA. In other words, the movement in DDA partially stems from its response to the movement in DFA, which is an alternative way to observe incomplete sterilisation.

Policy Options on the RMB Exchange Rate

Since it is the speculation on future yuan appreciation that accounts for the large inflow of foreign exchange reserves, excessive money growth, overheated investment and overcapacity, the foreign currency exchange rate has been, and will continuously be, an integrated issue in China's macroeconomic management. Before the PBC's public announcement of the RMB exchange rate regime reform, investors and the financial market had little doubt that the PBC would eventually make China's exchange rate more flexible to market forces; however, when and how it should be done caused a great deal of speculation.

It is probably helpful to develop a graphical analysis first before analysing the PBC's policy options. Consider two monetary assets: the one-year dollar deposits with the dollar interest rate [i.sub.$], and the one-year yuan deposits with the yuan interest rate [i.sub.yuan]. Suppose that the two rates of return are initially in balance when measured in a common currency, the dollar for instance, so that an American investor has no incentive to adjust his portfolio between the two deposits. In Figure 11, the vertical line represents the rate of return to dollar deposits, which is not affected by the dollar/yuan exchange rate to the American investor, whereas the downward sloping schedule represents the dollar rate of return to yuan deposits, because a lower current exchange value of the yuan will translate into a higher dollar rate of return over a one-year investment horizon. When the dollar/yuan exchange rate remains at the level of $0.12 per yuan (or 8.27 yuan per dollar) and market participants expect no potential changes from it, the dollar rate of return from yuan deposits is the same as the dollar interest rate for dollar deposits. However, if the yuan is widely expected to appreciate against the dollar by 12 per cent, say, in the future, the dollar rate of return from the yuan deposits will increase at any given level of the exchange rate. Graphically, the schedule shifts to the right. Without offsetting policy measures to neutralise the effects of rising anticipation of the yuan appreciation, the dollar/yuan exchange rate will be realigned with the higher level of $0.134 per yuan. Nevertheless, the PBC can, in principle, neutralise the effect by either lowering the yuan interest rate and/or mitigating the rising expected rate of yuan appreciation so that the scenario of yuan appreciation can be avoided. Another possible way out is for the dollar interest rate to rise to such a level that it just balances out the rising dollar rate of return from the yuan deposits, so that the market can continue to be at equilibrium at the existing exchange rate: $0.12 per yuan.


In other words, before the recent RMB exchange rate reform, the PBC, when facing increasing revaluation expectations, had four clear-cut scenarios to consider as its near-term policy options.

Scenario 1: Expand money supply without revaluing the RMB

Scenario 2: Wait for the Fed's tightening without revaluing the RMB

Scenario 3: Tighten macroeconomic environment, without revaluing RMB, in order to lower revaluation expectations

Scenario 4: Revalue the RMB

Taken individually, each scenario has weaknesses that are unacceptable to China's economic policy makers and thus not feasible in practice. In retrospect, Scenario 1 is completely in conflict with the PBC's current macroeconomic objectives. Scenario 2 would make an active and responsible central bank appear unrealistic and naive. Scenario 3 is highly uncertain: while it could lower revaluation expectations, it could also work the other way as far as the interest rate effect is concerned. Although scenarios 2 and 3 are sensible and useful, their effectiveness can be hampered by an exchange rate misalignment and associated expectations and speculation. In fact, with an undervalued currency vis-a-vis other major currencies in the world, it would be difficult for the policymakers' campaign of macroeconomic adjustment and control to achieve long-term success. As for

Scenario 4, the revaluation in isolation by itself appears to suggest that China would follow what Japan did in the late 1980s, which was unacceptable to the PBC. Under the circumstances, a plausible solution stems from a combination of scenarios 2, 3 and 4, and it turned out to be exactly the course of RMB exchange rate reform that the Chinese Government took before the PBC's recent currency move.

First, a favourable external monetary environment characterised by the Fed's monetary tightening facilitated the PBC's recent currency move. The US Federal Reserve, instead of seeking a "neutral" policy stance as it did last year, finally became serious about raising the interest rate this time in order to meet the upcoming challenges: an accelerating inflation (inflation measured by the CPI registering 3.1 per cent in March 2005, a 31-month high), a runaway current account deficit of $195 billion (trade balance data showed a $55 billion deficit in May 2005, and in particular, US merchandise trade deficit with China reaching a record-breaking level of close to $15.7 billion) (12), and potential property bubbles. To some extent, the Fed's policy of raising interest rates is helping reduce the expectation of a yuan revaluation. (13)

Next, China's policymakers had been implementing a series of macroeconomic policies to provide a favourable multi-dimensional environment for a smooth and healthy exchange rate adjustment, including increases in interest rates and the required reserve ratio, moral suasion to reduce excessive bank lending, tightened administrative measures on foreign enterprise profit taxation and speculative capital, and policies to cool down real estate investment, among others. The aim of these policy measures has been to prick bubbles, squeeze the room of speculative profits, and thus reduce excessive speculative pressures in order to assess the fundamentals in determining the equilibrium exchange rates and minimise the risk of the RMB exchange rate reform.

As far as the RMB exchange rate reform per se is concerned, the PBC's decision to de-link the RMB from the US dollar and adopt a basket of currencies as reference for the managed exchange rate floats has profound influences on its capacity to conduct effective macroeconomic management. As the well-known theorem of inconsistent trinity indicates, policymakers in open economies face a macroeconomic trilemma, which concerns "three typically desirable, yet contradictory, objectives: to stabilise the exchange rate; to enjoy free international capital mobility; to engage in a monetary policy oriented towards domestic goals". (14) Indeed, as it has greatly relaxed capital inflows, China is no longer a country with complete control of its inter-national capital mobility, especially inflows of long-term inward FDI. Therefore, international capital mobility imposes structural constraints on China's ability to control monetary overheating, as evidenced in the earlier sections of this study. Given the constraint of partial capital mobility, China's newly announced managed floating RMB exchange rate regime is characteristic of a flexible exchange rate system without completely losing government control, thereby providing a much larger arena for monetary policy to exhibit its effectiveness in China.

What is really important at this stage is not the magnitude of the RMB exchange rate realignment, but the establishment of China's managed floating RMB exchange rate system per se. Though the yuan undervaluation, as well as the resulting influx of foreign capital and economic overheating could continue to be challenging issues at the top of the macroeconomic management agenda in China, there are many reasons to believe that the new managed floating RMB exchange rate system will be more effective and sustainable than the dollar-pegging regime in serving the fast-growing, giant Chinese economy and helping China break away from the aforementioned monetary policy dilemma.

High Opportunity Costs

As indicated earlier, China's economic overheating is an integral part of prolonged and profound global imbalances, and any measure to cool it down can hardly be successful without fundamental changes in China's exchange rate regime. In an era of globalisation, the carefully implemented exchange rate reform in China will be a win-win scenario. Unilateralism will fail in both the international political and economic arenas. (15) Indeed, the yuan exchange rate reform is not merely an issue of trade advantages or foreign pressures, but more an issue of China's need to achieve a soft economic landing and sustain long-term growth.

Historical experiences with earlier investment booms in China suggest that an economy's soft landing may well take several years for its completion. (16) Considering the contractionary real effects of a revaluation, it is preferable for China to choose to increase the yuan's market exposure at a time when its overheated economy has not completed its soft landing. In other words, it would not be sensible to let the yuan revaluation take place at a time when the economy may slide into a recession thereafter.

What would have happened had China missed the opportunity to reform its exchange rate regime in a timely way, resulting in excessive capital inflow? The risks would have been so high that China could ill-afford not to act: a flood of easily-accessed credit, an unsustainable investment boom, unchecked spiralling asset prices followed by inflation and consequent interest-payment difficulty, overcapacity and a vicious deflation leading to a bursting of the bubble, credit contraction and widespread bankruptcies. Additionally, from a long-term perspective, an undervalued yuan exchange rate tends to lead to a structural bias favouring the low value-added labour intensive sector which can hinder industrial upgrading.


This article uses a monetary approach to analyse the role of foreign exchange reserve inflow in determination of the money supply in China. An undervalued Chinese yuan is one of the root causes of the dramatic growth of foreign exchange reserves held in China, and this in turn has led to robust monetary growth and therefore financed the recent investment boom and capacity expansion. As a result, in recent years, there has been a mixed picture of inflation in China: rapidly rising real estate prices and raw-material prices, and the disinflation/ deflation in the market for manufactured products, especially those covered in the consumer price index. It appears insufficient to argue that China's economy is not overheated because of the lack of significant CPI inflation. (17)

China's central bank has certainly been implementing its sterilisation policy (the PBC bill issuance and sales of government securities) to reduce the heat in the recent breakneck growth. Nevertheless, this sterilisation measure has not been very effective. The fundamental institutional reason is that China's control of international capital mobility was incomplete while the yuan was pegged to the US dollar, and actually became a case for the variant of so-called inconsistent trinity. Moreover, China's central bank bills as well as its government securities, though without capital requirement, carry low interest yields and thus cannot help Chinese banks in improving their profits and balance-sheet positions except in relieving capital adequacy pressures.

The findings in this article provide robust empirical evidence of the incomplete monetary sterilisation in China. Specifically, an examination of the time series of the domestic assets and foreign asset components of the monetary base suggests that the foreign assets, which have been growing throughout the past ten years, have overtaken, in magnitude, the domestic assets since the fourth quarter of 2002 and thus become the major determinant of the monetary base in China. The share of foreign exchange reserves in the monetary base has risen to 70 per cent at the end of the first quarter of 2005, even after accounting for a series of recent monetary austerity measures, which is in sharp contrast to the previous economic overheating when the share was only 25 per cent. Nevertheless, the cointegration analysis of a long-run equilibrium relationship indicates that only forty cents were sterilised for every yuan of the inflow of foreign exchange reserves from 1995:Q1 to 2005:Q1. Furthermore, there were fifteen quarters from 1995Q1 to 2005Q1 that saw incomplete sterilisation and twenty quarters that saw no sterilisation at all. Therefore, the quarters with incomplete sterilisation or no sterilisation accounted for 85 per cent of the 41 quarters in the period, and on average, only about 24 per cent of foreign exchange reserve inflow was sterilised each quarter. In particular, even in 2004 when the PBC and Central Government took significant steps to cool down the overheated investment sector, only 32 per cent of the foreign exchange reserve inflows were sterilised that year.

The major part of this research was done while Ying Wu was a Visiting Senior Research Fellow at the East Asian Institute, National University of Singapore in 2005. He thanks two anonymous referees for their useful comments on the paper, as well as the participants at an EAI seminar for their helpful discussion where an earlier version of this study was presented. Special appreciation is extended to Drs. Yongnian Zheng and Elspeth Thomson for their editorial support.

(1) Three insightful sources are Morris Goldstein, "China and the Renminbi Exchange Rate", in Dollar Adjustment: How Far? Against What?, ed. C. Fred Bergsten and John Williamson (Washington DC: Institute for International Economics); Michael Funke and Jorg Rahn, "Just How Undervalued is the Chinese Renminbi?", The World Economy 28, no. 4 (2005); and Jianhuai Shi and Haifeng Yu, "Renminbi Equilibrium Exchange Rate and China's Exchange Rate Misalignment: 1991-2004", CCER Working Paper, no. C2005002, Peking University, 2005.

(2) Jiming Ha recently argued that the expected inflation or the "true" rate of inflation in China exceeds the official CPI inflation rate by three percentage points. See Caijing (Finance Magazine), no. 10, 2005. For the pertinent research methodology, see Andrew Feltenstein and Jiming Ha, "Measurement of Repressed Inflation in China", Journal of Development Economics 36 (1991): 279-94.

(3) Weijian Shan, "China's Yuan Is Overvalued", Asian Wall Street Journal, 23 June 2005.

(4) In a series of articles published in 2003 and 2004, Michael Dooley, David Folkerts-Landau and Peter Garber (three Deutsche Bank economists) argue that the US and China as well as other Asian economies have an implicit economic and financial bond that can continue and significantly benefit both parties for years. For example, see Michael Dooley, David Folkerts-Landau and Peter Garber, "An Essay on the Revived Bretton Woods System", NBER Working Paper, no. 9971, Cambridge, MA: National Bureau of Economic Research, Sept. 2003.

(5) See Morris Goldstein and Nicholas R. Lardy, "What Kind of Landing for the Chinese Economy?", Policy Briefs in International Economics (Washington DC: Institute for International Economics, 2004). In this study, it is argued that based on past experience, a celebration of the success of a soft landing in China is too early to be convincing.

(6) See Vivian Tse, "China Posts 16.6% Rise in Industrial Output", Asian Wall Street Journal, 16 June 2005, and "Key China Investment Picks Up Pace", Asian Wall Street Journal, 17 June 2005.

(7) See "The Dragon and the Eagle", Economist, 30 Sept. 2004. For a more formal analysis, see Michael P. Dooley, David Folkerts-Landau and Peter Garber, "An Essay on the Revived Bretton Woods System".

(8) Studies that suggest there is a full (or complete) monetary sterilisation in China, however, include Alice Y. Ouyang and Ramkishen S. Rajan, "Monetary Sterilisation in China since the 1990s: How Much and How Effective", Discussion Paper No. 0507, University of Adelaide, 2005; and R.C.K. Burdekin and P.L. Siklos, "What has Driven Chinese Monetary Policy: Some Lessons and an Overview", Working Paper, Wilfrid Laurier University, 2005.

(9) A comprehensive and informative study in this regard is Eswar Prasad and Shang-Jin Wei, "The Chinese Approach to Capital Inflows: Carrots and Sticks, or Deeper Forces at Work?", IMF Working Paper, 2005.

(10) In the existing studies that estimate the extent of sterilisation, an example of the OLS model is Sung Yeung Kwack, "An Empirical Assessment of Monetary Policy Responses to Capital Inflows in Asia before the Financial Crisis", International Economic Journal 15, no. 1 (2001): 95-113. An example of the VAR model is Ramon Moreno, "Intervention, Sterilisation and Monetary Control in Korea and Taiwan", Federal Reserve Bank of San Francisco Economic Review, no. 3 (1996): 23-33.

(11) The more detailed estimation results and related diagnostic tests are available upon request from the author.

(12) The latest trade data are based on the US Bureau of Economic Analysis website: <> [2 Nov. 2005].

(13) Stephen Roach views the Fed's tightening as a move that is in fact "doing China a favour" by facilitating China's mission of a soft-landing. See Stephen Roach, "How the Fed is Doing China a Favour", Financial Times, 22 Apr. 2005.

(14) Maurice Obstfeld and Alan M. Taylor, "The Great Depression as a Watershed: International Capital Mobility over the Long Run", in The Defining Moment: The Great Depression and the American Economy in the Twentieth Century, ed. Michael. D. Bordo, Claudia Goldin and Eugene N. White (Chicago and London: University of Chicago Press, NBER Project Report series, 1998), pp. 353-402. Obstfeld and Taylor first invoked the term "trilemma" for the scenario in the above article.

(15) Note that another misperception, however, is to link the yuan reform directly with the correction of the US current account deficit. In fact, an appreciation of the yuan will only be helpful but not sufficient to reduce US external imbalances and their effects. In this regard, the most forthright and convincing speeches are those made by two former US Treasury Secretaries (see Lawrence H. Summers, The US Current Account Deficit and the Global Economy, Per Jacobsson Lecture, Harvard University, 3 Oct. 2004; and Robert Rubin, Keynote Speech at the 2005 Trade Policy Conference, Washington DC: Institute for International Economics, 15 Feb. 2005).

(16) This point follows from Morris Goldstein and Nicholas R. Lardy, "What Kind of Landing for the Chinese Economy?".

(17) Wu provides evidence that it is asset prices rather than commodity prices that correlate with the money supply in China. See Zhiwen Wu, "The China Paradox: A Critical Review and a New Hypothesis", China Economic Quarterly 3, no. 1 (2003): 39-70.

Ying Wu ( is Associate Professor of Economics at Franklin P. Perdue School of Business, Salisbury University, Maryland. He earned his PhD in economics from the University of Oregon. His specialty areas are macroeconomics and monetary economics, international economics and Asian economies.
Table 1. Stelization Ratio and Unsterilised Foreign Reserve Changes


1995:1 -20.72 54.14 33.42 -0.38
1995:2 -41.22 32.99 -8.23 -1.24
1995:3 31.87 69.75 101.62 0.45
1995:4 111.86 64.94 176.80 1.72
1996:1 -6.66 65.99 59.33 -0.10
1996:2 -57.31 108.02 50.71 -0.53
1996:3 22.98 31.95 54.93 0.71
1996:4 333.27 83.31 416.58 4.00
1997:1 65.45 139.71 205.16 0.46
1997:2 -23.43 77.29 53.86 -0.30
1997:3 -11.62 110.71 99.09 -0.10
1997:4 100.24 61.28 161.52 1.63
1998:1 -27.73 -9.04 -36.77 3.06
1998:2 -31.45 -2.43 -33.88 12.94
1998:3 -192.72 11.27 -181.45 -17.10
1998:4 204.19 31.16 235.35 6.55
1999:1 -81.34 9.09 -72.25 -8.94
1999:2 -30.03 2.77 -27.26 -10.84
1999:3 67.56 37.2 104.76 1.81
1999:4 362.25 60.52 422.77 5.98
2000:1 -123.76 19.15 -104.61 -6.46
2000:2 80.15 10.68 90.83 7.50
2000:3 97.20 3.6 100.8 27.00
2000:4 238.54 39.1 277.64 6.10
2001:1 -257.28 27.49 -229.79 -9.35
2001:2 141.48 118 259.48 1.19
2001:3 -12.806 122.6 109.794 -0.10
2001:4 34.924 159.67 194.594 0.21
2002:1 -23.943 -20.47 -44.413 1.16
2002:2 -38.534 62.18 23.646 -0.61
2002:3 -5.016 114.72 109.704 -0.04
2002:4 39.764 181.81 221.574 0.21
2003:1 -44.032 197.94 153.908 -0.22
2003:2 -26.097 192.92 166.823 -0.13
2003:3 100.187 279.35 379.537 0.35
2003:4 -55.3 119.69 64.39 -0.46
2004:1 -49.603 283.95 234.347 -0.17
2004:2 133.069 243.78 376.849 0.54
2004:3 -28.994 303.44 274.446 -0.09
2004:4 -49.557 750.66 701.103 -0.06
2005:1 -35.532 447.21 411.678 -0.07

Source: Author's calculation based on IMF, International Financial

Table 2. Four Cases of Sterilisation Analysis

 Case 1: Case 2:
 Incomplete No
 sterilisation sterilisation

DDA negative/positive positive (or zero)/
 negative(or zero)

DFA positive/negative positive/negative

UNSTEZ positive/negative positive/negative

RATIO (-1,0) (0, + infinity)

 Case 3: Case 4:
 Over- Complete
 sterilisation sterilisation

DDA negative/positive negative/positive

DFA positive/negative positive/negative

UNSTEZ negative/positive zero

RATIO (- [infinity], -1) -1

Table 3. Johansen Co-integration Tests for DDA and DFA

Cointegration Equation: DDA = -63.54 + 0.41DFA (1.90)

 Eigenvalue [H.sub.0]

[[lambda].sub.trace] test 0.521 r = 0
 0.005 r [less than or equal to] 1

[[lambda].sub.trace] test 0.521 r = 0
 0.005 r = 1

 [H.sub.1] Statistics

[[lambda].sub.trace] test r > 0 29.65
 r > 1 0.218

[[lambda].sub.trace] test r = 0 29.43
 r = 1 0.218

 5% c.v. 1% c.v.

[[lambda].sub.trace] test 15.41 20.04
 3.76 6.65

[[lambda].sub.trace] test 14.07 18.63
 3.76 6.65

Notes: The figure in the parenthesis is the t-value. The symbol r
in the table denotes the number of cointegrating equations.
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Title Annotation:Ren Min B
Author:Wu, Ying
Publication:China: An International Journal
Geographic Code:9CHIN
Date:Mar 1, 2006
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