China’s Trilemma Maneuvers

China’s exchange rate, which had been appreciating against the dollar since 2005, has fallen in value since February. U.S. officials, worried about the impact of the weaker renminbi upon U.S.-China trade flows, have expressed their concern. But the new exchange rate policy most likely reflects an attempt by the Chinese authorities to curb the inflows of short-run capital that have contributed to the expansion of credit in that country rather than a return to export-led growth. Their response illustrates the difficulty of relaxing the constraints of Mundell’s “trilemma”.

Robert Mundell showed that a country can have two—but only two—of three features of international finance: use of the money supply as an autonomous policy tool, control of the exchange rate, and unregulated international capital flows. Greg Mankiw has written about the different responses of U.S., European and Chinese officials to the challenge of the trilemma. Traditionally, the Chinese sought to control the exchange rate and money supply, and therefore restricted capital flows.

In recent years, however, the Chinese authorities have pulled back on controlling the exchange rate and capital flows, allowing each to respond more to market forces. The increase in the value of renminbi followed a period when it had been pegged to increase net exports. As the renminbi appreciated, foreign currency traders and others sought to profit from the rise, which increased short-run capital inflows and led to an increase in foreign bank claims on China. But this inflow contributed to the domestic credit bubble that has fueled increases in housing prices. Private debt scaled by GDP has risen to levels that were followed by crises in other countries, such as Japan in the 1980s and South Korea in the 1990s. All of this gave the policymakers a motive for trying to discourage further capital inflows by making it clear the renminbi’s movement need not be one way.

Moreover, the authorities may have wanted to hold down further appreciation of the renminbi. The release of new GDP estimates for China based on revised purchasing power parity data showed that country’s economy to be larger than previously thought. The new GDP data, in turn, have led to revisions by Marvin Kessler and Arvind Subramanian of the renminbi exchange rate that would be consistent with the Balassa-Samuelson model that correlates exchange rates to levels of income. Their results indicate that the exchange rate is now “fairly valued.” With the current account surplus in 2013 down to 2% of GDP, Chinese officials may believe that there is little room for further appreciation.

Gavyn Davies points out that there is another way to relieve the pressure on the exchange rate due to capital inflows: allow more outflows. Even if domestic savers receive the higher rates of return that government officials are signaling will come, Chinese investors would undoubtedly want to take advantage of the opportunity to diversity their asset holdings. As pointed out previously, however, capital outflows could pose a threat to the Chinese financial system as well as international financial stability. Chinese economists such as Yu Yongding have warned of the consequences of too rapid a liberalization of the capital account.

The Chinese authorities, therefore, face difficult policy choices due to the constraints of the trilemma. Relaxing the constraints on capital flows could cause the exchange rate to overshoot while further adding to the domestic credit boom that the central bank seeks to restrain. But clamping down on capital flows would slow down the increase in the use of the renminbi for international trade. As long as the policymakers seek to maneuver around the restraints of the trilemma, they will be reacting to the responses in foreign exchange and capital markets to their own previous initiatives.