Capital Flows Sterilization and the Independenceof Monetary PolicyThe Case of China.docx
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Capital Flows Sterilization and the Independenceof Monetary PolicyThe Case of China.docx
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CapitalFlowsSterilizationandtheIndependenceofMonetaryPolicyTheCaseofChina
CapitalFlows,Sterilization,andtheIndependence
ofMonetaryPolicy:
TheCaseofChina
I.IntroductionandLiteratureSurvey
ThispaperstudiestheeffectsofcapitalflowsonthemonetarypolicyindependenceandthefeasibilityofsterilizationinthepastdecadeinChina.
Whenadoptingregimesoffixed,pegged,andmanaged-floatingexchangerates,monetaryauthoritieshavetointerveneintheforeignexchangemarkettomaintainsuchexchangeratearrangements.Asaresult,theirmonetarypolicyandexchangeratepolicymaynolongerbemutuallyindependent,becausetheinterventioncaninfluencethesupplyofmoney.Forexample,thecreditexpansionaimedataffectingdomesticmarketswillcauseanincipientweakeningoftheexchangerate.Tomaintaintheexchangerateatapredeterminedlevel(ortostabilizetheexchangerateundermanagedfloating),thecentralbankhastoreducehigh-poweredmoneybysellingforeignexchangereservesinthemarket.Inthismanner,attemptstoalterthedomesticcomponentofthemonetarybaseareimpededduetooffsettingmovementsoftheforeignreservescomponent.Completeoffsettothedomesticcreditexpansionmeansthatthemonetarybaseisoutofthecontrolofthecentralbank.Toavoidthis,centralbankshaveoftenattemptedtoneutralizetheeffectsoftheinterventionactivitiesonthemoneysupplybyundertakingoffsettingoperationsindomesticfinancialmarkets.Thisiscalledsterilization.Anofficialpurchaseofforeignexchangecanbesterilizedbyacorrespondingopenmarketsalesofdomesticsecurities.Thetransaction,whichisequivalenttoanofficialforwardsaleofdomesticcurrency,leavesrelativemoneysuppliesunchanged,butalteringtherelativesuppliesofforeignanddomesticcurrencysecuritiesavailabletothepublic.Generallyspeaking,thesterilizationpolicycanbeviewedasanattemptthatacentralbankmakestoattainindependentexchange-rateandmoney-supplytargets.
Therehasalreadybeenalargetheoreticalandempiricalliteratureconcernedwiththefeasibilityofsterilizationandwiththedegreetowhichmonetaryauthoritiesactuallysterilize..Themajorityofliteratureconcerningwithsterilizationiscastwithintheboundsofperfectsubstitutabilityofinterest-earningassetsandperfectcapitalmobility.Sterilizedinterventionhasnoroletoplayinsuchcircumstances(Mondell,1968).FurtherresearchmadebyStockman(1979),Boyer(1979),Obstfeld(1980)pointoutthatbothimperfectsubstitutabilitybetweeninterest-bearingassetsofdifferentcurrencydenominationandimperfectmobilityofcapitalwillofferthemonetaryauthoritysomeshort-runpolicyindependence.Imperfectsubstitutabilitycanariseifvariousrisksrendertheperceivedreturnsondomesticandforeignassetsstochastic.Whenthisisso,thedesiredportfolioshareofdomesticbondsindomesticwealthisanincreasingfunctionofthehomeinterestrate,andthecentralbankcaninfluencethisrate(andso,thedemandformoney)byvaryingthestockofoutsidedomesticcurrencydebtavailabletoprivatewealthowners.Obstfeld(1980,1982)alsopointoutthatcostsassociatedwithrapidportfolioadjustmentmayallowinternationalinterestratearbitragetooccuronlyovertime.Thustheimperfectcapitalmobilityaffordsthemonetaryauthorityasecondmeansoftemporarilyinfluencingdomesticcreditconditions.
However,thefeasibilityofsterilizationandconductingindependentmonetarypolicydependsonthedegreeofcapitalmobility.Whencapitalmobilityislessthanperfect,theauthoritycertainlycanchoosetosterilizepartoralloftheeffectsofthebalanceofpayment.Suchoperationswillinsulatethedomesticeconomypartlyorfullyfromtheshockofexternaldisturbances.Butifthedegreeofcapitalmobilityismorethanzero,sterilizationpolicieswillalsoworsenthevariationsinthebalanceofpaymentsandinternationalreserves,becausetheywillleadtofurthercapitalflows.Thehigheristhedegreeofcapitalmobility,theworsethesituationwillbe.Thereforethereisatrade-offbetweenthedomesticandexternaltargetsfortheauthorityinchoosingthedegreeofsterilization.Thisexplainswhythemonetaryauthoritiestendtocontrolinternationalcapitalmovementsinpursuingsterilizationpoliciesunderafixedexchangerateregime.
Todeterminethefeasibilityofsterilizationpolicy,wehavetomeasuretheoffsetcoefficient--thefractionofanydomesticcreditexpansionreversedbyforeignreservelossesovertherelevanttimehorizon.Awidelyusedempiricalmethoddevelopedtoestimatetheoffsetcoefficientisthereduced-formapproach.Itisanapproximatelinearequationderivedfromthebondandmoneymarketequilibriumconditionsandthecentralbank’sbalancesheet.Atypicalreduced-formusedtoestimatethecoefficientisasfollows:
where
denotesthechangeininternationalreservesduringperiodt,DAtdenotesthechangeinthedomesticassetscomponentofthemonetarybase,Xtdenotesavectorofotherfactorsthatinducechangesininternationalreserves,andutdenotestheerrorterm.Inequation(1.1)theparameter2iscalledtheoffsetcoefficient.Itisameasureofthedegreetowhichchangesinthedomesticassetcomponentofmonetarybaseisoffsetbychangesinthestockofinternationalreserves.Anegativevalueof2indicatesthatlossesofreservesoffsettheeffectsofcreditexpansion.When2=-1,theoffsetiscomplete.
Theoffsetcoefficientdependsonthecurrent-accountaswellasthecapitalaccountresponsetodomesticcreditexpansion.Empiricalstudiestypicallyassumedthatthecapital-accountresponseisdominantintheshort-run.Sothecurrentaccountandincomearepredetermined.Theoffsetcoefficientisthereforeinterpretedasameasureofcapitalaccountsensitivitytodomesticcreditexpansion.Equation(1.1)canberewrittenasfollows:
whereCAPtisthecapitalaccountsurplus(deficit)inperiodt,CURRtiscurrentaccountsurplus(deficit)inperiodt.
Thereduced-formapproachhasoftenfailedtoaccountforsterilizationbecauseitviewsthedomesticcomponentofbasemoneyasapredeterminedvariableforthepurposeofestimatingtheoffsetcoefficient.TheproblemistheendogeneityofthedomesticcreditvariableDAinequation(1.1)whenthecentralbankfollowsasterilizationpolicy.AsemphasizedbyCumbyandObstfeld(1981),totheextendthatdomesticcreditpolicyisinfluencedbythestateofthebalanceofpayments,ordinary-least-squares(OLS)estimatesof2willbebiased.Thedependenceofdomesticcreditpolicyonthebalanceofpaymentsisusuallyrationalizedbynotingthatthemonetaryauthoritymaywishtosterilizetheconsequencesofthebalanceofpayments.Suchasterilizationfunctionisdescribedinequation(1.2):
whereYtdenotesavectorofotherfactorsdeterminingcreditpolicy,andtdenotesanerrorterm.Inequation(1.2),2isrefereedtoasthesterilizationcoefficient.Anegativevalueof2indicatesthatthemonetaryauthorityattemptstosterilizethemonetaryconsequencesofreserveflows,andwhen2=-1,sterilizationiscomplete.Evidently,whenthebehaviorofthemonetaryauthorityischaracterizedbyequation(1.2)with2<0(thatis,conductingasterilizationpolicy),DAtwillbecorrelatedwithut,andtheOLSestimateofoffsetcoefficient2inequation(1.1)wouldgenerallybebiaseddownward(algebraically).Thishasbeingdiscussedbyanumberofauthors,includingArgyandKouri(1974),Magee(1976),GirtonandRoper(1977),Murray(1978)andreiteratedbyCumbyandObstfeld(1980,1982).
Empiricalstudiesofoffsettingcapitalflowshaveconcentratedalmostexclusivelyontheindustrializedcountries.Therearemuchlessrestrictionsoncapitalflowsinthesecountiesthaninmostofthelessdevelopedcountries.ThecapitalmarketsintheLDCsareunderdeveloped,theinterestratesarerigidandarecontrolledbygovernments,andverystrictrestrictionsarealsoimposedontheircapitalaccounttransactions(inmostofthedevelopingcountries,currenciesareinconvertible).ThisimpliesthattheoffseteffectscausedbythecapitalflowaremuchlessimportantintheLDCsthaninthedevelopedcountries.Nevertheless,thismaynotalwaysbetrue.Duringthepasttwodecades,significantfinancialreformshavebeenundertakentoliberalizetherestrictionsonexternalanddomesticfinancialtransactionsinmanydevelopingcountries.Thiswasmotivatedinpartbythedesiretoimprovefinancialefficiencybyincreasingcompetitionindomesticfinancialsystems.Ontheotherhand,thestructurechangesandotherfactorshavereducedtheabilityofcapitalcontrolstoinsulatedomesticfinancialconditionsfromthoseinexternalmarkets.Infact,theevasionsagainstexchangecontrolsandrestrictionsoncapitalaccounttransactionsexistwidelyindevelopingcountries.Someofthesecountriesevenexperiencedseriouscapitalflightwhentheyemployedexpansionarymonetarypolicy.
SinceChinaadoptedthereformandopen-doorpolicyin1978,adramaticchangehashappenedinitseconomicsystemandstructure.Theeconomyhasbecomeincreasinglyopen.Thelinkagebetweenitsinternalmarketandtherestoftheworldhasgreatlybeenstrengthened.Between1990and1993,Chinaadoptedaveryloosemonetarypolicy.ThisisaperiodwhenalotofChinesecompaniesestablishedtheiroverseasbusinessoperations,usingofficiallyorunofficiallymoved-outcapital.In1994and1995,thedomesticcreditbecameextremelytight,andChinasawhugecapitalinflows.Thecountry’sforeignexchangereservesincreasedby30.42billionsin1994,and11.02billioninthefirstsixmonthsof19
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