Trilemma, dilemma, and the PBoC's primer for the 'new normal'

"Recently the trend has been a return to normality, a return to rationality, a return to fundamentals. Unless there is some unusual circumstance, I believe this trend will continue." Such were the remarks by People's Bank of China (PBoC) governor Zhou Xiaochuan during a press conference on the sidelines of China's rubber-stamp National People's Congress in March 2016.

Whether the macroeconomic situation has improved in China is, of course, up for debate. However, what Zhou did recognise was that there had been a deviation from 'normality', 'rationality', and 'fundamentals' in the Chinese economy. Indeed, the PBoC has been in fire-fighter mode in the last nine months as issues have been flaring up one after another in China's financial system, of which the Bank is mandated to maintain overall stability. It started with a stock market crash in June 2015, followed by a surprise devaluation of the renminbi two months later, and eventuated into a massive capital exodus since then. The financial turbulence that gripped China has in turn sent shocks to the financial markets in the rest of the world.

The trilemma

For many, what the PBoC faces should be a typical scenario of 'trilemma', or 'impossible trinity', as first framed by the economist Robert Mundell in the late 1960s. It reminds central bankers that it is impossible to simultaneously pursue more than two of three goals: an independent monetary policy; a fixed exchange rate; and free capital movements. The problem for China is that Beijing appears to be ambitious in achieving them all at the same time: it prefers a stable RMB exchange rate and has been liberalising its capital account, but refuses to relinquish autonomy in monetary policy.

The trilemma hypothesis suggests that a country's international economic policy invariably involves a series of trade-offs. However, if we look closer, the situation in China seems less complicated, as monetary policy independence has been an imperative. The expectation of monetary tightening in the US and a continued slowdown in the Chinese economy means the Bank must reserve its ammunition in dealing with overcapacity and deflation.

The dilemma

For the PBoC, therefore, the situation has been a dilemma rather the trilemma: a trade-off between exchange rate stability and capital controls, although it is no less painful as a result. If China persists with capital liberalisation, it would have to allow the currency to fall sharply or eventually float freely, which will be unchartered waters for Chinese policy-makers who are used to managing the economy through quantitative control; if China opted to stabilise the renminbi exchange rate, as Bank of Japan governor Haruhiko Kuroda suggests, it would have to reverse the current trend of capital liberalisation and reintroduce tighter controls over cross-border transactions¹. This would be a severe blow to China's financial reforms so far and Beijing's achievement in internationalising the renminbi.

Beijing's initial strategy was to devalue the renminbi in the wake of sluggish growth of the economy, amid the IMF's decision to include the Chinese currency into its SDR basket. The PBoC further announced in December 2015 that it would switch the renminbi's peg from the US dollar to a trade-weighted basket of currencies, which effectively led to a weaker yuan against the dollar. Nevertheless, the bleak prospects for the economy, the official devaluation and the switched peg triggered a market panic that saw a sell-off of the yuan (particularly in offshore markets) and an international exodus from renminbi-denominated assets.

The PBoC was initially forced to steady the yuan without resorting to capital controls, at the expense of China's foreign reserves – they were poured in to stabilise the yuan's exchange rate. Largely because of the operation, China's official reserves were reduced from a peak of $4 trillion in mid-2014 to $3.2 trillion by February 2016, including a record $107.9 billion plunge in December 2015.

Given the rapid dwindling of its war chest, the PBoC had to prioritise the yuan's stability over market reforms. While reluctant to acknowledge this, the Bank has imposed controls over firms' and domestic individuals' foreign exchange transactions, aimed at preventing money from leaving the country. At the same time, it tried to inject liquidity into the domestic financial system through a combination of lending facilities that have been on trial in the last two years. This includes short-term liquidity operations (SLO), the medium-term lending facility (MLF), and pledged supplementary lending (PSL).

It seems the PBoC has also been experimenting with a new trick that would allow currency liberalisation without destabilising its value. The Bank has reportedly adopted a strategy of buying time in exchange for (policy) space, which sees the PBoC acquire foreign exchange liquidity in the forward market that is to be used in the spot market to defend the yuan². Such buy/sell operations in the swap market would help achieve the goal of strengthening the yuan without using China's foreign reserves, and thus help to stabilise and guide market expectations of yuan's value.

The primer

The recent trend in 2016 could award the Bank a reprieve, at least for now. The RMB exchange rate against the dollar has reached a peak in the last few months; the monthly reduction of reserves has decreased from more than $100 billion to $30 billion in February, meaning a slowdown in capital outflows.

However, the real challenge for the Chinese central bank will be to explore a new policy framework for the 'new normal' of the Chinese economy, which is a slower-paced economy amid the transition from public investment to consumption and innovation. In particular, how to maintain the space for monetary policy to adjust when it is forced to give in to political pressures for easing? How to manage the process of currency liberalisation without triggering a backlash in the domestic non-tradable sectors that could lose from the move? How to liberalise capital flows without causing financial instability? How to improve its communications with the market while reserving its initiatives and discretion?

The PBoC's experience in dealing with the trilemma/dilemma in the last nine months should serve as a primer for the central bank. It is an early taste of what is to come and what to expect in a new policy environment in which strong economic growth and appreciation of the currency are no longer a one-way bet. The trade-offs will be more complicated and sensitive, the stakes are high. The Bank has had a fairly impressive track record in helping manage China's macroeconomy, especially since the 2000s, and it will continue to play a key role in the more daunting task of China's grand economic transition.

1. Chris Giles, 'Kuroda calls for China to tighten capital controls', Financial Times, January 23, 2016.
2. 'The PBoC's New Trick: Stabilising the Exchange Rate No Longer Burdensome', Reuters China Blog