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Economy

Chinese policymakers stuck in a trilemma

Monetary policy autonomy and free capital flows ... or a stable yuan

The People's Bank of China headquarters, in Beijing

HONG KONG -- It seems China is running up against what international economists call the trilemma, or the impossible trinity.

This is the idea that a country cannot have an independent monetary policy, free flows of capital and a stable currency at the same time.

China has tried to stabilize the yuan and maintain a unique monetary policy under stringent capital regulations.

In recent years, China has tried to internationalize the yuan in phases. Toward this end, it has established the Pilot Free Trade Zones and created a link through which investors in Shanghai and Hong Kong can trade on either city's stock exchange.

It would also like to move toward an economy through which capital moves freely; it would like the market to set the yuan's value; the government also wants to keep its independence when it comes to monetary policymaking.

Faced with this trilemma, though, the government will have to choose: monetary policy independence and free capital movement, or a stable currency.

Currently, China has adopted an ambiguous stance toward yuan stability and the free flow of capital. The yuan, which is expected to trend lower, is likely to come under selling pressure if no measures are taken.

But a measure is being taken -- by the People's Bank of China, the country's central bank, which is selling off large chunks of its foreign currency reserves to support the yuan.

Tough choice

With the yuan weakening, Chinese who hold the currency want to offshore their savings. In other words, they want to buy non-yuan-based assets. To keep capital from flowing out of the country, Chinese authorities are beginning to clamp down by:

  • Tightening currency exchange controls;
  • Restricting some uses of credit cards;
  • Keeping a close watch on individuals buying foreign currency-denominated insurance policies;
  • Even making it difficult for Chinese companies to use yuan to acquire overseas rivals.

The clampdown goes against efforts to internationalize the yuan and liberalize capital transactions.

China's foreign reserves at the end of January came to $2.99 trillion, dropping below the $3 trillion mark for the first time since February 2011, according to the PBOC.

In one month, these reserves fell by $12.3 billion as the government used them to defend the yuan. The country's piles of foreign currencies are still dwindling at a disquieting pace, though not quite as fast as in that one particular month.

According to Amy Yuan Zhuang, chief Asia analyst at Nordea Markets in Singapore, some $44 billion worth of yuan flew out of the country in January, up from $33 billion in December. This easily offset a $32 billion increase in the value of the government's foreign reserves due to the dollar's depreciation against other currencies.

This is alarming, Zhuang said, considering Beijing's clampdown.

If cash keeps making such dramatic exits from China and the yuan continues to depreciate, the country's economy could find itself locked up. Chaos could result.

Even Chinese companies that raise cash in dollars and other foreign currencies could see their financial positions deteriorate.

Spanish bank BBVA predicts that China will shift to a floating exchange rate as early as the second half of 2018. In this case, the yuan would fluctuate and it would be difficult to avoid an "overshooting of exchange rate," a BBVA representative said.

Still, the only way China can escape its trilemma is to give up trying to stabilize its currency.

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