By: Mat Lystra, Sr. Research Analyst
There’s an economic axiom called “The Impossible Trinity” which states that a country cannot simultaneously control its exchange rate and its monetary policy while also allowing unrestricted cross-border capital flows. Those anticipating the fall of the Chinese currency, the Renminbi, often point to this theory to support their hypothesis. In this economic juggling act, as the theory goes, something must drop. Historically it’s been a managed exchange rate that countries have most often let go of, often with dramatic effects on asset prices. Can China defy this proposed inevitability?
In this first of a three-part series, we’ll explore China’s efforts to maintain a stable Renminbi/USD (CNY/USD) exchange rate. Subsequent posts will examine the other two pieces of the trinity—monetary policy and capital flows. For now, let’s take a look at how the Renminbi is valued and the steps China is taking to maintain at least partial control of its exchange rate.
The value of CNY relative to USD does not float freely, but is allowed to move within a certain range above or below a daily reference point set by the People’s Bank of China (PBOC). China has continued to make progress towards internationalizing the Renminbi, doing enough to be awarded membership in the IMF’s “Special Drawing Right” basket of currencies. However, it is also straining to resist the forces pressing for devaluation.
As illustrated below, to ward off a devaluation, China has spent almost $800B of what was a nearly $4T foreign currency reserve fortress to support the Renminbi in the last year—selling dollars into the market to buy back its own currency. Thus, reversing a multi-year build-up of foreign exchange reserves.
China Forex reserves vs. reserves of other BRIC Countries (Brazil, Russia, India)
Source: Bloomberg through January 31, 2016.
This tactic does come with a downside as a liquidity-inflation dilemma emerges when the Renminbi is moved out of the global market and piles up onshore. A secondary symptom of the buyback program arises from the need to “sterilize” the repurchased CNY before inflation sets in -- leading to the second leg of the trilemma -- monetary policy.
The currency sterilization process seeks to “trap” as much of the incoming excess currency as possible in order to avoid an imbalance between an increasing supply of money and a limited number of goods and services that can be purchased. Since banks are viewed as natural sponges that can soak up the extra liquidity, the PBOC has maintained a high reserve requirement ratio (RRR) for the country’s deposit-taking institutions. The higher RRR means domestic banks must hold on to more cash thus decreasing the lending activities that could help to stimulate the economy.
We can see in the chart below that China’s RRR is significantly higher than those of the other BRIC countries. However, as the CNY/USD exchange rate has been allowed to appreciate in recent months, China has taken to cautiously reducing the RRR to leave room for some lending to help boost the ailing economy.
BRIC required reserve ratio comparison
Source: Bloomberg through January 31, 2016.
The banded-exchange rate, expenditures of foreign reserves and a higher peer-relative RRR are all strong indicators that China is committed to a partially-controlled exchange rate regime (i.e. not pegged to a completely fixed CNY/USD rate), at least in the near term.
As the three-part series concludes, we’ll end up with a view as to the three currency-related tests of the “trilemma” with which we can weigh-in on whether China may be able to bend the rules of the trinity without breaking them.
Watch for part two of this blog series which will examine the second piece of the impossible trinity: monetary policy.
 The author wishes to thank Tom Goodwin and Catherine Yoshimoto for their contributions to this research.
 Grenville, S. (2011). The Impossible Trinity and Capital Flows in East Asia. Asian Development Bank Institute accessed on March 1, 2016 at: http://www.eaber.org/sites/default/files/documents/2011.11.07.wp319.impossible.trinity.capital.flows_.east_.asia_.pdf
 Buiter, W.H., Corsetti, G.M., & Pesenti, P. (1998). Interpreting the ERM Crisis: Country-Specific and Systemic Issues. Princeton University, accessed on March 9, 2016 at: https://www.princeton.edu/~ies/IES_Studies/S84.pdf; and Whitt, J.A. (1996). The Mexican Peso Crisis. U.S. Federal Reserve Bank of Atlanta Policy Paper, accessed on March 3, 2016 at: https://www.frbatlanta.org/-/media/Documents/filelegacydocs/Jwhi811.pdf
 India’s most recent figure was from 12/31/2015 as was carried forward to 1/31/2016.
 Glick, R. & Hutchison, M. (2011). Currency Crises. U.S. Federal Reserve Bank of San Francisco Working Paper, accessed on March 1, 2016 at: http://www.frbsf.org/economic-research/files/wp11-22bk.pdf
 Lee, J-Y. (1997). Sterilizing Capital Inflows. International Monetary Fund, access on March 29th, 2016 at: http://www.imf.org/EXTERNAL/PUBS/FT/ISSUES7/INDEX.HTM
© 2016 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE TMX Global Debt Capital Markets Inc. and FTSE TMX Global Debt Capital Markets Limited (together, “FTSE TMX”) and (4) MTSNext Limited (“MTSNext”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE TMX and MTS Next Limited. “FTSE®”, “Russell®”, “FTSE Russell®” “MTS®”, “FTSE TMX®”, “FTSE4Good®” and “ICB®” and all other trademarks and service marks used herein (whether registered or unregistered) are trade marks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, or FTSE TMX.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for any errors or for any loss from use of this publication or any of the information or data contained herein.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell indexes or the fitness or suitability of the indexes for any particular purpose to which they might be put.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group index data and the use of their data to create financial products require a license from FTSE, Russell, FTSE TMX, MTSNext and/or their respective licensors.