The Impossible Trinity or Trilemma is a trilemma in international economics which states that it is impossible to have all three of the following at the same time:
- A fixed foreign exchange rate
- Free capital movement (absence of capital controls)
- An independent monetary policy
When the PBOC buys dollar assets, they do so
by increasing the Chinese domestic monetary base (the domestic
banking system's yuan reserve balance) which puts downward pressure on Chinese
interbank interest rates. In order to target a specific FX rate the PBOC
must accumulate foreign exchange reserves when their current account surplus is
greater than the capital account deficit. This is what it means to have a
positive balance of payments.
On the other side of these balances are China's trading
partners who must run corresponding negative balance of payments. In
other words, countries like the US end up running large current account (trade)
deficits. Bernanke wrote a series of posts that were critical of
countries that attempted to perpetually accumulate foreign reserves as
this practice reduces global aggregate demand relative to supply.
Now consider the opposite scenario where Chinese policy
changes by prioritize domestic liquidity conditions by adding yuan reserves to
their banking system through domestic open market operations that work to
offset the sale of any dollar assets off of the PBOC's balance sheet.
This would put downward pressure on Chinese interest rates relative to what would occur if the PBOC were to solely sell off dollar assets in order to stabilize the FX rate.* What this
also does is release a supply of safe dollar t-securities at a time where
dollar demand relative to supply has been elevated as witnessed by the rapid
appreciation of the dollar against most currencies. If anything this
should alleviate tight global dollar financial conditions.
Moreover, if policies that have led to the persistent
accumulation of foreign exchange reserves have reduced global aggregate demand
and thereby inflation and LT interest rates (via the term premium) in developed
markets for over a decade, then I would suspect that any deaccumulation should
boost global demand. In the process this boost to global aggregate demand
should close global output gaps enough to possibly reverse the disinflationary
trends and weak wage growth witnessed in the developed world.
Therefore, what may be best for global demand
would be for China to ease domestic monetary conditions by increasing their
domestic reserve balances within their banking system until they stabilize the
deceleration in nominal GDP. As this
would likely induce capital flight, the PBOC should sell off their dollar
assets while simultaneously responding by buying Chinese government securities
to offset any monetary tightness.
A Chinese economic rebalancing away from export and
investment lead growth to an economy that is more geared toward Chinese
domestic consumption does not necessarily need to translate to slowing global
growth. If anything, the rise of the Chinese consumer should create a new
source of demand.
As for any comparison between PBOC dollar/t-security
selling to the reversal of the Fed's QE program which would also involve the
sale of t-securities, these are not the same. Yes selling dollar assets
off of PBOC's balance sheet would act as a domestic monetary tightening, but they could improve liquidity conditions in China by buying yuan securities to offset these
dollar sales. I suspect that the move away from tightly managing the FX
rate is to signal that this is in fact what they plan to do where Chinese
monetary policy will be more oriented toward steering domestic interest rates
as the main policy lever.**
On the other hand, if the Fed were to reverse their
previous asset purchases it would be because they feel that US NGDP,
employment, and inflation are expected to increase at a pace that is above
their mandates. In other words, in that state of the world, US economic
activity would be much better than what we are currently experiencing.
The Fed would be signaling that their balance sheet would be set to
shrink because US growth was expected to be that strong.***
**It does not seem like the PBOC primarily desires a
lower FX rate as this undermines attempts to rebalance the economy away from investment lead growth, property development/speculation, and to a lesser extent (post GFC) export dependence, toward one that is more reliant on domestic consumption. A declining FX rate reduces household share of income unless domestic unemployment is low enough to cause household income growth to accelerate.
Thus, it's more about steering domestic rates in a way
that helps mitigate a slowdown in the domestic nominal economy that threatens to cause rising unemployment and political instability. This
does not necessarily mean that the yuan must weaken materially as long as the PBOC are
willing to sell off their dollar reserves while offsetting such sales by buying
yuan government bonds. Eventually, the goal is for the yuan to become a
freely floating currency. Setting policy in a way that guaranteed yuan
appreciation was problematic as this promoted excessive private leverage and a carry
trade, but this doesn't mean they should set expectations that the yuan can
only fall. If that is the case then what prevents market participants
from initiating leveraged short trades against the yuan (in other words leveraged long dollar bets)? To reduce leveraged bets on the FX rate moving in either direction, volatility must be increased. The PBOC's large US dollar reserve position enables them to manage the trade in such a way.
Moreover, if the PBOC were to allow the domestic monetary base to
continue contracting while Chinese nominal and real GDP decelerated, then this strikes
me as the worst option available for the global economy. If they attempt
to stabilize/increase the domestic monetary base by engaging in yuan asset
purchases that work to reduce domestic rates without managing the potential
decline in the FX rate by simultaneously selling dollar assets then this would
strike me as the second worse scenario. I do not see how the PBOC can credibly prevent a decline in the yuan over the intermediate or long term if global asset managers expect Chinese economic activity to be much lower in the future. A deteriorating Chinese economic picture (story) creates the expectation that the PBOC would have to eventually act by easing or that fiscal measures oriented toward the household sector will need to be considered.
***This is not to suggest that I think the Fed will set such expectations anytime soon or sell securities off their balance sheet. How the Fed manages its big balance sheet using tools such as IOER and ON RRP is the way of the future in terms of monetary policy in the US.
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