Abstract
This paper first reviews recent developments in exchange rate regimes, capital account liberalization, interest rate liberalization, and monetary policymaking in the People's Republic of China (PRC). It then observes that the PRC's monetary policy autonomy may have been reduced with falling capital control effectiveness and a rigid exchange regime that is still tightly managed against the United States (US) dollar. This hypothesis is investigated empirically using both the Taylor rule and the McCallum-like rule to test whether the PRC's money market interest rate and/or quantity of money supply are being increasingly influenced by the US interest rate or reserve accumulation. The paper concludes that there is considerable evidence suggesting diminishing monetary policy autonomy in the PRC. To regain policy autonomy, the monetary authority needs to substantially increase exchange rate flexibility of the renminbi as long as it continues to pursue capital account opening.
Highlights
The People’s Republic of China (PRC) is facing trilemma challenges as it continues to liberalize its capital account
This paper argues that while the PRC’s financial markets have become increasingly integrated with external markets, those in Hong Kong, China, the degree of RMB exchange rate flexibility has not risen much, and the combination of greater openness of its financial markets and lack of sufficient exchange rate flexibility has constrained the ability of the monetary authority to pursue autonomous monetary policy
If we find that a major monetary policy instrument, such as the policy interest rate and growth of monetary aggregates, was used successfully to achieve domestic policy objectives without being significantly constrained by foreign monetary policy changes or its own exchange rate regime, we can conclude that the PRC authority retains monetary policy autonomy
Summary
The People’s Republic of China (PRC) is facing trilemma challenges as it continues to liberalize its capital account. The trilemma hypothesis claims that a country’s monetary authority cannot achieve exchange rate stability, financial market (or capital account) openness, and monetary policy autonomy at the same time.. As financial market openness has increased over time in the PRC, its monetary authority must choose greater exchange rate flexibility to retain a high degree of monetary policy autonomy. This paper argues that while the PRC’s financial markets have become increasingly integrated with external markets, those in Hong Kong, China, the degree of RMB exchange rate flexibility has not risen much, and the combination of greater openness of its financial markets and lack of sufficient exchange rate flexibility has constrained the ability of the monetary authority to pursue autonomous monetary policy.
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