The costs and implications of PBC sterilization.

• Author: Greenwood, John
• Position: Essay

Since China revalued its currency against the U.S. dollar by 2.1 percent in July 2005, from RMB 8.27 per US$ to RMB 8.11, the RMB has appreciated by a further 14 per cent percent to about RMB 6.97 per US$ (as of May 2008). On a trade-weighted basis, however, the currency has appreciated less than half this amount. Using J.E Morgan's trade-weighted index (broad basis) for the RMB, the currency appreciated just 6.1 percent in nominal terms between August 2005 and May 2008. Although the currency has been very gradually appreciating, the flexibility promised by China's leaders has been more illusory than real, and, more importantly, the underlying international payment imbalances have continued to widen both in absolute terms and as a fraction of GDP.

In this article, I set out the magnitude of the problem of China's international payment imbalances, summarize the techniques used by the People's Bank of China to sterilize China's overall balance of payments surplus, and assess the costs and benefits of the PBC's sterilization strategy--both from a theoretical perspective and in the light of the experience of other East Asian currencies that have witnessed large-scale sterilization operations in the past. I also consider whether, for the purpose of ensuring satisfactory monetary arrangements in the 21st century, it is appropriate for a country of the size and stature of China to delay adjustment by means of large-scale sterilization.

China's International Payments Imbalance

In the period prior to 2002, there were few presumptions that China's currency would appreciate. There had been a long history of devaluations between 1960 and 1994. However, following the devaluation of 1994 and the subsequent monetary reforms the external value of the currency was held stable against the US$, notably throughout the Asian financial crisis of 1997-98. Nevertheless, the NDF (non-deliverable forward) value of China's currency traded at a persistent discount to the spot value of the currency (that is, weaker than the spot rate of around 8.27 per US$) until December 2002 when it moved to a premium for the first time (Figure 1). In the same year, the errors and omissions item in China's balance of payments shifted from negative to positive, suggesting a change from unreported outflows to unreported inflows. In 2003 and 2004 both the current account and the capital account showed marked increases in the size of their surpluses.

Since the revaluation of July 2005, and despite the gradual subsequent appreciation of the RMB against the U.S. dollar and other currencies, the low level of the Chinese currency is causing China to run increasingly large overall (current plus private sector capital account) surpluses in its balance of payments. The simplest measure of that overall (current and capital) surplus is the increase in China's foreign exchange reserves. (1) In 2006, the overall surplus was $246 billion or 9.1 percent of GDP, while the current account surplus was $249 billion or 9.2 percent of GDP (Table 1). In 2007, the current account surplus increased to $371.8 billion or 11.1 percent of GDR Similarly, the overall surplus in 2007 was $461.7 billion, or 13.8 percent of GDP. By any standard, these imbalances are of a very substantial magnitude, and will have large consequences for both China's trading partners as well as for China itself.

PBC's Sterilization Techniques

The overall surpluses in the balance of payments require the PBC, China's central bank, to intervene almost daily and buy any excess foreign currency on the Shanghai foreign exchange market in order to hold down the value of the RMB. Based on 250 trading days per year, the PBC's foreign exchange purchases exceeded $1.8 billion per day in 2007. In making these purchases, the PBC typically credits the reserve accounts of mainland banks with an equivalent amount of RMB, which in the normal course of events would cause China's money supply to accelerate (as in 2002-03), and this in turn would normally lead to inflation. The inflation--if permitted--would at some point render China uncompelitive at the prevailing exchange rate, and the balance of payments would revert to balance or even deficit.

However, having experienced several episodes of monetary acceleration, inflation mid its 'aftermath (in the form of social disturbances) in the past three decades (for example, in 1988-89 and 1993-95), the Chinese authorities seem nowadays determined to implement monetary policy in such a way as to avoid the same sequence of results. Therefore, after buying foreign currency and thus creating RMB, the PBC subsequently removes the RMB from the banking system. It has learned the techniques for doing this from other Asian central banks that have routinely conducted such sterilization operations over the past two or three decades. (2)

The essence of the PBC sterilization techniques is (1) to raise reserve requirements against deposits of commercial banks, and (2) to issue RMB-denominated bills and bonds (called sterilization bills or bonds) to the banks and other financial institutions. As of May 2008 the level of reserve requirements was 16.5 percent of bank deposits (up from 6 percent in 2003), while the value of...