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China’s currency: Bending without breaking - Part 2 of 3

By: Mat Lystra, Sr. Research Analyst

In part one of our blog series on China’s currency we introduced the notion of the “impossible trinity”, an economic theory which says a country cannot simultaneously control its exchange rate and its monetary policy while allowing unrestricted cross-border capital flows. We then explored the first component, China’s approach to managing the Renminbi (CNY)/USD exchange rate. In this post we will see the “Trilemma” come further into view as we explore the second piece of the impossible trinity – China’s monetary policy. 

After analyzing China’s exchange rate policy, we concluded that while China is taking steps to manage its exchange rate, it has allowed for some devaluation against the dollar. We have shown that the current exchange rate regime is enabled by a drawdown of foreign currency reserves. This creates the unfortunate side-effect of a higher reserve requirement ratio for its domestic banks which may negatively impact lending and growth. With this as a backdrop, let’s take a look at how the People’s Bank of China (PBOC) is trying to balance monetary policy against the desire to keep the CNY stable.

China’s economy has been slowing for several years now and part of the PBOC tool kit is to adjust its monetary policy by lowering borrowing rates in order to spur economic growth. The one-year lending rate has been falling incrementally since late 2014. The move from 6% in October 2014 to 4.35% a year later was managed methodically over a series of six different rate cuts, none larger than the first 0.4 percentage point drop.[1] As illustrated below, over the same time period, India had two moves of at least half a percent; and tightening in Brazil produced four moves of half a percent or more.  While economic conditions vary by country, the conservative approach taken by the PBOC as compared to its BRIC counterparts suggests the trilemma may be influencing monetary policy.

Key interest rates for China, India, Russia and Brazil

Source: Bloomberg through February 29, 2016.

Part of the rationale behind the impossible trinity is that most countries place a premium on keeping control of their domestic interest rates.[2] However, as discussed in part one of our series, inflationary pressure grows as China’s monetary base expands. This is where the tension emerges – as the PBOC needs to lower rates to stimulate economic growth, there is also a pull to keep them high enough to check inflation. This means that should China’s economy continue to decelerate, the PBOC’s monetary response could be constrained by the degree to which it continues to support the exchange rate.

As evidenced by China’s recent interest rate cuts, the PBOC can and will, use monetary policy in response to economic conditions. However, the extent of China’s responsiveness to the need for future stimulus may be conditioned on efforts to support the exchange rate.  In the final part of the series we will examine capital flows as the final consideration using the framework of the impossible trinity and come to a conclusion on our question: can China bend without breaking? 


[1] Bloomberg through February 29, 2016.

[2] Glick, R. & Hutchison, M. (2011). Currency Crises.  U.S. Federal Reserve Bank of San Francisco Working Paper, accessed on March 1, 2016 at:


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