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Mercantilism and marketization? Analysis of China's reserve accumulation and changes in exchange rate regime using the monetary policy trilemma
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Mercantilism and marketization? Analysis of China's reserve accumulation and changes in exchange rate regime using the monetary policy trilemma
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Content
Mercantilism and Marketization?
Analysis of China’s Reserve Accumulation and
Changes in Exchange Rate Regime Using the Monetary Policy Trilemma
By Yixuan (Ariel) Lim
A Thesis Presented to the
Faculty of the USC Graduate School
At the University of Southern California
December 2019
In Partial Fulfillment of the
Requirements for the Master of Arts Degree
In East Asian Area Studies
Dr. Saori Katada, Ph.D.
Thesis Committee Chair
Dr. David Kang, Ph.D.
Committee Member
Dr. Joshua Goldstein, Ph.D.
Committee Member
2
Table of Contents
Table of Contents ............................................................................................................................ 2
1.
Introduction .............................................................................................................................. 3
2.
Background: China’s Foreign Exchange Reserve Accumulation ............................................ 5
3.
Mercantilism – Past and Present .............................................................................................. 9
a.
Historical Discussions of Mercantilism ............................................................................................ 9
b.
Literature Review on China’s “Mercantilist” Accumulation of Reserves ...................................... 12
4.
Assessment: Is China’s Accumulation of Foreign Exchange Reserves Mercantilist? .......... 16
a.
Key Differences Between Contemporary and Historical Phenomena ............................................ 17
b.
What Leverage Does Reserve Accumulation Confer to China? ..................................................... 21
5.
Changes in Exchange Rate Regime in light of the Monetary Policy Trilemma .................... 26
a.
Monetary Policy Trilemma ............................................................................................................. 27
b.
Shift in Exchange Rate Regime ....................................................................................................... 31
c.
Relationship between Parity Rate, Exchange Rate Reform and Reserves ...................................... 33
6.
Assessment using the Monetary Policy Trilemma ................................................................. 38
7.
Significance and Conclusion .................................................................................................. 40
Bibliography ................................................................................................................................. 44
3
1. Introduction
China’s sizeable accumulation of foreign exchange reserves, which peaked at US$3.99
trillion in June 2014, has been regarded a sure and visible indicator of the state’s management of
the exchange rate as well as the condition of global macroeconomic imbalances. China’s foreign
exchange reserve accumulation has been described as mercantilist in nature, drawing links to the
historic economic mode in which a state’s conception of national power was closely tied to its
ability to maintain an active balance of trade and thereby stockpile gold reserves. In this case, the
primary tool would be China’s management and deliberate undervaluation of its exchange rate.
While there are clear differences in the post-Bretton Woods monetary order where currencies are
no longer backed by tangible and finite resources (i.e. gold), the assessment of mercantilism does
point to fears surrounding China’s rise as a significant global power economically and
politically, as well as concerns regarding its intentions and revisionism. Thus, this paper will
seek to analyze China’s reserve accumulation along two dimensions: firstly, how it differs from
the historical phenomenon and secondly, whether it actually augments state power.
At the same time, this paper argues that it is insufficient to simply assess whether China’s
management of its exchange rate as “mercantilist” because, alongside the broad trend of reserve
accumulation, there have been major changes in its exchange rate regime and shift in market
pressures from appreciation to depreciation. Firstly, with the shift in market sentiments and
increase in pressures toward devaluation, the Chinese central bank stabilized the parity rate at
around 6.1 RMB/USD from beginning 2014 to August 2015, the highest value it has been
historically, whilst experiencing a decline in reserves of almost 25%. Secondly, in August 2015,
the central bank introduced a change to the exchange rate regime, which allowed a greater extent
of market determination. The result is that China has been to stabilize the level of reserves at
4
above US$3 trillion since 2017, defend the exchange rate from devaluation expectations (market
sentiment) whilst introducing of more bi-directionality into the exchange rate. Thus, this presents
the following puzzles against the mostly static mercantilist picture, namely: if reserve
accumulation is mercantilist, what explains the willingness to maintain appreciation even whilst
losing a significant amount of reserves? Furthermore, what explains variations in policy toward
the exchange rate regime and the move toward more market-oriented reforms, even as the
government seeks to maintain the level of reserves above US$3 trillion?
The paper uses the Mundell-Fleming monetary policy trilemma to examine shifts in the
exchange rate regime, as this allows for a finer-grained picture against the broader trend of
mercantilist accumulation. It suggests that China is opting for a controlled balance between the
three priorities of a stable exchange rate, free capital flows and monetary policy independence,
by sacrificing a bit of each whilst attaining all of them partially. The goals of maintaining a
generally high level of reserves above US$3 trillion, having a more flexible exchange rate
regime to ward against any unidirectional expectation and increasing monetary policy
independence seem to be the multi-faceted goals achieved by the shift. As such, it is impossible
to place China on any of the corners of the Mundell-Fleming trilemma, but at the center. These
tradeoffs are indicative of the state’s priorities in the direction of greater control.
The paper will first provide a background on China’s foreign exchange accumulation.
The next section will discuss the meaning of mercantilism, both historically and presently. The
following section will assess whether China’s foreign exchange reserve accumulation can be
considered as mercantilist by identifying differences between the present and historical
phenomena, as well as analyzing the extent to which reserve accumulation augments state power.
Subsequently, the paper will discuss changes in exchange rate regime and how it fits with the
5
picture of mercantilism, and end with a discussion on how China’s balancing of the three options
of the Mundell-Fleming trilemma reflects their priorities from a political economy perspective.
2. Background: China’s Foreign Exchange Reserve Accumulation
The growth in China’s foreign exchange reserves started to be noticeable in the mid-
2000s and peaked at an all-time-high of $3.99 trillion in 2014. Since then, it has fallen to more
modest levels of $3.10 trillion as of May 2019. Japan, by contrast, holds $1.24 trillion of foreign
exchange reserves as of May 2019
1
. The data on China’s official foreign exchange reserves is
published on the People’s Bank of China (PBOC) and the State Administration of Foreign
Exchange (SAFE) websites. While it is hard to know the official extent (and composition) of
China’s foreign exchange reserves as the PBOC figures do not include the reserves that have
been shifted off the balance sheet of the central bank to other local banks (Prasad and Sorkin
2009; Setser and Pandey 2009), the PBOC data is sufficient for the purposes of this paper.
In general, there are two ways to determine how much foreign exchange reserves a
country should hold. For the purposes of liquidity, the traditional rule of thumb is that central
banks should hold foreign reserves equivalent to three months of imports. (Rodrik 2006, 255)
With the rise in financial globalization, reserves are no longer solely used to manage the demand
and supply of foreign exchange arising from current account transactions, but also that pertaining
to a country’s financial assets and liabilities. Thus, an alternate guideline of required reserves
that is commonly used especially after the debt crises in emerging markets of Latin America and
Asia in the 1980s and 1990s is that countries should hold liquid reserves equal to their short-term
external debt, also known as the Guidotti-Greenspan rule. (258)
1
Source: https://www.mof.go.jp/english/international_policy/reference/official_reserve_assets/e0105.html
6
A look at how China’s foreign exchange reserves hold up against these recommendations
is instructive. Figure 1 plots China’s foreign exchange reserve accumulation against their
equivalent months in imports
(smoothed)
2
. In general, we can see
that China’s reserves have amounted
to between 11-24 months of imports
over the last two decades. In April
2019, reserves were equivalent to
17.2 times that month’s imports,
close to six times the recommended
amount.
On the other hand, Figure 2A plots China’s short-term and total external liabilities as a
percentage of its foreign exchange reserves on the right-hand axis. Before 2014, short-term
liabilities as a percentage of reserves declined to a low of 10.8% of reserves in 2009, and were
maintained below 20% of reserves. After 2014, the fall in reserves and rise of short-term external
debt to US$1.27 trillion in 2018 meant that the latter amounted to 41.4% of official foreign
exchange reserves in 2018. In general, China’s foreign exchange reserves are more than
sufficient to cover both its short and long term external liabilities, though the resurgence in
external liabilities as a percentage of reserves after a temporary decline in 2015 and 2016 is
notable. (Rodrik 2006; own calculations from SAFE data)Figure 2B plots reserves, short-term
and total external debt as a percentage of gross domestic product (GDP). We can observe that
foreign exchange reserves as a percentage of GDP has been declining since 2010 to more
2
As both monthly data of reserves and imports are used, a loess smoothing method was used to reduce the amount
of noise.
Figure 1: China’s Foreign Exchange Reserves Against
Equivalent Months in Exports
7
moderate levels of 23.4% of GDP in 2018. In general, reserves grew faster than GDP before
2010; after 2010, GDP grew faster than reserves, which experienced negative growth between
2014 and 2017
3
. On the other hand, short-term external liabilities have been maintained at
modest levels of under 10% with the exception of 2014. Thus, while short-term liabilities have
increased as a percentage of reserves, they are still maintained at reasonable levels.
Overall, the scale of reserve assets held by China is substantial and can be considered as
excessive when compared with the required amounts in terms of monthly imports as well as to
cover short-term foreign liabilities. Any growth of reserves in excess of these amounts can be
seen as driven by attempts at self-insurance or mercantilist motives, when the central bank
deliberately intervenes to maintain the exchange rate at an undervalued level in order to boost
exports. An addendum to the precautionary/self-insurance motive is that a country may exhibit
3
Changes in GDP are also affected by changes in exchange rate. As GDP is quoted in the domestic currency, the
relevant value of GDP to be compared with reserves and external liabilities, which are denominated in USD, is
obtained by dividing the GDP figure in renminbi (RMB) with the average monthly exchange rate.
Figure 2: China’s Foreign Exchange Reserves against External Debt
8
characteristics of “fear of floating” as well as a “fear of losing reserves”, besides just making
sure it has enough liquidity to cover future imports and short-term liabilities. (Aizenman and Sun
2012) In this case, reserves serve the purpose of defending against a currency crisis and
potentially damaging speculative runs on the currency, as in the Asian Financial Crisis of 1997.
As these reasons could exist simultaneously and it is hard to determine what is the
threshold for the self-insurance motives and the “fear of floating” phenomenon, this paper will
primarily examine China’s accumulation of reserves in light of the mercantilist motive. The next
section will address a background discussion on historical mercantilism, as well as how it relates
to the present.
9
3. Mercantilism – Past and Present
a. Historical Discussions of Mercantilism
Broadly speaking, mercantilism is a form of national economic policy that aims at
maximizing the exports of a nation and accumulating monetary reserves through a positive
balance of trade, which is believed to augment state power. (Peukert 2012) In the historical
literature, Adam Smith and Jacob Viner were dominant voices in characterizing mercantilism
and juxtaposing it against the liberal perspective of eliminating restrictions to trade. According to
Smith and Viner, the mercantilist preoccupation with an export surplus was driven by their
conception of wealth 1) in which a favourable balance of trade was the only way for a country
without gold or silver mines to procure bullion, and 2) precious metals were regarded as the
primary measures of the wealth of the nation. (Viner 1965, 6, 15) The latter was subject to
critique by Smith based on incorrectly equating wealth with money, and was further discredited
once the price specie flow model gained prominence after publication by David Hume in 1752.
According to Hume’s model, a net inflow of gold specie would directly increase the price
level within a country, leading to a fall in exports and rise in imports and a net outflow of specie.
Thus, any artificially created imbalance between exports and imports would be self-correcting to
the equilibrium level. (Viner 1965, 51, 74) As such, mercantilism was seen as antithetical to the
self-regulating nature of market forces. Nevertheless, it can be noted that the self-correcting
nature of the price-specie flow model is not completely inconsistent with a system in which the
central banks stockpiled their own reserves, which were not readily convertible by members of
their own populace or international creditors. However, as Viner points out, and what constitutes
a key difference between historical mercantilist thought and practice and that today was the
absence of a state treasury (and associated role of central banks mandated to maintain internal
10
balance in the economy) in the seventeenth century. (23) Furthermore, as Eichengreen has
discussed, governments under the bimetallic and gold standards were more concerned with
maintaining external balance, i.e. currency convertibility, rather than internal balance, e.g.
domestic price levels, thus these capital controls were generally not erected. (Eichengreen 2008)
While both Smith and Viner sought to retrace the bases of mercantilism through a review
of the original literature, Magnusson, one of the foremost scholars today in seeking to rethink
past conceptions of mercantilism, designates Smith as the “main creator of ‘Mercantilism’
proper”. He argues that it was Smith who ‘constructed’ mercantilism into a more or less coherent
‘system’, which influenced subsequent thinking about the concept when it never purported to be
a well-structured doctrine. (Magnusson 2015, 3, 217) Instead, he seeks to rehabilitate
mercantilism into as a “discourse(s) rather than doctrine”, arguing that it embodied a “common
set of questions, concepts, vocabulary and interpretive frameworks” rather than any fixed
principles or policy measures. (217, 219) Proponents of mercantilism sought to answer questions
regarding power and plenty, i.e. how to increase the wealth and power of their respective nation,
and he asserts that the outcome of their labors is the economic doctrines of today (thus focusing
more on the process and long-run outcome rather than the substance of the mercantilist debate).
Magnusson highlights a significant aspect of mercantilism in which states may be
interested (and justifiably so) in pursuing the wealth of their nation, rather than that of nations
generally. Other thinkers such as Hirschman have underscored ways in which trade could be
employed as a tool to increase national power relative to other states. (Hirschman 1980) It is thus
not entirely inconceivable that states may have different conceptions of how trade serves to
augment national power. While the state and the market are sometimes conceived as being
opposed in much of the neoliberal literature, one of the defining features of neomercantilism
11
instead is the pursuit of “stateness”, or the “articulation of the nation-state logic vis-à-vis the free
play of market forces”. (Hettne 1993, 236) Quoting Robert Gilpin, Hettne juxtaposes the logic of
the state and the market against each other, noting that while the logic of the market is to
maximize productivity and profit, the logic of the state is to “capture and control the process of
economic growth and capital accumulation” (237). Indeed, a mercantilist state, just like the
German state described in Hirschman, intentionally or unintentionally seeks to utilize foreign
trade to maximize the power differential in its favour.
Overall, while mercantilism in a specific sense is based on maximizing exports and
limiting imports to increase the stock of bullion within a country that lacks gold or silver mines,
in a broad sense it employs a surplus in the balance of trade to augment the power of the nation.
Arguably, there have been key changes since historical mercantilism in the seventeenth and
eighteenth centuries. These include the shift away from currencies backed in gold, the rise of the
nation-state as the predominant political unit (and consequently the role of central banks) as well
as the hegemony of neoliberalism where trade and financial openness has been enshrined as a
norm under the US-led post-Bretton Woods order. These changes ensure that the way
mercantilism operates in the present day would certainly exhibit some differences from the
historical mode, though this paper takes the position that there are still sufficient similarities for
the contemporary phenomenon to be assessed using the same concept.
As we shall see in the next section, in the contemporary literature, mercantilism is
defined more loosely as strategies aimed to boost exports over imports (maintaining a persistent
current account surplus), leading to a consequent accumulation of reserves, not of gold but
foreign exchange.
12
b. Literature Review on China’s “Mercantilist” Accumulation of Reserves
In the modern context, various countries’, including China’s, strategies of growing
through export promotion have been variously characterized as ‘financial mercantilism’,
‘monetary mercantilism’ or neomercantilism. (Aizenman and Lee 2008; Vaggi 2018; Choi and
Taylor 2017) For example, Natasha Hamilton-Hart defines monetary mercantilism as a deliberate
policy of currency management to retain export competitiveness. (Hamilton-Hart 2014) She
considers East Asia as a whole and argues that both the accumulation of reserves and external
imbalance vary among the states, and cannot be reduced to a single cause or motive. However,
she privileges the role of domestic monetary politics in her explanation, especially the balance
between the political left and export sector vested interests and how this is affected by the extent
of democracy. Regarding China, she surmises that its external imbalance and undervalued
exchange rate could be due capture by export interests. (citing Steinberg and Shih 2012)
Nevertheless, to the extent that China’s foreign exchange accumulation is the result of capture by
export interests, it would undermine the thesis regarding the mercantilist orientation and the
culpability of the Chinese state in maintaining an undervalued exchange rate. To probe this
further, we would have to look closer at the structure of the Chinese macro economy.
The deepest sustained discussion of mercantilism in the East Asian context comes from
Aizenman and Lee, who separate mercantilism into financial and monetary components, looking
at the cases of Japan, Korea and China. Financial mercantilism is a policy of outward-oriented
growth by means of financial support (e.g. preferential financing and subsidized investment in
target sectors), while monetary mercantilism is policy of hoarding international reserves to keep
the exchange rate depreciated. (Aizenman and Lee 2008) They argue that the large hoarding of
reserves in Japan and Korea occurred in the aftermath of a growth strategy of export promotion
13
and credit subsidization. Furthermore, they suggest that monetary mercantilism is unlikely to be
sustained for a long time and is associated with declining growth and increasing financial
fragility. Their study sheds light on the mechanisms of China’s foreign exchange reserve
accumulation, though it is certainly curious how the hoarding of reserves have persisted through
the period of high growth up to today. While the two aspects of mercantilism are closely
intertwined, this paper will focus on the management of the exchange rate, which is tied more
closely to foreign exchange reserve accumulation.
Additionally, Dooley et al suggest that some aspects of exchange rate policy in dominant
surplus countries like Japan, Germany and, most recently, China could be characterized as
‘modern mercantilism’. However, they subordinate this to a broader theorizing of a Bretton
Woods II system, in which a “fixed exchange rate periphery” in Asia with the US as the “center
country”. (Dooley, Folkerts-Landau, and Garber 2008) They argue that the periphery is
employing a long term strategy of “export-led growth supported by undervalued exchange rates,
capital controls and official capital outflows in the form of accumulation of reserve asset claims
on the center country”, which eventually allows them to graduate to the center. The periphery
uses the center region as a financial intermediary that lends credibility to their financial system,
and receives long-term inflows/lending in terms of foreign direct investment. The Bretton Woods
II system invokes interesting parallels with the historical fixed exchange rate system, and the
extent to which many countries still peg their exchange rates to the dollar.
Nevertheless, it is less convincing given that not all pegged countries also employ export
promotion, and thus the Bretton Woods II system basically captures only a subset of countries,
most of which are located in East and Southeast Asia. Furthermore, many of the East Asian
currencies no longer pursue a strict peg to the dollar, including China, which has adopted a
14
crawling peg since 2005 and introduced some elements of floating after 2015, and Singapore,
which adopts a managed float. Their model may have been more suited to the pre-2005 regimes
described by Ronald McKinnon as the “East Asian Dollar Standard”, which was adopted to
facilitate hedging against exchange rate risk given that most of the region’s trade and its
(domestic and foreign) liabilities were invoiced/denominated in dollars, a manifestation of the
“original sin” of not being able to borrow in one’s own currency. (McKinnon 2006) Since then,
the economies and capital markets of East and Southeast Asian countries have developed
significantly, both independently and regionally, such that the imperative toward dollarization of
its transactions has been mitigated significantly. The Chinese government has also pushed for the
use of the RMB as a settlement currency for trade with Southeast Asia. Overall, the Bretton
Woods II model does not get us that far theoretically in terms of being able to determine which
countries pursue such a strategy and why it was necessary to employ such a strategy in order to
“graduate from the periphery”, and what it means to have successfully “graduated”.
McKinnon discusses how as early as 2006 China’s economy had already progressed to
becoming an international creditor due to its persistent balance of payments surpluses. At the
perhaps more premature stage at the time of writing, this was not discussed using the lens of
mercantilism. Instead, McKinnon tried to coin a new term, “conflicted virtue”, to describe the
situation in which the international creditor country cannot lend in its own currency, and can
only lend to foreigners by acquiring dollar claims on them, the “mirror image” of the original sin
problem. (McKinnon 2006, 19) He considers a country “virtuous” for having a relatively high
savings rate, which causes them to run current account surpluses leading to a buildup of liquid
claims on foreigners. (149-150) Consequently, the buildup in foreign lending will lead to the
following problems: domestic holders of foreign debt fear that a self-sustaining run into domestic
15
currency will force appreciation, and foreigners complain that the country’s persistent trade
surpluses is the result of having an undervalued currency intended to boost “mercantile
competitiveness” [a term used by McKinnon].
Nevertheless, the causal logic in McKinnon’s analysis is unclear given that his starting
point was the unconventional view that pegging to the dollar was justified given the structural
inability to hedge (with trade and liabilities denominated in dollars), and that collective pegging
to the dollar provided joint stability to the region.
4
Neoliberal critics may counter that a high
savings rate does not directly translate into current account surpluses, unless the country is
pegging the exchange rate artificially low for mercantilist purposes. Thus, McKinnon may have
reversed the causal logic. Unlike original sin, which is a structural constraint faced by emerging
economies with underdeveloped capital markets, conflicted virtue may not be entirely virtuous,
but may instead be the necessary implication of having an undervalued exchange rate. As a result
of this unaddressed tension, perhaps, “conflicted virtue” did not catch on to the same degree as
original sin (originally coined by Eichengreen and Hausmann 1999) and was never used except
by McKinnon himself.
Ultimately, McKinnon’s analysis points to the need to look at a countries’ exchange rate
regime in the assessment of mercantilism. Given that China’s exchange rate regime has evolved
in several iterations to introduce more scope for market determination, it is worth considering
how this fits in with the assessment of mercantilism and how to explain variations in the
exchange rate regime. The next section will discuss broadly whether China’s accumulation of
foreign exchange reserves can be considered as mercantilist, before moving on to discussing the
choice of exchange rate regime in Section 5.
4
At his time of writing, China’s exchange rate was fixed at a “traditional” rate of 8.28 to the dollar. (McKinnon
2006, 147)
16
4. Assessment: Is China’s Accumulation of Foreign Exchange Reserves Mercantilist?
This section will assess whether China’s present foreign exchange reserve accumulation
can be considered as mercantilist. Mercantilism is defined broadly in the contemporary context
as the emphasis on maintaining a current account surplus leading to an accumulation of reserves,
whether through “financial” (strategies designed to boost exporting sectors of the economy) or
“monetary” means (more direct manipulations of the exchange rate), as described by Aizenman
and Lee. As Section 3a notes, the major shifts in the global monetary system that have taken
place since render an absolute parallel between the two situations facile, at least on the surface.
As such, this paper posits that there are at least two key aspects that are relevant when assessing
the “mercantilist” aspect of foreign exchange reserve accumulation in the contemporary era,
namely: 1) how does the nature of reserve accumulation differ from the past, and 2) how does
reserve accumulation contribute to the goal of augmenting state power (however it is defined)?
In other words, what forms of power, structural or immediate, does the regime obtain from such
accumulation?
This paper takes the view that the link between reserve accumulation and augmentation
of state power need not be a reductionist and simplistic equating of reserves with wealth and
wealth with power, as in the Smithian critique of mercantilism [though it is less clear whether it
is Smith’s critique that is itself reductionist]. In the contemporary period, one of the primary
ways in which reserve accumulation augments state power is the potential leverage that accrues
to a state in becoming a net international creditor. Furthermore, if the goal is simply to maximize
exports, with reserve accumulation being more of a by-product, state power can augmented
directly through a continued trajectory of economic growth, which expands its power both
internally (through a maintenance of performance legitimacy) and externally.
17
a. Key Differences Between Contemporary and Historical Phenomena
As mentioned in Section 3a, the shift away from currencies backed in gold constitutes
one of the key differences between contemporary and historical mercantilism. In the post-Bretton
Woods monetary order, governments are free to regulate and control the money supply (of fiat
currency) with their economies. Furthermore, the role of the US dollar as the predominant global
reserve currency has vastly changed the picture, as the US possesses an “exorbitant privilege” of
being able to print dollars that can be used to purchase real resources from other countries. The
US dollar literally plays the role historically played by gold in providing global liquidity; it is a
leading currency in international transactions extending beyond its own shores, in which
commodity exchanges are quoted, and in which 85% of all foreign exchange transactions take
place. (Eichengreen 2012) The US’ role as the “center” country also means that it has no capital
controls, holds minimal foreign exchange reserves (US$127.3 billion as of April 2019
5
) and does
not intervene in the foreign exchange market. (McKinnon and Schnabl 2014, 2) Such “benign
neglect” is crucial to the functioning of the global financial and monetary system.
With the US dollar as the leading global reserve currency, a majority of international
reserves held in US dollars
6
and are recycled into purchases of US government debt. This is
because the market for US government bonds is deep and liquid on an incomparable scale and is
considered a risk-free asset. China held US$1.123 trillion of US government debt as of
December 2018, more than a third of its overall foreign exchange reserves.
7
This is in line with
Dooley et al’s conception of the Bretton Woods II system in which the periphery countries are
willing to “underwrite future deficits of the US”. (Dooley, Folkerts-Landau, and Garber 2008,
5
Source: https://www.federalreserve.gov/data/intlsumm/current.htm (Accessed 23 June 2019)
6
According to the IMF, 61.7% of all official foreign exchange reserves were held as claims in USD as of Q42018.
(International Monetary Fund 2018)
7
Source: https://www.investopedia.com/articles/investing/080615/china-owns-us-debt-how-much.asp (Accessed 14
April 2019)
18
18) The willingness of foreign countries to invest in US government debt largely derives from
the credibility it possesses in terms of its large and developed economy, its role in setting up the
structures of the Bretton Woods system, as well as it’s central bank’s commitment to maintaining
the real value of its currency, though the sustainability of its government deficit may increasingly
be called into question. The shift from gold to US dollar as the primary international reserve
currency makes it less clear whether leverage would accrue to the surplus or deficit country.
Under historical mercantilism, the coercive power of a surplus country as compared with the
deficit country (whose ability to engage in international trade was severely limited) was greatly
amplified. In this contemporary scenario, the Chinese and US economies are further intertwined
as China is invested in preventing capital losses on their existing holdings of US debt, limiting
the leverage associated with the ability to dump their holdings of debt.
Furthermore, in order to maintain the Chinese currency at an undervalued rate, the
Chinese central bank has to purchase excess stocks of US dollar from within its economy (in
exchange for Chinese Yuan), and subsequently engage in costly processes of sterilization to
prevent inflationary consequences to its economy. Sterilization is achieved through raising the
reserve requirements for state banks and issuing RMB-denominated bills and bonds
domestically. (Bell and Feng 2013, 237) Typically, sterilization imposes quasi-fiscal costs in
terms of the spread between the return on US Treasury bills and the interest paid on reserves and
bills by the Peoples’ Bank of China (PBOC), especially given that the US Treasury bonds pay
comparatively low interest rates due to their risk-free nature. As domestic interest rates are low
in China due to financial repression, the quasi-fiscal costs associated with sterilization are
minimized but nonetheless still costly.
19
At the same time, the PBOC is unable to sterilize all of the increase in liquidity; in 2015,
then-deputy governor and current governor of the PBOC shared in an internal meeting that it was
able to sterilize 80% of the RMB16 trillion released into the economy. (Bell and Feng 2013, 237)
The inflationary consequences of incomplete sterilization have caused the PBOC to be an
advocate for liberalization of the exchange rate regime, in a bid to cement its mandate as an
inflation-fighting central bank. (209) Furthermore, sterilization imposes longer-term structural
costs in terms of continued financial repression of domestic savers, transfer of income toward
inefficient state-owned enterprises and underdevelopment in the domestic financial sector.
(Vermeiren 2013, 105) China’s management of the exchange rate through intervention and
sterilization is also accompanied by the presence of capital controls. Capital controls make it
easier for the central bank to manage the exchange rate easier as it does not have to deal with the
volatility associated with inflows and outflows of speculative capital (“hot money”). Overall, the
continued management of the exchange rate along with capital controls has implications on
China’s ability to shift toward a more domestic consumption-based economy in the long run, as
well as move toward greater openness of its economy as it pursues other goals like RMB
internationalization to increase its structural power in the global economy. (Volz 2014)
In considering whether the Chinese economy is mercantilist in its accumulation of
foreign exchange reserves, another aspect would be to consider whether China’s management of
its exchange rate has ‘beggar-thy-neighbor’ implications on its trading partners or other countries
with similar capital/labor ratios. Aizenman and Lee provide a good explanation on whether
financial mercantilists ‘beggar their neighbors’, and conclude that in principle that is not the
case, as the benefit of efficiency gains improves the welfare of both home and foreign
consumers, and has the potential to compensate for static efficiency losses in the subsidy phase.
20
(Aizenman and Lee 2008) In the case of monetary mercantilism, it is less clear and warrants
further analysis. With regard to its trading partners and primary deficit country, the US, the
beggar-thy-neighbor situation does not hold, because in effect the persistent macroeconomic
imbalance allows US consumers to consume more than they produce, and represents a transfer of
domestic savings from China to the US. This is achieved through financial repression of the
domestic banking sector, where household savers obtain close to zero or even slightly negative
returns on their savings in real terms.
The material fact that an undervalued exchange rate supplements the consumption of US
consumers at the expense of China’s own populace (leading to a high savings rate of above 50%
in the economy) points perhaps to an underlying view of Chinese leaders that the goal of
macroeconomic policies is not to maximize consumption, contrary to the prevailing liberal ethos.
For example, in the Wealth of Nations, Adam Smith asserts:
“Consumption is the sole end and purpose of all production, and the interest of the
producer ought to be attended to only so far as necessary for promoting that of the
consumer. In a mercantile system, the interests of the consumer are sacrificed to that of
the producer.” (Smith 1977)
Instead of maximizing consumption, China’s leaders seem to prioritize the continued trajectory
of economic growth. In fact, one of the regime’s developmental goals articulated under the
banner of the “Chinese Dream” ( 中国梦) is to achieve a per capita GDP to $10,000 by 2021, at
the centenary of the formation of the Chinese Communist Party. (Allison 2017) This would
amount to an aggregate GDP of around US$14 trillion, though it is ironic that the goal of
increased wealth of the population depends on suppression of consumption and a transfer of
savings abroad. Nevertheless, distinct from the articulation by Smith, it is unclear which groups
21
are the prime beneficiaries of this “mercantilist” approach, though top beneficiaries would
certainly be the inefficient state-owned enterprises as well as current US consumers.
As for other peripheral countries with similar capital/labor ratios to China, it is also
unlikely that the past 20 years of export-driven growth ‘beggared their neighbors’, because of the
peculiar nature of China’s export industry. In the initial years of reform-and-opening up, China’s
export sector was largely export-processing and foreign-owned in nature, and in conjunction
with other preferential investment policies, fit into global production networks in a way that was
not simply by virtue of an undervalued exchange rates. The labor costs in China were lower, and
with much more spare labor to be absorbed, that rendered China an ideal location for export
processing as part of global value chains in a way that did not necessarily ‘beggar their
neighbors’. In a sense, with rising labor costs and production moving away to cheaper locales
like Vietnam and Cambodia, China has somewhat graduated from lower levels of the value chain
and is able to provide more value-add in its exports. Thus, the thesis of ‘beggar thy neighbor’
does not hold well in this aspect as well.
b. What Leverage Does Reserve Accumulation Confer to China?
One of the key sources of leverage accruing from reserve accumulation is that associated
with becoming the world’s leading international creditor, which is a source of strategic insecurity
particularly for the world’s largest external debtor nation, the United States. The US’ persistent
current account deficit is financed by foreign, including China’s, purchases of Treasury securities
and shares in US firms. The US fear toward its own strategic vulnerability in becoming a
significant debtor nation is evidenced in the Council on Foreign Relations report, Sovereign
Wealth and Sovereign Power: The Strategic Consequences of American Indebtedness. (Setser
22
2008) The report takes a somewhat nationalistic stance in focusing on the potential leverage
accrued to creditors, drawing analogy to the British Suez Canal Crisis in which the US was able
to force a withdrawal British of troops from the canal by threatening of selloff of its holding of
sterling pound bonds and restricting access to much-needed IMF liquidity. It identifies key
sources of threat to the US primarily including sudden shifts of foreign portfolios of US assets,
which diminishes its “soft” financial power and renders it susceptible to forms of pressure.
Nevertheless, Setser’s report should be read more as an expression of US strategic
insecurity rather than the actual leverage possessed by a creditor nation. It fails to note the degree
to which the fact that the US dollar is not committed to be convertible to any other currency and
that its external liabilities is denominated in its own currency limits its exposure to external
depreciative shocks caused by dumping of dollar-denominated assets by its creditors.
Fluctuations in the value of the dollar do not affect the value of USD-dominated assets
domestically, except for increasing the costs of imports and the value of its external assets (such
as the value of repatriated earnings from overseas subsidiaries), which would be a boon to
existing private US holdings abroad. A market-driven shock to the USD would even be
corrective toward the US current account balance by reducing its external deficit, which would
be a positive outcome. Thus, any shocks to the value of the USD would more likely affect
foreign holders of dollar-denominated assets than the US economy itself, a point that Setser fails
to sufficiently realize. Overall, this significantly constrains the degree of leverage possessed by
China as a key creditor nation.
Besides the US, China also acts an international creditor around its periphery and in other
developing nations, operating bilaterally or through multilateral institutions to engage in lending
and outward direct investment (ODI), including infrastructural investments. This ODI takes
23
place in the form of investments by China’s sovereign wealth funds, the China Investment
Corporation (CIC) and SAFE Investment Company, as well as new multilateral financial
institutions such as the Asian Investment Infrastructural Bank (AIIB). (Drezner 2008; Naughton
2018) While the use of sovereign wealth funds may be considered a form of bilateral and
offensive systemic statecraft (L. E. Armijo and Katada 2015), the latter form of investments
through multilateral financial institutions and other forms of bilateral lending such as under the
Belt and Road Initiative (BRI) serve to enhance Chinese power systemically through the creation
of alternative institutions outside of the West. It should be noted that the BRI investments are
overwhelmingly financed in USD. (Bird 2019)
China’s preference for infrastructural investments under the BRI has been compared to
the US-led Marshall Plan to aid in postwar reconstruction of European states, which was aimed
to alleviate the dollar shortage prevailing in European countries with the US acting as a dominant
creditor at that time. The aim was to finally stimulate trade, fulfilling the US vision of free
international trade, and in which it possessed a dominant position in the export of capital goods
(Eichengreen 2008). Interestingly, comparing to the present, in the context of global imbalances,
BRI is not just a way for China to export its excess capacity, but also allows it to act as an
international creditor such that the peripheral countries can continue to trade with China and
export lower end manufactured goods and primary products in exchange more capital-intensive
goods, a reflection of China’s graduation from peripheral status. As the US-led Marshall plan
took place under the Bretton Woods system, and Dooley et al consider the current situation of
the fixed exchange rate periphery as a form of Bretton Woods II system, it would be interesting
to consider the role and vision of free trade under Bretton Woods with the US as a dominant
creditor and the current system with China as the dominant one.
24
Overall, this section has assessed that while China’s accumulation of foreign exchange
reserves exhibits mercantilist characteristics on the surface, in practice the changed structural
conditions of the international monetary system limits the leverage associated with it. Besides
being a significant creditor to the US and having a larger purse to invest in projects abroad,
reserve accumulation is associated with high domestic costs in terms of costly sterilization,
repressed domestic consumption and lack of reform of the financial sector. Indeed, a more
meaningful assessment of the structural leverage accrued to China as an international creditor
country would be to consider the purposes toward which its international lending were put, rather
than the accumulation of foreign reserves per se. Eventually, China’s economy will have to
rebalance away its currently heavily investment-driven low-consumption model, which is facing
diminishing returns. Thus, while China’s reserve accumulation exhibits the characteristics of
mercantilism on the surface, the high domestic costs and limited international leverage renders
the implications of the “new” mercantilism indeterminate.
Structurally, China may actually derive greater leverage from emulating certain aspects
of the US structural power, such as boosting the status of the RMB as an international reserve
currency, increasing the use of its currency abroad and deepening its bond markets such that
more external actors are invested in the value of the currency. In light of this, studying the
changes in its exchange rate regime becomes instructive, as it is one of the key levers to move
toward marketization and away from a heavy-handed state involvement in the economy. An
analysis of recent changes to the exchange rate regime breaks down the static mercantilist picture
to identify changes within the broader trend of reserve accumulation, presenting the puzzle: what
explains variations in policy toward the exchange rate regime and move toward more market-
oriented reforms? How have these market-oriented reforms actually served to bolster the
25
accumulation of reserves by helping stabilize its value at over US$3 trillion since 2017? This
will be the focus of the next section.
26
5. Changes in Exchange Rate Regime in light of the Monetary Policy Trilemma
The assessment of mercantilism is tied closely with a country’s choice of exchange rate
regime, because managing the exchange rate to keep it undervalued is arguably what leads to the
buildup in foreign exchange reserves. However, there seem to be other factors determining
choice of exchange rate regime, as China has undergone major changes in its exchange rate
regime since it began to accumulate significant foreign exchange reserves in the late 1990s. In
1994, China unified its official and swap markets at a rate of 8.7 RMB/USD, setting the
foundations for the evolution of the regime to what it is today. This eventually stabilized to a
fixed peg to the dollar at 8.28 RMB/USD from the end of 1998 up to 2005, which constituted
one of the pillars of its export-led growth strategy. (Bell and Feng 2013, 218) Key moments in
the history of its exchange rate regime include the decision not to devalue the currency during
the Asian Financial Crisis of 1997-1998, which contributed greatly to the stability in the region.
In 2005, the regime underwent partial liberalization in moving away from the dollar peg
to adopt a “crawling peg” regime, which was
associated with a step-revaluation from 8.28 to
8.11 RMB/USD overnight. (Yu, Zhang, and
Zhang 2017) The “crawling peg” regime is
depicted in the figure of the RMB/USD
central parity
8
rate in Figure 3, though the
regime temporarily deviated from this policy
between mid-2008 and mid-2010 when it
8
The central parity rate is a good proxy for the exchange rate as it is the center of the band within which the
currency is allowed to trade within each day. It is also an indicator of government policy and the range within which
the central bank is prepared to stabilize the exchange rate.
Figure 3: RMB/USD Central Parity Rate, 2006-2019
27
adopted a fixed peg at a central parity rate of about 6.8 RMB/USD. Since 2005, China’s
exchange rate has appreciated by close to 25% in nominal terms against the USD in the ten
ensuing years, and the trading band has widened from 0.2% to 2%.
Subsequent reforms beginning in August 2015 show a greater move toward marketization
with the clarification of the formula for the central parity rate and the currency basket used to
determine it. We start to witness greater variability and bi-directionality in the exchange rate
which reflects greater extent of market determination. Thus, this raises the question that if the
mercantilist thesis holds, what explains this move toward greater market determination? The use
of the Mundell-Fleming monetary policy trilemma framework is able to shed some light on the
issue, through understanding how the government conceptualizes the various tradeoffs between
exchange rate stability, monetary policy independence and capital market openness. This section
will first discuss the monetary policy trilemma framework, recent changes in the exchange rate
regime, and the implications for foreign exchange reserve accumulation.
a. Monetary Policy Trilemma
The Mundell-Fleming monetary policy
trilemma, also known as the “impossible trinity”,
dictates an unavoidable tradeoff between three
priorities of macroeconomic management, as
depicted in Figure 4. According to the trilemma,
policymakers experience a stark tradeoff between
exchange rate stability, monetary independence
and capital market openness, and have to forego one in order to achieve the other two; this has
Figure 4: Monetary Policy Trilemma
28
been observed to hold out through different periods of history. (Obstfeld, Shambaugh, and
Taylor 2005) If a country tries to maintain all three, the fixed exchange rate, arguably the
weakest link of the three, will be subject to speculative attack leading to economic crisis, as was
the case during the Asian Financial Crisis of 1997. What has previously been recognized about
China’s policy choice is that it has chosen side “c”, where it sacrificed free capital flows in
exchange for a fixed (albeit adjustable) exchange rate and sovereign monetary policy.
9
While China is open to foreign direct investment, it is less open to portfolio inflows and
the RMB is not fully convertible in the capital account, though initiatives have been taken to
“selectively” and “cautiously” dismantle some of the capital controls, in line with attempts to
boost the RMB’s status as an international currency. (Volz 2014; Prasad and Ye 2012, 6) There
are two typical measures of capital account openness: de jure openness (Chinn-Ito index) and de
facto openness (Lane and Milesi-Ferreti). The Chinn-Ito index (up to 2016) shows no movement
since 1993, but the de facto index which measures the level of gross external assets position
(sum of assets and liabilities) and its ratio to GDP show that China is gradually liberalizing.
China’s gross asset position has been growing at an average of 15.72% between 2004 and 2018,
though its ratio to GDP has hovered around 1.0x since 2006. However, these ratios are still low
compared to other countries with leading reserve currencies.
In general, capital inflows are tightly regulated, but restrictions have been loosened over
the years. For example, since 2002, licensed foreign investors known as Qualified Foreign
Institutional Investors (QFII) have been granted permission to invest in China’s capital markets,
but still face quota restrictions and are constrained to invest only in certain asset classes.
9
At the same time, monetary policy is not entirely autonomous either, as interest rates are not liberalized and the
domestic financial sector is still repressed with household savings being channeled to subsidize state-owned
enterprises. Thus, monetary policy is still a relatively weak lever as compared to fiscal policy. As such, the Chinese
regime can be seen as choosing side “a” and “c” simultaneously, sacrificing both capital flows and sovereign
monetary policy to a certain degree.
29
However, quota restrictions have been gradually expanded from a total quota of US$4 billion in
2002 to US$10 billion in 2005, US$30 billion in 2007, US$80 billion in 2012, and most recently
to US$300 billion in 2019. (“What Is QFII and RQFII?” n.d.; China Daily 2019) In 2010,
qualified financial institutions such as overseas central banks, cross-border settlement banks, and
RMB clearing banks were allowed to invest in China’s interbank bond market. Introduction of
the Bond Connect, a mutual market access scheme, in 2017 further allowed foreigners to invest
in China’s bond markets. (Zhang 2017) This will mainly benefit non-institutional investors and
also opens up a new source of capital flow into China. Currently, the limit foreign exchange
purchases by residents for remittance abroad for personal reasons stands at $50,000 a year.
While the ability to manage capital flows in and out of the country is evidently different
from the use of a currency in transactions abroad and whether central banks choose to use it to
store value as one of their reserve currencies, these two aspects are often linked as capital
account liberalization is often seen as the precursor and precondition of RMB
internationalization. Advocates for liberalization in China have often used the somewhat
economically nationalist goal of currency internationalization as a banner to push forward capital
account reforms. Thus, many of the attempts to liberalize the capital account were between 2012
and 2015, around the time China started pushing for RMB internationalization. These include the
announcement of plans to create a special zone to experiment with currency convertibility in
Shenzhen in June 2012, and the State Council’s announcement of its intention to establish a pilot
zone in Shanghai as a test ground for financial reforms, including interest rate liberalization and
full convertibility of the RMB. (Volz 2014, 112)
The presence of capital controls, however, does not mean that there are no ways to evade
them by disguising them as other forms of transactions. It has been recognized that the “error and
30
omissions” category of the balance of payments accounts for cross-border transfers that “have
not been properly classified”, and can often be rather large. Along with other components such
as short-term trade credits, net factor income and remittances, these constitute the disguised
flows that have evaded official controls. (Xie 2016; Naughton 2018, 442) The rise in these “hot
money” flows out of China between 2012 and 2016, which coincides with the decline in reserves
from the peak in 2014, led the Chinese government to hastily re-impose administrative controls.
The impetus toward capital outflows has persisted as it became clear that the trend of RMB
appreciation had reached its peak in August 2015. Thus, the overall state of China’s capital
account liberalization can be seen as selective and incomplete, with attempts at controlled
liberalization, while also regulating the type of capital flows that it considers as undesirable, a
veritable “capital account liberalization with Chinese characteristics”. (Prasad and Ye 2012, 54)
Overall, the Chinese government’s choice of side “c” that affords it the greatest degree of
control. Specifically, the government can fix the exchange rate at a level that is lower than if it
were freely floating and determined by market forces, with the goal of exporting more thus
accumulating foreign exchange reserves. Furthermore, the government is able to maintain
general control over its monetary policy, in service of goals such as maintaining full employment
and low inflation (though this might be hampered by the fact that domestic interest rates have not
been liberalized, with the presence of financial repression). Generally speaking, monetary policy
is a lever that a regime desirous of control would be scantly willing to sacrifice. To add on, while
there have been attempts to loosen capital controls, liberalization has been highly selective, and
ultimately still subject to the discretion of the government. For example, while the QFII quotas
have been increased over the years, it is still dependent on governmental approval, and the
quotas can be revoked at any time.
31
By choosing side “c”, the government chooses to sacrifice free capital flows, which may
not really be construed as a sacrifice given that the regime is wary of the potentially destabilizing
aspects of free capital flows and its effect on currency value, especially given the
underdeveloped nature of financial markets. A strategy of “c” would lend itself to the
accumulation of foreign exchange reserves through a fixed exchange rate and capital controls.
The question is then whether or not this has all been done in service of a mercantilist strategy and
what explains recent changes in that.
b. Shift in Exchange Rate Regime
Beginning in August 2015, the Peoples’ Bank of China (PBOC) engaged in series of
reforms that made the exchange rate regime more transparent and market-determined, based on a
basket of currencies. Key reforms are listed here:
• Reform of Regime (August 2015): On 11
th
August 2015, the PBOC announced the
reform in the RMB exchange rate regime in which market makers would submit quotes
for the fixing of the central parity rate to the China Foreign Exchange Trading System
(CFETS) with reference to the closing exchange rate of the previous trading day, after
considering supply and demand conditions with respect to a basket of currencies. (Prasad
and Ye 2012, 54) As a result, the central parity rate experienced a shock and rose 1.9%
on the same day, from 6.1162 to 6.2298 RMB/USD. The shock continued over the next
two days, where it had risen to 6.4010 RMB/USD two days later, amounting to a 4.66%
depreciation overall. As a result, the PBOC had to intervene to support the exchange rate.
• Clarification of currency basket peg (December 2015, December 2016): As early as
2005, the PBOC had announced that the RMB would be pegged to a basket of currencies;
32
however, the basket was first announced only in December 2015. (Hong Kong Exchanges
and Clearing Limited (HKEX) 2018, 4) Previous research has found that the RMB has
correlated with the USD strongly up till 2015 (Liu and Lam 2015) and this is further
evidenced by the divergences between the appreciation of the RMB/USD currency pair
and China’s nominal/real effective exchange rates from 2005 to 2015. As described
earlier, China’s exchange rate has appreciated by close to 25% in nominal terms against
the USD; however, its nominal (trade-weighted) and real effective exchange rates have
appreciated 44% and 58% respectively in the same period. (Das 2019) Thus, this shows
that the appreciation of China’s currency has not really exhibited adherence to a basket of
currencies prior to 2015.
• In December 2015, the PBOC published for the first time the composition of its reference
currency basket, also known as the China Foreign Exchange Trade System (CFETS)
RMB Index. This represented 60.4% of China’s external trade volume at that time, with
the USD having an effective weight
10
of 33% in the basket. The currency basket was
further expanded in December 2016 from 13 to 24 currencies, representing 74% of
China’s external trade. Furthermore, the effective weightage of the USD was reduced to
26.7% of the currency basket. This shows a greater effort by the PBOC to price its
currency at a rate more broadly reflective of its trade relations.
• Clarification of the central parity formula (January 2016): In January 2016, the
PBOC proceeded with reforms of the exchange rate regime by clarifying the exchange
rate formation mechanism, as the arithmetic average of the “closing price + theoretical
value of exchange rate that will keep the index of a currency basket unchanged”. As Yu
10
USD + HKD, which operates a currency board
33
et al note, as both the price index and the parity rate are calculated based on a published
formula, anyone can calculate the central parity rate for the current trading day before the
market is open based on available data. (Yu, Zhang, and Zhang 2017, 64)
• Introduction of counter-cyclical factor (May 2017): On May 26, 2017, the PBOC
further introduced a counter-cyclical factor with the objective of offsetting any “unilateral
expectation driven by market sentiments” that caused movements in the previous day’s
closing rate, independent of movements in the currency basket. (Hong Kong Exchanges
and Clearing Limited (HKEX) 2018, 7) This had the effect of reducing the “pass-
through” of the previous day’s closing to the current day’s central parity rate, i.e. how
much the former determines the latter. Predominantly, the counter-cyclical factor has
been interpreted as being employed with the effect of guarding against any “irrational”
depreciation expectations and “pro-cyclical” herding behavior. (Das 2019, 12) As
depreciation expectations subsided, the counter-cyclical factor was set to neutral in early
2018, and has only been re-employed to counter depreciation expectations, as was the
case in August 2018. Thus, the employment of the counter-cyclical factor can be seen as
primarily targeting depreciation, though some may observe it as a retraction of previous
more market-oriented reforms due to the reduction in transparency involved.
c. Relationship between Parity Rate, Exchange Rate Reform and Reserves
Overall, we observe changes in the direction of more market-oriented reforms. After the
implementation of these reforms, we start to witness greater variability and bi-directionality in
the exchange rate, which reflects greater extent of market determination, as well as the
stabilization of reserves at a level above USD$3.1 trillion. This section will analyze the change
34
in trend of foreign exchange reserves alongside changes in the RMB/USD parity, and the effect
of the change in exchange rate regime “shocks” on both reserves and parity.
The general relationship between foreign exchange reserve accumulation and parity
(which is declared at 9.15am of every trading day) is that foreign exchange reserves will either
be accumulated or drawn down upon in order to intervene in the exchange rate to maintain
within the 2% thresholds around the central parity in which the currency is allowed to trade at.
The government can be seen to have two key priorities, namely keeping the exchange rate at a
desired level in relation to market conditions at the time, and keeping the foreign exchange
reserves at a (unspecified) desirable level. The desired level of foreign exchange reserves can be
broken down into the following main priorities: 1) mercantilism, 2) defend the exchange rate
(precautionary motive) and 3) insuring of foreign liabilities. A potential additional reason could
be in preparation to eventually ease the transition into floating. (Das 2019, 14)
Figure 5 plots the central parity rate against changes in the RMB/USD parity as
determined by the Peoples’ Bank of China (PBOC). Looking at the parity rate, the figure shows a
gradual/controlled appreciation in the exchange rate at least until the shift in exchange rate
regime in August of 2015, as well as the peak in foreign exchange reserve accumulation at
USD$3.99 trillion in June 2014. Furthermore, even with the shift in market sentiments and
increase in market pressures toward devaluation at that time, the Chinese central bank stabilized
the parity rate at around 6.1 RMB/USD until August 2015. This is depicted as the trough in the
RMB parity rate from the beginning of 2014 to the first announcement of the exchange rate
reform. The decline in reserves (of close to 25%) exhibits some characteristics of a much-needed
correction in which the continued accumulation of reserves beyond the threshold of $4 trillion
had become unsustainable in macroeconomic terms and was recognized as such by the central
35
bank. Thus, they were willing to draw down the reserves to more manageable levels approaching
$3 trillion. However, the commitment of the central bank to defend the currency at a high of
6.1RMB/USD in the face of rapid capital outflows and depreciation expectations by drawing
down on reserves substantially provides somewhat of a challenge to the mercantilist picture.
The figure also documents the implications of the exchange rate reform and the
subsequent 4.66% step-like depreciation in August 2015, which represents a realignment of the
Figure 5: China’s Foreign Exchange Reserves Against RMB/USD Parity
36
exchange rate to reflect more of the market sentiment of devaluation at that time, as well as the
new move to an explicit peg against the basket of currencies. (Liu and Lam 2015; Yu, Zhang,
and Zhang 2017) The exchange rate reform and resultant step-devaluation can be seen as a
“shock” to the system, and Yu et al provide an interesting process tracing of the changes after 11
August 2015 whilst also tracing the market conditions at the time. They describe how the change
was swiftly reversed back to adherence to the crawling peg as the government sought to defend
against further devaluation of the RMB. The clarification of the formula to determine the central
parity in January 2016 further marketized and improved transparency of the exchange rate
determination, and is represented by a slight appreciation followed by subsequent depreciation.
The fact that the RMB was facing devaluation expectations and PBOC resisted it as well as
proceeded with reforms strongly qualifies the mercantilist thesis. The battle of the PBOC against
prevailing devaluation expectations depicts the familiar challenge faced by central-bank policy
makers as discussed in Eichengreen, in which central bank interventions to guard against
depreciation expectation leads to further outflows, as (mobile) domestic and foreign holders of
the currency seek to prevent further losses. (Eichengreen 2008)
The series of reforms culminated in the introduction of the counter-cyclical factor, which
is seen as targeting irrational devaluation expectations that is driven by market sentiment. The
main impact of the reform, as seen in the figure, was to stabilize reserves at a level above US$3.1
trillion and introduce a greater degree of bi-directionality and variation into the exchange rate
than before. Previously, the exchange rate exhibited a uni-directional appreciative trend up till
August 2015. Subsequently, it pushed through a series of reforms while battling depreciation
expectations and substantially drawing down on foreign exchange reserves. The introduction of
the counter-cyclical factor completes the picture as we see stabilization in the level of foreign
37
exchange reserves as well as two-direction movement in the exchange rate. This is a significant
move toward marketization as market participants can no longer rely on a one-way expectation
for the exchange rate (both long- and short- positions) to engage in arbitrage, but will have more
incentive to hedge against foreign exchange risks.
Furthermore, instead of allowing minute variations in the
trading around the central parity, the central bank is seen to allow a
sine-curve-like variation (Figure 6) in the exchange rate with far
broader variability than ever before, only introducing the counter-
cyclical factor when the depreciation pressures threaten to drive the
exchange rate below a certain level. While this still demonstrates a
high degree of intervention such that the exchange rate regime is still
a distance away from a freely floating regime, the employment of the
counter-cyclical factor to guard against excessive devaluation provides a strong challenge against
the mercantilist thesis. An additional qualification could be that the time period may be too short
to provide a definitive conclusion of the direction of China’s macro-economic policy-making,
but the future trend is definitely worth watching. (At the end of the graph in 2019, which shows
the parity rate up to end June 2019, the parity rate shows a trend toward depreciation, beginning
in May 2019. The PBOC can be seen to have allowed the RMB to depreciate, with the escalation
of the trade war with the US that month leading to the imposition of tariffs, whilst maintaining it
above 7.0 RMB/USD).
Figure 6: Sine Curve-like
Variation in the Exchange
Rate from 2017-2019
38
6. Assessment using the Monetary Policy Trilemma
With the market-driven reforms that introduce
greater flexibility into the exchange rate, it is evident
that China is moving increasingly away from the fixed
exchange rate corner of the monetary policy trilemma
(choosing “c”, or “c” and “a” simultaneously). It
remains to be seen what exact benefit this yields, given
that the regime is still seeking to regulate capital flows
and preventing excessive outflows. One of the possible reasons is that this allows the PBOC
greater monetary policy flexibility and to push ahead reforms in the domestic financial sector in
the future, such as reforming the state-owned banks. (Volz 2014) In The Rise of the People’s
Bank of China, Bell and Feng document the rising authority of the PBOC within Beijing’s
decision-making hierarchy, arguing that the PBOC was able to slowly develop market
instruments “uniquely suited to Chinese political and institutional requirements for bargained
gradualism” through its “techniques of institutional change and adaptation”. (Bell and Feng
2013, 8,18) This served to foster mutual dependency with the regime itself that allowed the
institution greater autonomy over time.
Overall, while the regime has sacrificed some of the credibility associated with a fixed
exchange rate whilst increasing the degree of flexibility, it has shown itself unwilling to fully
sacrifice the credibility by still maintaining the parity within a broad range through the
adjustment using the counter-cyclical factor. This provides domestic and international market
participants a stable degree of expectation regarding where the exchange rate will lie, while also
introducing two-direction variability to counter excessive pressures in any one direction. If we
China’s
position
Figure 6: Movements in China’s Position
in the Monetary Policy Trilemma
The
point
indicates
what
the
regime
has
been
willing
to
sacrifice
39
were to place China somewhere on the triangle, instead of choosing sides “c” and “a”
simultaneously (as previously noted), the regime seems to be choosing all three sides at once,
placing its position somewhere in the center of the triangle. [There is no other mathematical
depiction if the regime chooses all three sides at once, and the triangle simply contracts.] While
there have been papers published by the PBOC “proving” that China has managed to escape the
constraints laid out by the trilemma through the adoption of a “scalene” rather than equilateral
triangle (e.g. Sun and Li 2017), the discussion above shows that the regime has chosen all three
sides at once, resulting in a condensed equilateral triangle.
At the center of the triangle, China has a measure of each of the freedoms but none in
totality, ultimately indicative of a regime desirous of control. This is overall in line with the
picture of the regime as one that is anomalous according to Western neoliberal standards, in the
sense that it does not accord to any of the main tenets prescribed by traditional models. As Bell
and Feng note, the party elite embodied in the Central Committee regards the financial sector as
one of its central concerns due to its relation to political stability and economic growth, rendering
it “an extremely sensitive area over which the party has traditionally been reluctant to relinquish
power”, along with the view that fiscal and monetary policies are inherently inseparable and
should be managed jointly. (Bell and Feng 2013, 9)
Indeed, a more domestically oriented assessment beyond the standard trilemma may yield
the conclusion that the ultimate position on the triangle that is chosen is the result of the
competition for influence among various groups including the party, institutions and other
interest groups such as local governments and state-owned enterprises. [Steinberg and Shih have
proposed such a model. (Steinberg and Shih 2012)] While a political economy model may posit
different “interest groups” fighting over influence in which the degree of success would depend
40
on their ability to mobilize, endogenizing the PBOC would introduce a layer of complication
given that it is both a principal and an agent, or an agent trying to liberate itself and establish its
independence. Within the monetary policy trilemma, the side corresponding to “monetary policy
autonomy” is thus not just a trade-off associated with some higher decision-making body’s
choices regarding the exchange rate regime and freedom of capital flows, but can be seen as the
outcome of an endogenous struggle by different groups to obtain often clashing goals, which
results in the phenomenon of choosing all three sides at once.
7. Significance and Conclusion
In his book The Long Twentieth Century, Giovanni Arrighi, a world-systems theorist,
discusses what he terms as “cycles of systemic accumulation” beginning with the dominance of
the Genoese city-state, followed by the Dutch empire, Great Britain and finally the United States.
He posits that history can be characterized by cycles in which the dominant power comprised of
blocs of government and business agencies that are able to concentrate power to control its own
regime of capital accumulation on a world scale. (Arrighi 2010) His analysis is prescient in its
view that financial expansions, defined as a situation in which most of capital is focused on
financial deals that can provide better returns than trade and production (9), often signal a
transition from one regime of accumulation on a world scale to another. The situation of
mercantilist accumulation of foreign exchange reserves in China, its control of significant global
liquidity and its attempts to obtain both political and economic returns on its assets through
means such as the Belt and Road Initiative and funding infrastructure projects abroad is arguably
a sign of such a financial expansion.
41
Unfortunately, Arrighi’s thesis, first published in 1994, came too early to comment on the
contemporary situation though some discussion on China’s rise can be found in the postscript of
the second edition published in 2010. While some aspects of Arrighi’s theory [including the view
that surplus capital would flow from declining to rising centers] do not fit the contemporary
picture, he makes the salient point in which one of the major obstacles to a non-catastrophic
transition to a China-led cycle is “US resistance to adjustment and accommodation”. (Arrighi
2010, 383) The US’s emergence as the dominant financial player and international creditor after
WWI up till the 1960s, as well as its role in setting up the Bretton Woods system (Eichengreen
2008) confers it a degree of structural power (Norrlof 2014; Eichengreen 2012; Andrews 2006)
and creates difficulties for non-dominant states trying to undermine it systemically. (L. E. Armijo
and Katada 2015) Overall, fears considering China’s “mercantilist” behaviors (or behaviors that
are perceived as such) stem on the one hand from the size, scale and unprecedented nature of
such accumulation
11
, but on the other hand from China’s different political and economic model.
Arguably, the US’s fears of its strategic vulnerability caused by its international debtor
status as raised by Setser in the Council on Foreign Relations report is a symptom of such a
resistance to adjustment and accommodation. Broadly speaking, fears of Chinese mercantilism
also reflect fears that the basis for Western and specifically US-dominance is eroding. Generally
speaking, there seems to be a normative aspect in characterizing China’s accumulation of foreign
exchange reserves and its management of the exchange rate as “mercantilistic” in nature. The
prevailing Western-led neoliberal order contains a norm toward free trade and international
capital movements and places a premium on democracy. Thus, it views China’s authoritarian
regime with suspicion and most of fears toward “currency manipulation” comes from the idea
11
Interestingly, the US’ equally sizeable stock of gold reserves in the post-war to early Bretton Woods era is not
similarly subject to the same scrutiny.
42
that the Chinese state can operate unilaterally in its domestic context. Yet, such an assessment is
too simplistic and does not take into account the changed conditions brought about by financial
globalization, as well as more recent changes in China’s exchange rate regime with more market-
oriented reforms.
Furthermore, as mentioned in the paper, the US dollar’s role as the leading global reserve
currency means that the US has no capital controls and does not engage in any management of
its exchange rate. Effectively, this means that in the light of global macroeconomic imbalances
such as the US’s persistent external deficits and China’s persistent surpluses, political actors and
commentators within the US often take the moral and ideological high ground in arguing that
these imbalances are the result of the “mercantilist” behavior of other nations that do have capital
controls and do manage their exchange rate. As such, the onus is often placed on other nations –
historically Japan, presently China and more recently Singapore, Malaysia and Vietnam (e.g.
Jamrisko and Goodman 2019) – to engage in internal adjustments when the US domestic policies
such as its fiscal and monetary policies and low savings rate are equally culpable for the
condition of global macroeconomic imbalances. For sure, this is but an example of the US
exerting its structural power and resisting adjustment and accommodation.
In sum, this paper has used the framework of mercantilism to analyze China’s foreign
exchange reserve accumulation as well as the management of the exchange rate, and further uses
the monetary policy trilemma to study changes in exchange rate regime within the broader
picture of mercantilism. It argues that reserve accumulation and exchange rate regime should be
studied in tandem to derive an understanding of the phenomenon of reserve accumulation at both
micro and macro levels. The analysis above has shown a conflicting picture in the directions of
43
both mercantilism and marketization. It has shown that the increased degree of marketization
indicated by recent PBOC reforms is ultimately still predicated on a degree of control (through
the employment of the counter-cyclical factor) as well as maintaining foreign exchange reserves
at a level above $3.1 trillion. Ultimately, this indicates both revisionism and accommodation, as
China resolutely refuses to conform to the image of the neoliberal West whilst making some
moves in that direction, just as how it sought to obtain control over all three aspects of the
monetary policy trilemma, while maintaining absolute control over none.
44
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Abstract (if available)
Abstract
This paper will examine China's foreign exchange reserves accumulation alongside changes to its exchange rate regime using the dual lens of mercantilism and marketization. It argues that a look at the mercantilistic accumulation of foreign exchange reserves alone is insufficient, but must be analyzed alongside changes to the exchange rate regime in the direction of more market-oriented reforms. The analysis shows that China is balancing the tradeoffs of the monetary policy trilemma, relinquishing control of each while maintaining absolute control over none.
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Lim, Yixuan (Ariel)
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Core Title
Mercantilism and marketization? Analysis of China's reserve accumulation and changes in exchange rate regime using the monetary policy trilemma
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College of Letters, Arts and Sciences
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Publication Date
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