Aaaargh!!! (Slaughter on China)

Why do economists writing about China pretend not to know the difference between sterilized and non-sterilized intervention? We’ve been through this before, but the latest case in point is Matthew Slaughter, writing in the Wall Street Journal (and cited uncritically by Greg Mankiw and Mark Thoma):

Economic theory and data are very clear here on two critical points. Controlling a nominal exchange rate is a form of sovereign monetary policy. And monetary policy, in turn, has no long-run effect on real economic outcomes such as output and trade flows.

Like all other central banks, the People's Bank of China uses its monopoly power over minting its money to control one nominal price. Since 1994 the PBOC has chosen to closely target the dollar-yuan price. In recent times, maintaining this target has required the PBOC to print yuan to buy dollars and thereby accumulate dollar-denominated assets on its balance sheet.

Under the standard paradigm, a central bank maintains a fixed exchange rate by adjusting interest rates so as to attract enough capital to keep its level of foreign reserves roughly constant. In the very short run, the level of reserves fluctuates, but if the central bank is truly trying “control one nominal price” with “sovereign monetary policy,” the level of reserves should not show a dramatic trend over time. As its level of foreign reserves increases, the central bank should recognize the increased demand for money and satisfy that demand by adding domestic reserves to the banking system. That’s the way “monetary policy” works.

What the People’s Bank of China is doing is something quite different. Even as it maintains its effective dollar peg, it is attempting to cool the economy by raising interest rates. It is not controlling “one nominal price”; rather, it is attempting (with limited success) to control two things at once. It is trying to keep exports strong by keeping the currency weak, and at the same time, it is trying to reduce domestic demand by tightening domestic monetary policy. As a result, it is accumulating a huge, huge, huge quantity of dollar-denominated assets, and this rate of accumulation is clear evidence of a policy conflict.

The conflict might be a bit more obvious if things were going in the other direction. If China were trying to peg the yuan too high rather than too low, while at the same time trying to stimulate, rather than cool, its domestic economy, it would be losing reserves rapidly. The process couldn’t continue, because it would run out of reserves. Then it would be forced either to abandon the peg or to tighten the domestic money supply dramatically. Because the process is now going in the opposite direction, there is no “crisis”, but otherwise what we are seeing is the exact inverse of conditions that would normally have led to a foreign exchange crisis. Of course, when a country does have a foreign exchange crisis, we don’t read economists saying that it is just “sovereign monetary policy” and nothing to worry about. When the process happens in reverse, though, apparently central banks can find plenty of apologists for their unsavory policies.