1、Monetary Policy Independence, the Currency Regime,and the Capital Account in China Author： Eswar S. Prasad Nationality: America Sourse and Type: Paper presented at the Conference on Chinas Exchange Rate Policy Peterson Institute for International Economics Http:/unjobs.org Journal time: October 19,
2、2007， P7-13 Chinas currency policy has of course received the most attention of late. Whether the maintenance of a fixed exchange rate is part of a deliberate mercantilist strategy to promote export-led growth has been the subject of intense debate. On the one hand, China has had a relatively stable
3、 exchange rate relative to the U.S. dollar since 1995. This policy was sustained even through the Asian crisis when the temptations for devaluing the currency were great. On the other hand, during this decade the exchange rate has been kept from appreciating only by massive intervention in the excha
4、nge market. In tandem with sustained high export growth and a burgeoning current account surplus that nearly hit 10 percent of GDP in 2006, this has been seen as prima facie evidence of a grossly undervalued currency. As discussed in more detail below, one of the principal concerns is that the lack
5、of exchange rate flexibility not only reduces monetary policy independence, it also hampers banking sector reforms. The inability of the PBC to use interest rates as a primary tool of monetary policy implies that credit growth has to be controlled by blunter and non-market-oriented tools, including
6、targets/ceilings for credit growth as well as “non-prudential administrative measures”. Chinas approach to exchange rate poliy and capital account liberalization may be indicative of a desire to maintain stability on the domestic and external fronts while opening up to trade and financial flows. And
7、 the large stock of foreign exchange reserves resulting from these policies may serve as insurance against vulnerabilities arising from a weak banking system.But there comes a point when the policy distortions needed to maintain this approach could generate imbalances, impose potentially large welfa
8、re costs, and themselves become a source of instability. To begin with, why is the exchange rate regime of such importance? After all, the exchange rate is just a relative price. Moreover, economic models tell us that macroeconomic fundamentals will eventually win out in terms of what really matters
9、- the real exchange rate rather than the nominal exchange rate. That is, if the nominal exchange rate doesnt adjust in response to changes in fundamentals, relative price levels will adjust. But a combination of policies such as financial repression and a closed capital account can delay this adjust
10、ment for a significant period. While this can boost export competitiveness by keeping the exchange rate undervalued, there can be subtle indirect costs, in terms of both economic welfare and reduced policy flexibility in responding to various shocks. What are the costs of an inflexible exchange rate
11、? The schematic diagram below lays out some of the connections, although this should of course be recognized as a heuristic diagram that ignores many of the complexities in the relationships depicted here. The main point is that an inflexible exchange rate, while not the root cause of imbalances in
12、the economy, requires a large set of distortionary policies for its maintenance over long periods. It is these distortions thatthrough multiple channelshurt economic welfare and could, over time, shift the balance of risks in the economy. Lack of Exchange Rage Flexibility Complicates Macro Policy an
13、d Reforms Making the Right Connections An independent interest rate policy is a key tool for improving domestic macroeconomic management and promoting stable growth and low inflation. As the Chinese economy becomes more complex and market-oriented, it will become harder to manage through command and
14、 control methods as in the past. And, as it becomes more exposed to global influences through its rising trade and financial linkages to the world economy, it will also become more exposed to external shocks. Monetary policy is typically the first line of defense against macroeconomic shocks, both i
15、nternal and external. Hence, having an independent monetary policy is important for overall macroeconomic stability. Monetary policy independence is, however, a mirage if the central bank is mandated to attain an exchange rate objective. Capital controls, which prevent money from moving in an out of an economy easily, do
