April 7, 2021 | China's Monetary Policy, Part 1

Part 1 of an intermittent series on China's monetary policy and its geopolitical impact on US-China relations

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Today and tomorrow, we’re opening a new series of posts focused on China’s monetary policy. Today we’ll examine why China is frequently criticized by the US and other leading economies for its currency practices. Today, we’ll try to bridge the gap between policy and macro by reviewing why China receives a great deal of criticism from developed countries for its currency policy.

Global powers like the United States frequently criticize China for its monetary practices. Namely, the United States argues China games the global financial system by using centralized state-controlled mechanisms to manipulate the value of its currency, the Yuan (CNY), on international foreign exchange (FX) markets.


**NOTE: We usually focus more on China’s digital currency, DCEP, or the e-CNY, but what we’re reviewing today is equally applicable to both the traditional fiat version and the blockchain-based version of its currencies. Better yet, it’s okay to look at the standard fiat currency and the digital currency as the same things.


To understand China’s currency (and any currency), we need to understand the function and purpose of a central bank. Central banks matter because they are the institutions responsible for “printing” new money and ensuring the value of the money they print remains stable enough for normal folks to use in their everyday lives.

The four most important central banks for the global economy (not in any particular order) are the Federal Reserve (United States; the “Fed”), The People’s Bank of China (China; PBOC), European Central Bank (European Union; ECB), and the Bank of Japan (Japan; BOJ).

All the banks I just mentioned more or less operate on what’s known as a “dual mandate.” Dual mandate means these banks have two objectives:

  1. To maintain stable prices (to avoid wild price swings)

  2. To maximize the numbered of people employed in their respective economies

All the world’s major central banks focus primarily on implementing this dual mandate, except for one: China’s PBOC.

China’s approach to monetary policy is far more hands-on than the US, EU, and others. Yes, China works to maintain stable prices and maximize employment like other monetary jurisdictions, but the PBOC’s mandate runs way deeper.

For most of China’s economic expansion from roughly 1980 until roughly 2015, the PBOC’s primary function was to facilitate China’s export-led growth model. China’s authorities succeeded in achieving this growth by artificially suppressing the Yuan's value compared to reserve currencies like the US dollar.

By devaluing its currency, China and any other country can instantly make their goods and services far cheaper on the international market than goods and services produced by countries that let their currency float on the open market.

So why doesn’t every country devalue its currency?

If every country managed monetary policy like China, the global economy would effectively cease to function. The modern economy depends heavily on the free exchange of goods and services. This free exchange applies to currencies as well.

For instance, what makes the US dollar immensely attractive as an international reserve currency is that you or I can take our dollars and exchange them with almost any other currency in the world with no hassle, no red tape, and no restrictions. China’s invasive monetary policy (among other factors) means the Yuan is not freely exchangeable in the same way.

The key takeaway from today’s notes is that China has benefited immensely from its tightly controlled monetary policy. By devaluing its currency in concert with a boom in US consumer demand from 1980-2014, Chinese goods were priced far more competitively on international markets. Moreover, China’s currency devaluation also made Chinese domestic labor far more competitive and incentivized US companies to outsource labor and shift supply chains to China during this same period.

Devaluing the Yuan helped China while it was an export-led, investment-driven economy. However, as China’s economy shifts towards becoming one built on domestic consumer demand and an expanding services sector, its monetary authorities still have major incentives to maintain the status quo. In the context of US-China geopolitics, this issue is one of the deepest sources of tensions and one that is unlikely to resolve itself any time soon.

We’ll explore why China is committed to its current monetary trajectory in tomorrow’s notes. We’ll also run through crucial concepts such as foreign capital inflows/outflows, and the capital account. Stay tuned.


Additional Reading

Yi Gang: China's monetary policy framework - supporting the real economy and striking a balance between internal and external equilibrium (Bank for International Settlements)

Lecture by Mr Yi Gang, Governor of the People's Bank of China, at Chang'an Forum, held by the Chinese Economists 50 Forum, Tsinghua University, Beijing, 13 December 2018.

Ex-PBOC Adviser Sees Risk of China Outflows Along With Other EMs (Bloomberg)

China faces the threat of foreign outflows from the second half of the year as rising borrowing costs in the U.S. drives investors out of emerging markets, according to a former adviser to China’s central bank.

The potential for a reversal in capital inflows and a possible wave of bond defaults are two of the biggest risks facing the economy this year, Li Daokui, a former member of the People’s Bank of China’s monetary policy committee, said in an interview. The instability is being fueled by the U.S.’s $1.9 trillion pandemic relief, which will benefit China by boosting exports, but also add to risks, he said.

Goldman, Citi Lead U.S. Banks Plowing Billions Into China

China faces the threat of foreign outflows from the second half of the year as rising borrowing costs in the U.S. drives investors out of emerging markets, according to a former adviser to China’s central bank.

The potential for a reversal in capital inflows and a possible wave of bond defaults are two of the biggest risks facing the economy this year, Li Daokui, a former member of the People’s Bank of China’s monetary policy committee, said in an interview. The instability is being fueled by the U.S.’s $1.9 trillion pandemic relief, which will benefit China by boosting exports, but also add to risks, he said.

Major Power Rivalry in East Asia (Council on Foreign Relations)

In an era of intensifying U.S.-China friction and volatility, the risks of conflict are real and growing in East Asia, and U.S. policymakers should revitalize existing tools and build new ones to manage an increasingly militarized competition.


Photo by Eric Prouzet on Unsplash