The Effects Of China’s Macroeconomic Policies On Its External Balance

Many countries worldwide are experiencing external imbalances. External imbalances bring many harmful consequences. While some studies point out that the government’s macro-economic policies also contributed to external imbalances, they rarely study the transmission mechanism in a systematic way. especially to quantify the contribution of the role of economic policies on the external balance. China is a country with sustained external surplus and its government plays an important role in economic activities, hence, a systematic and in-depth analysis of the impact of economic policies on external balance is of practical significance, the results can provide guidance for China’s external imbalance adjustment.In this paper, we reviews the characteristics of China’s fiscal, monetary and exchange rate policies, which lays the foundation for subsequent chapters in terms of building realistic theoretical and empirical models. The characteristic of China’s fiscal policie is low share of social security spending in fiscal expenditure. The characteristics of of China’s monetary policy are the government’s heavy reliance on quantitative monetary policy, the monetary aggregate M2as intermediate target and the use of various monetary instruments to achieve multiple objectives. The characteristics of China’s exchange rate policy include managed exchange rates, reserve accumulation and capital controls.The core part of the paper is consisted of Chapter4through Chapter6. In Chapter4and Chapter5, we seperately investigate how fiscal policy, monetary policy and exchange rate policies affect external balance. By identifying the direction of each policy’s effect on external balance theoretically and empirically, we can provide inputs for sign restriction methods in subsequent quantitative analysis of China’s external imbalance. The main results are that fiscal expansion leads to external deficits, monetary expansion leads to external surplus and exchange rate undervaluation leads to external surplus. Chapter6uses a comprehensive accounting framework to quantify Chinese government’s contribution of its external imbalance, the result of which can provide policy implications for Chinese government’s role in future imbalance adjustment. The empirical results show that in the sample period, monetary policy exerts largest effect on China’s external imbalance, while the fiscal and exchange rate policies exerts comparable effect, the policy factors in aggregate can explain about50%of the variation in China’s external balance.This study brings three innovations to the literature:Firstly, it emphasizes the importance of policy factors. An analysis focusing on government behavior provides new insights into possible tools for external imbalance adjustments.Secondly, we build theoretical models in line with the characteristics of Chinese macro-economic policies to explore the transmission mechanism of economic policy on external balance, and derive testable propositions. Elements of our models include money stock targeting, capital control and managed exchange rate, etc.Thirdly, in empirical parts, we use newly developed methods such as a panel percentile model, panel conditional homogeneity VAR model (PCHVAR) and Bayesian VAR with sign restrition model, to test the effect of policy factors on the external balance. Besides, we discuss potential policy messures for its external imbalances adjustment.As complements to existing results, we based on theoretical and empirical analysis in this paper and taking into account current situation of Chinese economic development, further make the following policy recommendations regarding the role of the Chinese government in its external imbalance adjustment:For fiscal policy, measures aimed at increasing the share of social security expenditure are conducive to external imbalances adjustment. For monetary policy, slower money injection serves to bring down external surplus. Besides, to push forward RMB internationalization may effectively reduce liquidity demand for foreign exchange accumulation. For exchange rate policy, the major issue at present is how to utilize foreign exchange reserves in a more effective way. Moreover, the government should allow more flexible exchange rate formation mechanism and gradual RMB appreciation.