A Study On Performance And Sustainability Of PBOC’s Sterilization Policy

Since 2001, because of the continuing current account surpluses and capital inflows, China’s foreign exchange reserves continued to grow. China is facing tremendous pressure of the appreciation of RMB. In order to keep the RMB exchange rate stable, the People’s Bank of China has been buying excess supply of foreign exchange to prevent excessive appreciation of the RMB exchange rate. In the process of foreign exchange market intervention, the central bank injected a large amount of high-power base money, resulting in the excessive liquidity in China’s domestic money market and the increasing inflationary pressures.Facing the excessive liquidity and inflationary pressures caused by reserve accumulation, the People’s Bank of China has carried out an active sterilization policy in order to achieve monetary policy targets. On the one hand, the PBOC raised the required reserve ratio many times. On the other hand, the PBOC also issued interest-bearing central bank bills as a major sterilization means. From April 22th, 2003 when the PBOC firstly began issuing central bank bills through open market operations, the outstanding balance of central bank bills increases from more than 300 billion yuan to 4 trillion yuan at the end of 2010.Through the accumulation of reserves and active sterilization policy, PBOC on the one hand could keep the stability and gradual appreciation of RMB exchange rate, and on the other hand maintained a steady growth of base money and achieved the coordination between the exchange rate target and the monetary policy targets.According to Paul Krugman’s Impossible Trinity, in an open economy, a country could not simultaneously aquire the independence of monetary policy, the stability of exchange rate and capital mobility. It could only meet two goals, while it must give up another goal. Facing reserve inflows, Southeast Asian countries and China chose a policy combination of maintaining the independence of monetary policy and the stability of exchange rate at the expense of full capital mobility and implementing capital controls to some extent. To achieve this policy mix, these countries implemented reserve accumulation and active sterilization operations.In this context, it is necessary to find out how effective the PBOC’s sterilization practice is, and whether the cost of its sterilization can be covered by the income of its foreign exchange reserves. This paper studies the issues of the PBOC’s sterilization in depth from these two angles.This paper constructs an open economy Bernanke-Blinder model. In this model, a banking sector is introduced into the standard IS-LM model, also a BOP equation is introduced in order to find out the influence that capital inflows have on the domestic economy and the central bank’s policy responses. According to the comparative static analysis results, the use of required reserve ratio has a greater impact on interest rates and the domestic economy than open market operations (decreasing high-powered money stock). That is why many developing countries tend to use required reserve ratio as an important sterilization means.Then this paper assesses the effects of PBOC’s sterilized intervention. This paper uses a VAR model that contains four endogenous variables (changes in net foreign assets, changes in net domestic assets, changes in domestic credit and changes in domestic interest rate) and one exogenous variable (the level of foreign interest rate) to assess the effects of PBOC’s sterilization operations in the past few years and examine whether the decrease in foreign interest rate and the widening spreads between domestic and foreign interest rates is the main reason of China’s reserve inflows. Estimation results show that the net domestic assets response significantly to the changes in net foreign assets, while the domestic credit and interest rates have no obvious responses to the changes in net foreign assets. This proves that the PBOC have implemented an active sterilization policy and successfully isolated the domestic monetary conditions from reserve accumulation. Finally, this paper analyzes the sustainability of the PBOC’s sterilization policy.From the perspective of costs and benefits, this paper examines the costs of PBOC’s sterilization operation and the benefits from foreign reserve assets. If the yields on foreign reserve assets are greater than the costs of sterilization, the current sterilizaton operation can be carried out continuously, and the central bank can achieve the coordination between monetary policy and exchange rate target. Conversely, if the benefits from foreign reserve assets can not make up the costs of sterilization, the sterilization operation will not be sustainable and should be ended. The central bank must seek for other solutions. Estimation results show that currently the yields on foreign reserve assets are greater than the costs of sterilization, if the average term of foreign assets held by the PBOC is long (e.g. 10 years). So the sterilization operation can still continue for some time. But in the long run, with the appreciation of yuan, the issuance of central bank bills and the increases in the required reserve ratio, the costs of sterilization will exceed the benefits from foreign reserves, particularly if the average duration of foreign assets is short (such as 5 years or below), then the sterilization operation could not continue and should be ended.Although reserve accumulation and sterilization policy can solve the Krugman’s Impossible Trinity to a certain extent in the short run, this policy mix could not sustain in the long run because the costs of sterilization will eventually exceed the benefits from foreign reserves. The central bank must seek for other ways to solve the issues of external imbalances and maintain the independence of monetary policy.