Estimating Effectiveness Of China's Sterilization Policy

China's Balance of Payment has been in surplus in recent years, which results in rocketing foreign reserves. In 2008, China overtook Japan to become the country with the largest foreign reserves, and at the same time, Funds Outstanding for Foreign Exchange becomes the main channel of domestic currency issuing. If domestic money supply exceeds domestic money demand, it may cause inflation. In the face of rocketing foreign reserves, people begin to wonder whether this may erode the independency of China's monetary policy. This no doubt will call into question the effectiveness of sterilization, since it is believed that when capital movement is restricted, sterilization can somehow shield domestic monetary policy from exchange rate intervention. As a result, we need to consider the following three aspects:first, whether sterilization remains effective in the face of massive capital inflow; second, the cost of sterilization; third, how to relieve the pressure from sterilization.Current papers has done a lot of research on the above three aspects, and this paper will try to present a review of these and then focus on the effectiveness of China's sterilization policy. The effectiveness of China's sterilization policy can be measured in many different ways, such as the sterilization coefficient, its impact on money supply or price level. Among this, the sterilization coefficient is most used, which is defined as the ratio between the change of Net Domestic Asset (ΔNDA) and the change of Net Foreign Asset (AΔNFA). This coefficient can be estimated using the following two methods:the first method makes this estimation based on the central bank's balance sheet; the second method makes this estimation by building models. This paper will estimate the sterilization coefficient by employing these two techniques in the first two parts of the empirical study. When using the first method, this paper applies different time-lengths to see how the coefficient changes. When using the second techniques, the paper tries to adjust the BGT model based on the works of Ouyang and Wang and the characteristics of China's monetary policy, and then estimate the coefficient based on the model derived. However, these two techniques share the same disadvantage:they fail to exclude non-sterilization factors from their estimation. Thus what this paper will do is to estimate the effectiveness of sterilization by observing how well the central bank can control monetary base and M2. The central bank establishes a target for money supply each year, and it does not need to sterilize all the "Funds outstanding for foreign exchange", but only need to sterilize the amount which exceed the annual target. This paper shows that although sterilization was not so effective in terms of monetary base, but it is quite effective in terms of M2. Nonetheless, the central bank's ability is quite limited. The last part of this paper gives some advice on how to relieve pressure from sterilization and improve the effectiveness of sterilization policy in China, such as establishing a stabilization fund, increasing the flexibility of RMB exchange rate, and encouraging outward investment.