Sterilization In China:Effectiveness And Sustainability

China has experienced a large increase in its foreign exchange reserves since2001, due to a continuous surplus in both current account and capital account and the commitment to maintain a fixed rate against the dollar initially and then a crawling peg exchange rate regime. Among these operations, the accumulation of foreign assets has an expansionary monetary effect and poses a challenge for domestic macroeconomics management. As a response, the People’s Bank of China (PBC for short) sterilizes the increase in foreign assets by taking offsetting actions with domestic assets.This paper adapts a LS method to estimate the extent of China’s sterilization using monthly data from2001to2011, generating ΔND A and ANFA from NDA and NFA’s first difference data, I scale ΔNDA and ΔNFA with GDP of the corresponding period, get new variables: DNFAt=ΔNFAt/GDPt and DNDAt=ΔNDAt/GDPt. Then I use LS to estimate the equation: DNDA,=α+βDNFAt+εt, get the result as follow: DNDA,=0.037763-0.841817DNFA,+εt, the sterilization coefficient is-0.84, indicating a relatively high level, but less than full sterilization by the PBC during my estimation period. However, the model’s r2is only0.12, that is very low, indicating that this model maybe lack of variables, so this regression’s result should be viewed with caution. To observe the sterilization coefficient futher, I use the ratio of ΔNDA,/ΔNFA, to do a descriptive statistic, we can see the PBC indeed sterilized, but the fluctuation is obvious, especially in2000-2001, and2009-2011.The sterilization comes at a cost, as the foreign reserves keep accumulating, the PBC has to issue more debt for sterilization purpose, which may drive up the interest rates on the PBC bills. Finally the cost may become too high to carry out the sterilization. The foreign reserves can get some investment return of course, so whether the investment return from the foreign reserves could offset the cost determines the sustainability of the sterilization operation. This paper uses monthly data from September2004to December2011to estimate the sterilization’s cost and return. The cost of sterilization is generated from two categories on the liability side on the PBC’s balance sheet:the interest on the outstanding PBC bills and on the total reserves. I use a approximation of the composition of China’s foreign reserves:US dollar assets’ratio is around70%, EURO assets25%, and Japanese Yen assets5%, yields on these assets are approximated by five and two year government bonds issued by the corresponding national governments. From the comparison of cost and return, we can see that so far the PBC’s sterilization almost can be covered by its income from foreign reserves, but further appreciation of RMB may have a negative impact on the PBC’s income from foreign reserves in domestic currency terms.In order to improve the sterilization, I put forward some suggestions in keeping on reforming the RMB exchange rate mechanism and foreign reserves management system, adjusting the sterilization tools and making innovations, such as using the special treasury bonds, establishing the foreign exchange stabilized fund, and some other new foreign exchange derivations.