Monetary sterilization in China: Rule vs. discretion

While China has been construed as a country that consistently sterilizes monetary impacts of its foreign exchange market interventions, whether its sterilization policy is conducted by rule or by discretion remains an open question.  This paper analyzes China’s sterilization strategy in a money-market framework and derives an implied sterilization rule that prescribes a relationship among the sterilization intensity, the rate of renminbi appreciation against the dollar, and the growth rate of the Chinese central bank’s net foreign assets (NFAs).

Net capital inflow causes renminbi to appreciate and NFAs to increase and therefore the iso-sterilization intensity loci are featured as a positive relationship between NFA growth and the rate of appreciation.  Similarly net capital outflow leads to renminbi depreciation and decreases in NFAs, yielding the iso-sterilization intensity loci characterizing a positive relationship between NFA decline and the rate of depreciation.  In contrast to conventional views, the established sterilization rule identifies a neighborhood in which the sterilization intensity is generally insensitive to changes of less than 50% in the exchange rate and NFAs.  Outside the neighborhood, however, the sterilization rule exhibits asymmetric responses to changes in the exchange rate and NFAs: while the rule calls for the maximal sterilization once the boundary dividing the non-sterilization area from the sterilization area is crossed, the subsequent response of sterilization intensity can be different as the exchange rate and NFAs change further in the sterilization area.  More specifically, in tackling the growth of NFAs and resulting monetary expansion, the sterilization rule prescribes the maximal sterilization intensity to completely offset endogenous monetary expansion; whereas in dealing with declining NFAs and consequent monetary contraction, the rule-based sterilization intensity will first sustain its maximum within a narrow range of NFA declines and then turn to weakening as NFAs continue to fall.  

China’s sterilization policy in practice nevertheless exhibits a considerable gap from what the identified sterilization rule has predicted.  With the VAR approach, the empirical study analyzes two distinct periods: the pre-crisis period (2005-2009) vs. the post-crisis period (2010-2015).  The findings suggest that China has essentially followed a discretionary sterilization policy rather than the sterilization rule as identified in this study.  Particularly, in the recent decade, China has over-sterilized the monetary impacts of its foreign exchange market intervention in both magnitude and timing.
* Renminbi is China’s currency.