Money and Banking Lecture X: Capital Flow, Exchange Rate and Monetary Policy in China

Guoxiong ZHANG, Ph.D. Shanghai Jiao Tong University, Antai

December 20th, 2016

RMB Internationalization

Source: https://sputniknews.com

Road Map

IS-LM in the open-economy small open economy model (Mundell-Fleming) large open economy model

The Impossible Trilemma Financial reform of China

The Mundell-Fleming Model

This model carries the IS-LM framework to a small open economy An economy is called small open economy if it can not have any impact of the rest of the world In this model, a small open economy takes the interest rate as given

The Goods Market and the IS* Curve Assumptions: 1. the domestic interest rate r equals the world interest rate r* (small open economy) 2. price level is exogenously fixed (short run) 3. money supply is exogenously fixed as well (monetary policy)

The IS* Curve:

Y = C (Y − T ) + I (r *) + G + NX (e ) e

= nominal exchange rate (vs real exchange rate)

e

↓ e ⇒ ↑ NX ⇒ ↑ Y I S*

Y

The Money Market and the LM* Curve The LM* Curve:

M P = L (r *,Y ) e

LM *

The LM* curve • is drawn for a given value of r*. • is vertical because: given r* , there is only one value of Y that equates money demand with supply, regardless of e .

Y

Equilibrium in the Mundell-Fleming Model

Y = C (Y − T ) + I (r *) + G + NX (e ) M P = L (r *,Y ) e

LM *

equilibrium exchange rate

equilibrium level of income

I S*

Y

Fiscal Policy under Floating Exchange Rate

At any given value of e , a fiscal expansion increases Y, shifting IS* to the right.

Results: ∆e > 0, ∆Y = 0

e

LM 1*

e2 e1 I S 2* I S 1* Y1

Y

Fiscal Policy under Floating Exchange Rate At any given value of e , a fiscal expansion increases Y, shifting IS* to the right. Results: ∆e > 0, ∆Y = 0 • •

In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. “Crowding out” – closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. – small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate.

e

LM 1*

e2 e1 I S 2* I S 1* Y1

Y

Monetary Policy under Floating Exchange Rate An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. Results: ∆e < 0, ∆Y > 0 • Monetary policy affects output by affecting the components of aggregate demand: closed

e

economy: ↑M ⇒ ↓r ⇒ ↑I ⇒ ↑Y small open economy: ↑M ⇒ ↓e ⇒ ↑NX ⇒ ↑Y

• Expansionary monetary policy does not raise world aggregate demand, it merely shifts demand from foreign to domestic products. So, the increases in domestic income and employment are at the expense of losses abroad.

LM 1*LM 2*

e1 e2 I S 1* Y1 Y2

Y

Trade Policy under Floating Exchange Rate At any given value of e , a tariff or quota reduces imports, increases NX, and shifts IS* to the right. Results: ∆e > 0, ∆Y = 0 • Import restrictions cannot reduce a trade deficit. Even though NX is unchanged, there is less trade: - the trade restriction reduces imports. - the exchange rate appreciation reduces exports. • Less trade means fewer “gains from trade.” Import restrictions cannot reduce a trade deficit. • Even though NX is unchanged, there is less trade: - the trade restriction reduces imports. - the exchange rate appreciation reduces exports. • Less trade means fewer “gains from trade.”

e

LM 1*

e2 e1 I S 2* I S 1* Y1

Y

Fiscal Policy under Fixed Exchange Rate

To maintain a fixed exchange rate, the money supply has to be increased as well after a fiscal expansion. Results: ∆e = 0, ∆Y > 0

e

LM 1*LM 2*

I S 2* I S 1* Y1 Y2

Y

Monetary Policy under Fixed Exchange Rate

Under fixed exchange rate, monetary policy can not be used to stimulate economy at all. Results: ∆e = 0, ∆Y = 0

e

LM 1*LM 2*

e1 I S 1* Y1

Y

Trade Policy under Fixed Exchange Rate

Under fixed exchange rate, monetary policy can not be used to stimulate economy at all. Results: ∆e = 0, ∆Y = 0

e

LM 1*LM 2*

I S 2* I S 1* Y1 Y2

Y

Trade Policy under Fixed Exchange Rate

Under fixed exchange rate, import restriction be used to stimulate economy. Results: ∆e = 0, ∆Y > 0

e

LM 1*LM 2*

e1 I S 2* I S 1* Y1 Y2

Y

International Interest Rates Differentials Two reasons why r may differ from r* - country risk : The risk that the country’s borrowers will default on their loan repayments because of political or economic turmoil. Lenders require a higher interest rate to compensate them for this risk. - expected exchange rate changes : If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation.

r = r *+ θ where θ (Greek letter “theta”) is a risk premium, assumed exogenous. Substitute the expression for r into the IS* and LM* equations:

Y = C (Y − T ) + I (r * + θ ) + G + NX (e )

M P = L (r * + θ ,Y )

The Effects of an Increase in θ IS* shifts left, because ↑θ ⇒ ↑r ⇒ ↓I LM* shifts right, because ↑θ ⇒ ↑r ⇒ ↓(M/P)d, so Y must rise to restore money market equilibrium. Results: ∆e < 0, ∆Y > 0 The fall in e is intuitive: - An increase in country risk or an expected depreciation makes holding the country’s currency less attractive. Note: an expected depreciation is a self-fulfilling prophecy .

e

LM 1*LM 2*

e1

The increase in Y occurs because the boost in NX (from the depreciation) is greater than the fall in I (from the rise in r ).

e2 Y1

I S 1* I S 2* Y

A Large Open Economy Model

For a large open economy, the interest rate is endogenous: Y = C(Y T ) + I(r) + G + N X(e) M = L(r, Y ) P N X(e) = CF (r), which can be transformed as Y = C(Y T ) + I(r) + G + CF (r) M = L(r, Y ) LM P

IS

IS-LM for a Large Open Economy

Source: Mankiw (2011)

Fiscal Expansion in a Large Open Economy

Source: Mankiw (2011)

Monetary Expansion in a Large Open Economy

Source: Mankiw (2011)

Impossible Trilemma

Uncovered Interest Rate Parity

The logic behind the impossible trilemma is the uncovered interest rate parity: 1 + iCN = where 1U SD = St RM B.

Et (St+1 ) (1 + iU S ), St

Financial Reform in China

Missions of the ongoing financial reform in China: interest rate liberalization (done) Renminbi internationalization (ongoing) exchange rate liberalization (just started) capital account liberalization (not yet)

Why We Need Interest Rate Liberalization

Shadow Banking

Interest Rate Liberalization

In July 2013, the lower bound for lending rate was removed In October 2015, the upper bound for deposit rate was removed

Benefits of Being an International Currency

There are several benefits to be an international currency Convenience for the country’s residents More business for the country’s banks and other financial institutions Seigniorage Political power and prestige “Safety premium” and risk diversification if becoming a reserve currency

Costs of Being an International Currency

There are also costs to be an international currency Larger fluctuations in demand for the currency An increase in the average demand for the currency (appreciation hurts export) Burden of responsibility

Internationalization of RMB

O↵shore RMB bond market (dim sum) was created at Hong Kong in 2007 Many countries have signed cross-border trade RMB settlement agreement since 2008 O↵-shore RMB market was created at Hong Kong in 2009 RMB has been able to flow freely between Shanghai Free Trade Zone, non-resident onshore account and o↵shore account since 2013 RMB successfully joint the SDR of IMF

Fundamental Determinants of Currency Status

The currency of a country that has a large share in international output, trade, and finance has a big natural advantage Capital and money markets in the home country must be not only open and free of controls, but also deep and well-developed Confidence in the value of the currency. network externalities inertia: small changes in the determinants will not produce corresponding changes in the reserve currency numbers, at least not in the short run economies of scope: one is more likely to use a given currency in his or her transactions if everyone else is doing so

Reserve Currency

Source: Frankle (2011)

Internationalization of Deutsche Mark in the 1970s-1980s

Through 1950s to 1960s, a rising U.S. balance of payment deficits and declining ratio of U.S. gold reserves to dollar liabilities brought into question the long-term prospects for the dollar President Richard Nixon took the dollar entirely o↵ gold in 1971 and the fixed exchange rate system definitively ended in 1973 Deutsche Mark became attractive while dollar became weaker Nevertheless, the mark continued to gain status throughout the 1980s. It was a side e↵ect of the growing size of the German economy (especially trade) and the impeccable reputation that the Bundesbank had established for keeping the mark strong in value Deutsche Mark lost its share largely due to the fact that Germany was paving the way for Euro

Internationalization of Japanese Yen in the 1980s

For the same reason as Germany, Japan has always reluctant to internationalization of Japanese Yen The U.S. motive in pushing for internationalization of the yen was a theory that it would lead to appreciation and help U.S. exporters International use of the yen continued gradually to rise in the 1980s despite reluctance of the Japanese government In the mid-1990s, official policy at last shifted firmly in favor of internationalization reducing exchange rate risk for domestic firms, facilitating business for Japanese banks and other financial institutions promoting Japan as a financial center

Ironically the share of Yen in the World’s reserve currency actually started to decline in mid-1990s

Prospect of RMB Internationalization: Size of China

Source: Frankle (2011)

Prospect of RMB Internationalization: Financial Openness

Source: Frankle (2011)

Current Account of China

Goods Trade Balance of China

Service Trade Balance of China

Cross-border Factor Income and Expense of China

International Transfer of China

Capital Account of China

Capital Account of China

Cross-border Direct Investment of China

Cross-border Portfolio Investment of China

Financialization of China