China’s trilemma—and a possible solution | Brookings Institution

Ben Bernanke: The Courage to Act

From Ben Bernanke:

China faces the classic policy trilemma of international economics, that a country cannot simultaneously have more than two of the following three: (1) a fixed exchange rate; (2) independent monetary policy; and (3) free international capital flows. Accordingly, China’s ability to manage its exchange rate may depend, among other factors, on its willingness and ability to adjust on other policy margins.

…..An economy that is growing more slowly, and in which monetary easing is the principal macroeconomic response, is not an economy that offers high returns to domestic savers. Consequently, Chinese households and firms who are able to do so are spurning yuan-denominated investments and looking abroad for higher returns. However, increased private capital outflows also constitute a flight from the yuan toward the dollar and other currencies; that, in turn, puts downward pressure on China’s exchange rate.

In the short run, the PBOC can offset this pressure by selling some of its enormous stocks of dollar-denominated securities and buying yuan; indeed, Chinese reserves have fallen over $700 billion over the past year and a half. With more than $3 trillion in reserves yet remaining, China should be able to defend its exchange rate for some time. If nothing else changes, however, eventually China will run low on reserves and will no longer be willing or able to buy up yuan in the foreign-exchange market. At that point the currency would fall, probably sharply….

The former Fed Chairman’s analysis of possible solutions provides insight into the extent of the problem:

  1. Sharp devaluation would cause global deflation and spark currency wars;
  2. Controls on capital outflows are unlikely to be effective and would discourage investment; and
  3. Fiscal policies aimed at re-balancing the economy and increased welfare payments would need massive scale to have an impact.

It is clear there is a giant panda (rather than an elephant) loose in the lifeboat which is likely to destabilize the global economy over the next decade.

Source: China’s trilemma—and a possible solution | Brookings Institution