By Chun Chang, Zheng Liu and Mark M. Spiegel
We examine optimal monetary policy under prevailing Chinese policy – including capital controls and nominal exchange rate targets – in a DSGE model calibrated to Chinese and global data. Under the closed capital account, domestic citizens are prohibited from holding foreign assets. Foreign currency revenues are sold to the central bank, which then sterilizes these purchases by issuing domestic debt. Uncovered interest parity conditions do not hold, so sterilization results in transfers between the private sector and the government. Given a negative shock to relative foreign interest rates, similar to that which occurred during the global financial crisis, sterilization costs increase and optimal policy calls for a reduction in sterilization activity, resulting in an easing of monetary policy and an increase in Chinese inflation. We then compare these dynamics to three alternative liberalizations: A partial opening of the capital account, removing the exchange rate peg, or doing both simultaneously. The regime with liberalized capital accounts and floating exchange rate yields the lowest losses to the central bank under the foreign interest rate shock. However, intermediate reforms do less well. In particular, letting the exchange rate float without opening the capital account results in higher losses following the interest rate shock than the benchmark case of no liberalization.
Many have been clamoring for the People’s Bank of China to relax its policies, and this interesting paper looks at how the Chinese economy would react to foreign interest rate shocks under various scenarios. Relaxed policies seem to lead to better outcones, but one has to wonder how costly a transition to these new policies would be. Simulating such exit strategies (there is not much economic history to draw from) would be particularly interesting with this model.