The open-economy trilemma in China: Monetary and exchange-rate policy interaction under financial repression

Abstract

This paper models China's monetary-cum-exchange rate policy, in which sterilization measures insulate base money from the full effects of capital inflow while the accumulation of net foreign assets (NFAs) limits exchange-rate appreciation. I find that the negative-risk premium in the interest rate-which compensates NFA holders for exchange-rate risk with a higher relative rate of return on their NFAs-plays a pivotal role in influencing the magnitude of sterilization and in inducing endogenous change in the exchange rate. I show that a feedback loop between the exchange rate and capital inflow exists in the form of a multiplier mechanism that jeopardizes both monetary autonomy and exchange-rate stability. The findings testify to the open-economy trilemma challenging the effectiveness and sustainability of China's monetary-cum-exchange rate policy and point to a flexible exchange rate as a solution that can enhance monetary sovereignty, reduce financial repression and improve economic efficiency.