china's policy

At City National Rochdale, we believe our intellectual capital is in our domain knowledge and in our understanding of underlying theories and policy initiatives which provide us the ability to filter out noise and to focus on the long-term. The following composition is a rather academic resource to put the current developments in China into perspective.  

We believe the policymakers in China’s Central Bank (PBoC) are currently treading on thin ice amid the emerging markets’ noise and commotion. The Mundell-Fleming (M-F) model is relevant in today’s context especially when we analyze China. The M-F model is fairly complex, but the conclusions of the model are quite simple. Often referred to as the “Impossible Trinity” where independent monetary policy, capital mobility, and exchange rate controls cannot coexist at the same time. The M-F model is represented in the graphic below.

Source: N. Gregory Mankiw, Professor of Economics at Harvard University

Let us apply the model to real world examples: 

Hong Kong: has a pegged exchange rate and free capital mobility. However, the monetary policy is not independent; the authorities do not and cannot control money supply or interest rates.

USA: the Fed controls U.S. monetary policy and the U.S. enjoys free capital flows. However, the Fed does not control the exchange rate and does not manipulate the U.S. dollar.

China: HAD a pegged currency (it is trying to move to a more market-determined exchange rate regime). China had cross-border capital flows (mostly inflows and is further liberalizing flows, now resulting in outflows. The PBoC had and still has tight reign monetary policy controls.

Why is the above construct relevant?  Historically, as countries moved policy regimes from pegged currency to more flexible regimes, amid capital account reforms and capital mobility, there have been instances of significant instability in financial markets (Mexico, Thailand/Southeast Asia, etc.). China had a virtual peg against the U.S. dollar for a decade until July 2005. Thereafter, it was a “dirty peg” for another ten years, until recently as of August 11, 2015 when the PBoC devalued the yuan by 1.9% by moving the USD/CNY reference rate. The PBoC has shifted to a more market-linked exchange rate. While the absolute currency move is not significant, the policy departure from a peg to a dirty float has broader implications. See table below on fiscal and monetary policy.

Source: N. Gregory Mankiw, Professor of Economics at Harvard University

Fiscal versus monetary policy?  China’s wonder years of growth were investment led and propped by fiscal expansion. A move towards a more flexible and market-determined exchange rate would have a very different impact on the potency of China’s fiscal and monetary policy initiatives. Imagine a China where the fiscal planning, GDP growth targets, and provincial infra capex targets, etc. lose significance. It is easier said than done. The M-F doctrine underscores the risks of such a transition and the world is aware of what happened in other markets (“too big to fail” does not count in this context).

Will China make a smooth transition from the right to the left (above table)? Or will China stall the initiative and revert to its time-tested controlled economy model? In my view, China faces a Hobson’s choice. The transition in policy regime is essential, as the current regime is clearly not working (growth faltering with mounting debt). Is a smooth transition feasible? I believe it is possible. China would want to support its domestic economy through monetary expansion (with viable potency as per the M-F model – see table above) . However, that poses a challenge when the debt levels in the economy are already so high.

We will closely watch the upcoming developments and refrain from speculating and predicting near-term outcomes.

For now, gloom and doom prevails in emerging market equities, and we cannot escape that reality.


Anindya Chatterjee

Managing Director, Senior Portfolio Manager

City National Rochdale

Office: (212) 702-3544

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1.  Mundell, Robert A. (1963). "Capital mobility and stabilization policy under fixed and flexible exchange rates". Canadian Journal of Economic and Political Science 29 (4): 475–485. doi:10.2307/139336. Reprinted in Mundell, Robert A. (1968). International Economics. New York: Macmillan.

2.  Fleming, J. Marcus (1962). "Domestic financial policies under fixed and floating exchange rates". IMF Staff Papers 9: 369–379. doi:10.2307/3866091. Reprinted in Cooper, Richard N., ed. (1969). International Finance. New York: Penguin Books.

3.  Dornbusch, R. (1976). "Exchange Rate Expectations and Monetary Policy". Journal of International Economics 6 (3): 231–244. doi:10.1016/0022-1996(76)90001-5.

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