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.
.. 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.[3] 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.
.. Chinese reserves have fallen over $700 billion over the past year and a half. With more than $3 trillion in reserves yet remainin
.. a big yuan devaluation would likely be deflationary for the rest of the world. (Indeed, fairly or not, a devaluing China could face accusations of waging a “currency war,” that is, weakening its currency to “steal” exports and aggregate demand from other countries.)
.. A second possibility for China would be to stop or reverse the process of liberalizing capital flows, making it more difficult for Chinese households and businesses to invest outside the country.
.. It would sacrifice some of the progress that China has made in opening up its financial system—which is itself a prerequisite for achieving China’s goal of making the renminbi an international reserve currency. Moreover, the horse may be out of the proverbial barn, in that the effectiveness of new capital controls in China would be uncertain.
.. the lack of a strong social safety net—the fact that Chinese citizens are mostly on their own when it comes to covering costs of health care, education, and retirement—is an important motivation for China’s extraordinarily high household saving rate.
.. Fiscal policies aimed at increasing income security, such as strengthening the pension system, would help to promote consumer confidence and consumer spending.
.. Unlike monetary easing, which works by lowering domestic interest rates, fiscal policy can support aggregate demand and near-term growth without creating an incentive for capital to flow out of the country. At the same time, killing two birds with one stone, a targeted fiscal approach would also serve the goals of reform and rebalancing the economy in the longer term