Should the Exchange Rate or Interest Rates Be the Priority?

Since China's entry into the World Trade Organization and its gradual move towards capital convertibility,the link between the nation's exchange rate and domestic interest rates has become increasingly important. More than a decade ago,Professor Song Guoqing from Peking University asserted that the exchange rate was the key issue because it impeded the effectiveness of monetary policy. It suggested that the distortions of the exchange rate distorted interest rates. The assertion reflects the policy choices under the framework of the so-called "impossible trinity" - namely independent monetary policy,the free flow of capital and a fixed exchange rate. China opened the current account in 1996 and in recent years there has been a gradual move toward greater capital account convertibility. It is becoming more and more difficult to control cross-border capital flows. In theory,a country finds it difficult to manage flexibility in the exchange rate and maintain an independent monetary policy. Therefore,a question that remains to be answered is whether the exchange rate should be the focus or interest rates? What have China's authorities said about these policy choices in more recent years and what are the pros and cons of their approaches? Most importantly,what conclusions can we draw from the debate?

It is not difficult to see that 2014 was the point when there was a shift from heavy capital inflows to heavy outflows.

There were relatively strong expectations of renminbi appreciation between 2003 and 2013 with a relatively heavy upward pressure on the currency from capital inflows. From 2014 on,however,there have been relatively strong expectations of renminbi depreciation and pressure from capital outflows.

Pressure from Capital Inflows

China's economy maintained rapid growth,with relatively low benchmark interest rates from 2003 to 2013. From 1990 to 2002,China's average GDP growth was 9.68%,while the annual interest rate on loans of six months to one year was 8.53%. From 2003 to 2013,China's GDP growth averaged 10.30% a year,but the average annual interest rate on six-month to one-year loans was just 4.66 %. The question is why were interest rates so low during a period of fast economic growth? One possible answer would be that the exchange rate was a major factor.

Heavy capital inflows during this period posed great challenges to the People's Bank of China. In the China Monetary Policy Implementation Report issued by the People's Bank of China in the fourth quarter in 2005,the central bank said that the effectiveness and flexibility of monetary policy were facing challenges from a growing imbalance in the nation's international payments. Similarly,the report of the first quarter in 2007 stated that the continuing surplus in international payments forced the central bank to make foreign exchange purchases,which in turn reduced the effectiveness of monetary policy due to an expansion of the money supply. In fact,short term interest rates and short-term capital inflows showed a positive correlation from 2003 to 2013. To curb the excess inflows of capital and ease the strong expectations of renminbi appreciation,China had to sacrifice some of its monetary policy flexibility. This meant it could curb capital inflows and expectations of currency appreciation,but at the cost of rising domestic prices,particularly asset prices.

The Period of Capital Outflows

Since the credit crunch of 2013,interest rates on the domestic interbank market have become more and more important with a gradual promoting of market-based rates. More recently,the market has paid special attention to the seven-