Karthikeyan Perumal

China has a history of implementing high levels of a monetary policy known as sterilization to manage its increasing foreign exchange reserves and crawling peg exchange rate. How do these policies work and how have they evolved over the years? In the face of new macroeconomic developments, what changes are necessary?

Written by Emily Yan

Edited by Noah Chun

Since 2006, China has remained the world’s largest holder of foreign currency reserves. The sheer amount of foreign reserves China manages cannot be understated. Japan, the world’s second largest foreign reserves holder, holds $1.26 trillion as of October 2024 and Switzerland, the world’s third largest foreign reserves holder, holds $831 billion as of October 2024. These quantities pale in comparison to the $3.26 trillion. China holds as of October 2024 – a foreign currency reserve almost three times larger than Japan’s. However, this substantial number is just the tip of the iceberg. Further exploration reveals the careful implementation of a monetary policy known as sterilization that maintains a stable real exchange rate relative to currencies the renminbi is pegged to and reduces the potential of extreme inflationary pressures on the Chinese economy.

To understand how sterilization works and the need for sterilization, it is crucial to take a step back and first understand the events that led to China’s dramatic increase in foreign reserves. As shown in Figure 1, this development began with gradual increases between 1990 to 2000, and a transition to exponential increases during the early 2000s. The drivers, as identified in a 2010 study by Alice Y. Ouyang, Ramkishen S. Rajan and Thomas D. Willett, include growing trade surpluses and “a surge in portfolio capital flows as well as ‘other investments’ (i.e. short-term debt flows).” This was likely due to the expectation, starting in 2003, for revaluation of the RMB, which was believed by a majority of observers to be undervalued. Combined, the two effects led to rising surpluses in both China’s current and capital accounts. This was exacerbated by a sharp increase in the trade surplus beginning in 2005 and a gradual increase in capital outflow due to loosening restrictions. A critical question of sustainability also arose in July 2005 when China adopted the crawling peg exchange rate system linked to a basket of currencies. In order to prevent rapid appreciation of the RMB, as higher demand for domestic currency would increase the exchange rate relative to other currencies, intervention by China’s central bank, the People’s Bank of China, became necessary. 

Figure 1

Central bank intervention occurs when the PBC purchases excess foreign reserves using RMB. While such an action helps China temporarily maintain a stable exchange rate, cushion shocks to the balance of payments and meet foreign debt obligations, additional foreign reserves in the central bank’s balance sheet increase the monetary base as it leads to a rise in assets, which correspondingly increases reserve money in total liabilities. This puts inflationary pressure on the economy, which can be visualized in Figure 2, which shows the conventional IS-LM-BOP model in general equilibrium (assuming imperfect capital mobility, as is the case in China). Monetary expansion shifts the LM curve to the right, causing a decrease in interest rates which drives business investment. These expansionary pressures force a return to the previous situation of a higher valuation of the domestic currency, or in other words, appreciation. To prevent the formalization of this cycle that threatens the pegged exchange rate, sterilization is enacted by the PBC. Typically, central banks perform sterilization by conducting monetary policy opposite of their initial intervention to offset its effects on the monetary base. In China’s situation, if the PBC first intervenes in the foreign exchange market by purchasing excess foreign reserves with RMB, corresponding sterilization would be implemented using contractionary monetary policy such as open market sales or increasing reserve requirements. This would then reduce net domestic assets in the PBC’s balance sheet and decrease liabilities, thereby curbing monetary expansion.  

Figure 2

The evolution of China’s sterilization policies can be separated into pre-2006 and post-2006. Starting in April 2003, increasing waves of international capital inflow led to sharp rises in the issuance of central bank bills. These high degrees of sterilization measures continued to roll out, with the percentages of outstanding bonds relative to foreign reserves increasing every year until April of 2006, when they peaked at over 40%. This is visualized in Figure 3, which was included in Chenying Zhang’s 2011 study of sterilization effectiveness. However, the feasibility of sustaining sterilization through bond issuances declined in 2006 as interest payments rose with expiring bills. Consequently, China transitioned to raising the reserve requirement ratio in hopes of maintaining previous levels of sterilization. Figure 4 shows that the switch-up to this policy tool led to a massive jump in the reserve requirement ratio from 8.5% in 2006 to 17.0% in 2008. In late 2007 to early 2008, the effects of the severe recession in multiple economies around the world began to trickle into China’s economy and the PBC turned its focus to implementing expansionary monetary policy. Importantly, due to highly restrictive capital controls on Chinese residents investing abroad and foreign banks entering the Chinese market, the impact of the financial crisis was limited, relative to hard-hit economies. UNCTAD, the Bank of International Settlements and the IMF estimated a loss of 2% of pre-crisis GDP between 2007 and 2009 in China.

Figure 3

Figure 4

Following 2007, with economic growth gradually recovering, international capital inflow continued to rise at a large volume, leading to a further rise in the required reserve ratio and the introduction of repurchase agreements as a significant tool to control the money supply and price levels. Also known as repos, repurchase agreements are short-term contracts in which one party would sell securities to another investor and agree to repurchase them at a designated time in the future. By acting as the initial selling party, a central bank can then temporarily decrease the monetary supply. The levels of repos involved rose from 1.2 trillion RMB in repo transactions in 2007 to 3.4 trillion RMB in 2008 and four trillion RMB in 2009. Reverse repos, which is the inverse of repos, are short-term contracts in which the central bank purchases securities from investors and sells them back later on, thereby injecting money into the economy. These were also implemented starting in the second quarter of 2012 to the first quarter of 2013, with the PBC decreasing the required reserve ratio aiming to stimulate the real economy in the face of financial difficulties. This reduction in reserve requirements formally marked a new period of relaxing sterilization policies with the required reserve ratio only falling since 2012, and the quantities of bill issuance and repo transactions also decreasing since then. The increasing gap between the reserve money and reserves of all state-owned commercial banks, along with the fall of bonds issued, visualizes the underlying problem of a growing money supply with stagnating GDP growth. Figure 6, compiled by Shuiqing Yang in “Capital Flows, Sterilization, and Macro-Prudential Policy in China”, shows these two trends which, when combined, can indicate stagflation where there is slow economic growth with high prices and high unemployment.

Figure 5

 Figure 6

This problem became increasingly evident in 2014, when the former trend of appreciation switched to depreciation in the face of a slowdown in economic growth and a fall in interest rates. This turned investor interests towards, as Huichao Gong summarizes in an analysis, a “warmer American economy and the unwinding of Quantitative Easing.” Sterilization degrees dramatically increased in response to sharp depreciations in the RMB throughout 2014 and 2015, until appreciation returned in 2017, leading to the current wave of calmness in sterilization policies. When faced with the evolution of China’s sterilization operations, contemplating its actions is one aspect to consider. However, the greater question one would ask is whether these policies were sufficient and effective at helping the country attain its goals of sustaining a large foreign exchange reserve, maintaining a relatively fixed exchange rate and stably increasing the money supply. The overarching problem facing China’s central bank is the famous Trilemma theory, which states that countries need to select between having a fixed exchange rate, open capital markets or independent monetary policy. A core conflict arises between China’s crawling peg exchange rate and its increasing capital mobility. Balancing the exchange rate requires sterilization measures to decrease the money supply, but with liberalized capital controls, these efforts are partially offset by international capital inflows that come from demand for the increased quantity of financial instruments made available by sterilization.

There has been a range of studies focused on measuring the effectiveness of China’s sterilization operations. Recent papers have concentrated on the effectiveness of specific policy tools, such as Yanzhen Wang, Xiumin Li, Dong Huang and Aihua Wang’s article “Revision of the Effectiveness of China’s Sterilization Policies Considering the Role of the Reserve Requirement Ratio Adjustment.” This article concluded that “China’s sterilization operations are fairly effective and that China has been able to maintain a great deal of domestic monetary independence despite a limited degree of exchange rate flexibility.” Zhang’s paper in 2010 also noted that the PBC’s sterilization measures of bond issuances and open market operations had “no significant impact on current M2,” with percent changes in the consumer price index remaining generally stable when compared to percent changes in net foreign assets, as shown in Figure 7 from her paper. This indicates that the PBC was, in one way, successful at sterilizing capital inflows and controlling the domestic monetary supply – an argument supported by Yang in 2016 who identified that China had focused on sterilizing components of capital inflows with drastic fluctuations. 

Figure 7

However, it is crucial to note that to achieve highly accurate measurements of the effectiveness of China’s sterilization policies, the calculation process would be overwhelmingly convoluted due to the lack of information published on the exact measures taken by the PBC and the constant evolution of these policies. The ushering in of a new era of potential depreciation and net capital outflow will likely contribute to this complexity, as net foreign direct investment flows have been dropping drastically in recent years and China’s accumulation of foreign reserves has been gradually slowing down. This was most significant recently in 2023 when FDI outflows majorly contributed to the offset of China’s current account surplus, as noted by Robin Brooks from the Brookings Institution. Over the past two decades, China has consistently demonstrated interest in diversifying its outward direct investment through yearly FDI in Latin America, substantial increases in investment in South Asian countries – especially in the past six years – and smaller investments in Europe. Investors have also been hesitant on greater involvement in China’s equity markets following its real estate crisis. Beyond capital outflow, whether China’s current account surplus may be facing a downward trend or stagnation is up for debate as the country faces not only increasingly strong tariffs from various developed countries, but also increased trade opportunities with emerging economies.

Figure 8

Figure 9

Added together, what does this mean for China’s future sterilization policies? With uncertainty in capital outflow from domestic investment, FDI interests abroad and decreased foreign demand for RMB, if the concern that the RMB will depreciate exists on a large enough scale, higher degrees of sterilization will be necessary to maintain the country’s exchange rate. However, this would not be a repeat of the 2014 depreciation of the RMB as China faces the additional problem of increasingly stronger deflationary pressures within the country’s domestic economy. Taking this into account, the PBC will need to weigh what new combination of monetary tools it would need to utilize to address both the fluctuations in China’s balance of payments and to pull the domestic economy from its current slump, all while ensuring there is no overwhelming concern of a sharp depreciation in the RMB. As global markets continue to enter into periods of greater uncertainty, it would be necessary for China to quickly readapt its sterilization policies, re-examine the degree of flexibility it wants with its exchange rate and take swift action in rebalancing its domestic economy and markets.