China’s Tetralemma

Many countries have three policy objectives: (1) being able to set their own monetary policy, in order to keep their own inflation and unemployment at desired levels; (2) having a stable exchange rate, in order to avoid disruptive shifts in exports or imports; and (3) allowing free capital flows, in order to help the country’s citizens and firms find the most efficient sources and uses of capital. But the famous policy trilemma of international economics claims that any country is going to be forced to give up on one of those three goals.

Source: Aizenman and Ito (2013).

Exchange rate stability has always been a key priority for China. The policy objective they gave up to achieve this was the right leg of the above triangle. China’s current capital controls include limits on the ability of Chinese residents to convert yuan into foreign currency and restrictions on cross-border financial transactions.

But within that bottom leg of the triangle there is itself a separate dilemma– with which currency does China seek a stable exchange rate? If the ultimate policy objective is stable exports, the answer would be stability with respect to the currencies of China’s major trading partners. But over the last few years, the euro has plunged against the dollar. The U.S. and Europe pursued very different monetary policies, with Europe pushing deeper into negative interest rates even as the U.S. began another cycle of rate hikes.

Number of U.S. dollars needed to buy one euro, normalized at 100 for March 5, 2012, daily from March 5, 2012 to April 7, 2017. Data source: FRED.

On the other hand, China’s yuan stayed with the dollar through most of 2015.

Number of U.S. dollars needed to buy one euro and number of U.S. dollars needed to buy one yuan, both normalized at 100 for March 5, 2012, daily from March 5, 2012 to April 7, 2017. Data source: FRED.