The financial turbulence that gripped China and the rest of the world in the past few weeks has blown over for now. Last weekend, with the renminbi stable again, Zhou Xiaochuan, China’s central bank governor, broke a lengthy silence to insist that there was no basis for devaluation, that the country’s reserves were adequate, and that China had no need for tighter capital controls. These assurances have worked for the time being but the causes of China’s large capital outflows could manifest themselves at any time. China has come up against a problem known as the “impossible trinity”. Resolving it, either by means of a devaluation of the renminbi or tighter capital controls, will have far-reaching consequences.
The impossible trinity, framed originally by the economist Robert Mundell in the late 1960s, is about the pursuit of incompatible objectives. Simply, it is impossible to simultaneously pursue more than two of an independent monetary policy, a fixed exchange rate and free capital movements. China has a fixed but adjustable exchange rate, wants monetary autonomy, and has pledged to liberalise capital transactions. Something has to give, especially in view of the government’s passive attention to rapid credit creation, which surged again in January.
The point at which China has to choose its renminbi and capital regime trade-off is approaching fast. If China persists with capital liberalisation, it would have to allow the currency to fall sharply or float freely. A small devaluation would barely offset Chinese wage gains, while encouraging expectations of further depreciation. A shock devaluation of, say, 40 per cent or more, would be politically dangerous and run against the grain of economic rebalancing.