Effectiveness of Capital Controls and Sterilizations in China

Since 2003, China has been facing a trilemma of determining how to maintain independent monetary policy and limit exchange rate flexibility simultaneously, while facing persistent and substantial international capital flows. The present paper is an empirical evaluation of the effectiveness of China's sterilizations and capital mobility regulations, measured by sterilization and offset coefficients, respectively, using monthly data between mid-1999 and March 2009. We find that the effectiveness of China's sterilizations is almost perfect in terms of the monetary base, but not in terms of M2, and that China's capital controls still work but are not quite effective. Recursive estimation reveals that increasing mobility of capital flows and decreasing effectiveness of sterilizations might undercut China's ability to maintain monetary autonomy and domestic currency stability simultaneously. To solve the trilemma smoothly, China's monetary authority should continue to relax the management of the exchange rate, and take further steps towards deregulation of capital outflows.