The People’s Bank of China (PBOC)’s balance sheet as of June 2009 is as follows

Question

The People’s Bank of China (PBOC)’s balance sheet as of June 2009 is as follows (in trillion yuans):

a) On July 17, 2005 the exchange rate of Chinese yuan left a decade-long fixed peg (RMB/USD = 8.28) to the U.S. dollar. The yuan continued appreciating to the value 6.81 for just three years until July 2008 and then started to vary within a narrow band around 6.83. The pattern of the yuan is classified by the IMF as a de facto crawling peg to dollars although the PBOC calls this “managed floating”. Having a stable exchange rate helps firms and households to make transactions with less uncertainty about the future value of the exchange rate. Other than this argument, what else do you think motivates the PBOC to pursue this strategy?

b) From 2002 to 2009, the PBOC’s foreign assets expanded dramatically from 1.9 trillion yuans to 17.2 trillion yuans (see the table above).

(i)        Briefly explain the cause of this spectacular change during this period on the basis of the above discussion on the yuan’s peg.

(ii)       Consider money demand from the quantity theory. The annual growth rate of nominal GDP is 15.5% during the period. Assume money velocity doesn’t change. What is the annual growth rate of money demand?

(iii)      Suppose the PBOC didn’t sterilize any increase of foreign assets and the corresponding change all went to the monetary base. How much would the monetary base increase? Assume money multipliers are constant over time. What would you expect the annual growth rate of China’s money supply to be during the seven years?

(iv)      Comparing the money demand growth with the hypothetical money supply growth you derived, what can you conclude on the PBOC’s sterilization strategy.

c) What is the common strategy that a central bank uses to sterilize an acquisition of foreign assets? Why is it not feasible for the PBOC to follow this strategy during the period? (Hint: The PBOC uses its domestic assets as collateral to issue some of its short-term liabilities. If you still do not understand what the hint implies, consider the stock of domestic assets, not the change.)

d) Since 2002 the PBOC has been issuing “sterilization” bonds. These bonds are viewed as almost riskless because Chinese government is implicitly behind the PBOC, so the bonds are equivalents of short-term treasury bills or treasury notes. Explain how issuing bonds is a type of sterilized foreign exchange intervention.

Explanation / Answer

ii. Growth rate of GDP will be the same as the growth rate of money if the velocity of money is constant.

iii. Growth multiplied by the initial amount. Annual growth would be 15.5%

iv. Sell off foreign assets.

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