Portfolio | Why China’s currency is key to resolving its economic policy “trilemma”

Beijing’s move to scrap the loan-deposit ratio lending cap on banks may be the clearest sign yet of how hard it is becoming for the government to ease monetary conditions given conflicting economic policy priorities.

The government is trying to manage what economists call the “impossible trinity” – capital account opening, exchange rate stability and monetary policy autonomy.

Alex Wolf, emerging market economist at fund manager Standard Life Investments describes it more colourfully as “the Chinese Trilemma”.

Equity investors had widely anticipated a move to ease monetary policy in the wake of last week’s sharp stock market sell-off.

The problem for Beijing is whether it should cut interest rates to calm jittery financial markets just as the Fed is getting ready to hike and thus pile the pressure on a currency pair that the People’s Bank of China (PBOC) and the State Administration of Foreign Exchange (SAFE) have fought hard to keep stable and virtually flat year to date?

And does it do so at the same time as it is accelerating the easing of restrictions on cross-border capital flows to deliver on its long-held promise to further open its capital account?

“The threat is that volatile capital flows will impact domestic rates and complicate the PBOC’s efforts to ease, forcing the central bank to eventually abandon either the stable exchange rate policy or capital account reforms,” Wolf wrote in a new note to clients.