PBOC market intervention: it’s really muddle on steroids

Beijing defies Milton Friedman’s explanation of how foreign exchange controls should work

PUBLISHED : Saturday, 20 February, 2016, 10:29pm
UPDATED : Saturday, 20 February, 2016, 11:15pm

The mainland’s central bank will conduct open market operations every working day, it said in a statement posted on its website.

Business, Feb. 19


Years ago I had the good fortune to be invited to a lecture here by the famous American economist, Milton Friedman.

His stature is no longer as great as it once was. His association with Chilean dictator Augusto Pinochet tarred his image and his ideas on targeting monetary aggregates to control inflation have been found more difficult in practice than in theory.

But then he never really stood tall. He was short of stature and the chair they gave him on the stage at the Academy for Performing Arts was so high that his feet barely touched the floor.

As I recall, he did not say much in the way of a speech but rather took questions and, of the sprightly answers, one about foreign exchange controls particularly sticks in my mind.

Friedman hopped off his chair, walked to a whiteboard, drew a triangle and marked its three points as I have done in the chart.

He then turned back to us and said (I still have it almost word for word), “Here’s how it works. You can have any two points of this triangle but you can’t have all three.

“If you want to fix your currency’s exchange rate and open your borders to capital flows then you have to let your domestic interest rates be determined by the market.

“If, on the other hand, you want to control interest rates and still open your borders to capital flows then you have to let your exchange rate be determined by the market.

“If you want to control both your exchange rate and your interest rates then you have to close your borders to capital flows.

“But when you demand all three points of this triangle you turn up the heat under a pressure cooker and you will get a financial crisis.”

Then Friedman walked back to his chair, hopped on it again and looked round for follow-up questions. There were none. It was perfectly clear.

His first scenario, fixed exchange rates and open borders, is us in Hong Kong with our linked exchange rate to the US dollar. We fulfil the requirement. We leave our interest rates to be determined by the market.

His second scenario, controlled interest rates and open borders, is the United States and there again the requirement is met. The US dollar’s exchange rate is determined by the market.

His third scenario, control of both the exchange rate and interest rates is North Korea and it works. North Korea keeps its borders closed to capital flows.

But now here is the big question. Where does China fit in this scheme?

I think the answer has to be that it’s a bit of a muddle at the moment. What passes for policy actually seems to consist of desperate lunges from one point to another of the triangle with attempts to take as much of all three as possible.

The exchange rate is fixed but then again it’s not and the authorities will be diligent in providing firm guidance and blah, blah, blah.

Likewise, interest rates are controlled but then again they are not and the authorities will take measures against illegal activities and blah, blah, blah.

As to closed or open borders, well, we in Hong Kong wash mainland capital flows whiter than white. Let’s hope they continue to flow. But don’t look too closely.

And now the People’s Bank of China has announced that it will intervene in the market every day. This is called a muddle on steroids.