Under these conditions, excessive money supply would ordinarily have created inflation in the face of a fixed nominal exchange rate. However, this was prevented by prioritizing investment over consumption, with rapid capital formation resulting in a huge quantity of under-utilized economic resources in China.

The GFC: An opportunity to run an independent China monetary policy

The Global Financial Crisis resulted in all the major economic blocs running unorthodox monetary policy. This benign back drop presented the PBOC with the opportunity to run an independent China monetary policy – one free from the constraints of foreign reserve accumulation. It was also a necessity as China’s deteriorating economic fundamentals and slower reserve growth (and then falling reserves) meant that, had they stuck to the pre-existing model, the economy would have experienced a monetary deflation which in turn could have presented a challenge to Communist Party rule.

The size of the monetary expansion that China has undertaken post-crisis to keep economic growth alive in the face of deteriorating capital output ratios, together with the fall in reserves, means that the RMB’s dollar backing has fallen back to about 10% from a high of 25% in 2008. This has coincided with China’s efforts to internationalize the RMB and the “going out” philosophy of internationalizing the activities of China’s state-owned enterprises of which the Belt and Road Initiative became a part. The conundrum is that without dollar backing, the tendency for capital flight is increased, requiring more draconian capital controls. Such controls, however, are an obstacle to internationalizing the RMB. So, China needs more US dollars.

China monetary policy initiatives

China has introduced two policies aimed at increasing the dollar inflows and enhancing the utility of the RMB to promote its internationalization: 1) the opening up of Chinese capital markets to foreign investors and 2) the digitalization of the RMB.

Foreign investors currently own about USD500bn or 3% of Chinese financial assets (stocks and bonds). A rise in this ownership level to 10% would produce about USD1.2 trillion of dollar inflows. The rise of passive investing means that benchmark inclusion would help facilitate this aim and so China is keen to influence benchmark providers to include Chinese bonds and shares in global benchmarks. Passive money would follow into Chinese assets in order to track the benchmark.

The digitalization of the RMB is aimed at increasing the utility of the currency particularly for settling trade transactions. The uptake in part will depend on confidence in the currency and the exchange rate which in turn would be enhanced by greater holdings of dollars. Perversely therefore it appears that the next phase in China’s “National Rejuvenation” may require holding considerably more dollars.