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Senior officials of China’s central bank, the People’s Bank of China (PBOC), have left a trail of curious statements over the past month that appears to tell an interesting tale.

The story starts with an interview PBOC Governor Zhou Xiaochaun gave at the G20 meeting in Paris on February 18, in which he said China would use all mechanisms at its disposal, including bank reserve requirements, interest rates, and the exchange rate, to combat inflation:

Zhou Xiaochuan, the nation’s central bank governor, said reserve requirements are just one tool to curb price gains in the fastest-growing major economy.

"We can’t really say that it’s the only method that we’ll use to battle inflation, it’s about using all means including rates and currency," he said in a Feb. 18 interview. "One method doesn’t exclude the other," said Zhou, who was attending a Group of 20 nations summit in Paris.

Another source, the Oriental Morning Post, quoted him as saying "RRR is not the only tool. We will use all, including interest rate and exchange rate."

Ironically, that next Monday, the official People’s Daily covered Zhou’s G20 appearance under the headline "Yuan reform pace remains unchanged" and had him pledging to keep the exchange rate for the RMB stable — not exactly surprising that he would at least nod in this direction, since such comments have become such a staple from Chinese officials these days it’s virtually the reflexive equivalent of a Catholic genuflecting in church. But his other comments did seem to tie China’s currency peg to its inflation problem in a way I had never heard from a senior PBOC official, at least in public.

The next chapter in this story was reported on February 26 by the Wall Street Journal, referring to a university lecture given by Yi Gang, the PBOC’s deputy governor and head of managing its foreign-exchange reserves:

China’s large external imbalances, combined with its interventions in the foreign -exchange market, are the "root cause" of the country’s current inflation problem, Yi Gang, vice governor of the People’s Bank of China, said Saturday.

China should increase the flexibility of the yuan exchange rate and undertake a number of internal structural changes to reduce its trade surplus, Mr. Yi said, adding that China’s focus should be on boosting imports rather than suppressing exports.

Yi went on to make the connection between the exchange rate peg and inflation even clearer:

"Why do we have so much base money? Why is the money supply relatively loose? A major reason is that our surpluses are too large," Mr. Yi said. "To maintain the basic stability of the yuan exchange rate, the central bank buys up foreign exchange inflows. If it didn’t, the yuan wouldn’t be so stable."

"We have been undertaking sterilization efforts to lock up excessive liquidity and maintain price stability," Mr. Yi said. "But all these actions have costs. We have to take into account the marginal costs and benefits if this state of affairs persists."

I would only note that this is the heart of the argument I have been making repeatedly for some time now (you can watch me make it here), that the purchase of FX reserves, and issuance of RMB in exchange, accounts for the excess liquidity in the Chinese financial system, that this pool of available liquidity is what enabled the massive lending boom and monetary expansion China pursued in the wake of the global financial crisis.

Then came the National People’s Congress (NPC). The same day that Premier Wen Jiabao opened the NPC, on March 5, pledging to rein in inflation while maintaining 8% GDP growth for the year, Bloomberg filed this curious report:

The yuan’s exchange rate is the closest to "equilibrium" as it has ever been, Chinese central bank deputy governor Yi Gang said.

Bolstering domestic consumption, restructuring the economy and reducing surpluses will help the currency reach equilibrium, Yi, who is also head of the State Administration of Foreign Exchange, said at the opening of the annual session of the National People’s Congress in Beijing today. The "yuan exchange rate has never been closer to equilibrium," Yi said.

Strange, I thought, coming from the same official who, just a week earlier, had pretty explicitly attributed China’s inflation problem to the aggressive central bank intervention required to keep the RMB below market value. If the yuan were at equilibrium, why would the PBOC be buying and accumulating forex reserves?

The next day, I was on a special show on CCTV News devoted to covering the NPC. I was somewhat surprised when, earlier in the show, I overheard an interview with my Tsinghua colleague Li Daokui, who serves as an advisor and effectively a backdoor spokesman for the PBOC, in which he stated that the rapid expansion of China’s money supply is not a particularly important factor in explaining the rise of either wages or consumer prices. Obviously I disagree, and without calling him out by name argued vigorously to the contrary later in the program. If you watch the show, you can definitely tell that I’m the guy who either didn’t get the memo or didn’t read it, because my entire line of thinking was wholly at odds with what was evidently the approved message of the evening.

Then last Friday, March 11, PBOC Governor Zhou offered this striking revision of his February 18th comments, as reported by the Wall Street Journal:

China’s central bank governor emphasized the importance of interest rates in fighting inflation, fueling expectations for further tightening after the government said that consumer prices continued to rise at a rapid pace last month.

People’s Bank of China Governor Zhou Xiaochuan also played down the role of the Chinese currency’s exchange rate in curbing rising prices, saying at a news conference Friday that the government’s anti-inflation efforts "don’t particularly emphasize the exchange-rate tool." His comments echo other recent remarks from Chinese officials that appear aimed in part at parrying U.S. calls for Beijing to tame prices by letting the yuan strengthen more quickly.

In case there’s any room for misinterpretation, it’s worth reading the Reuters account as well:

The yuan plays only a secondary role among China’s options to temper inflation, and monetary policy alone won’t be enough to rein in prices, central bank governor Zhou Xiaochuan said on Friday.

The People’s Bank of China will use a mix of banks’ required reserves and interest rates as well as open market operations to mop up excessive cash, Zhou told a news conference during the annual parliament session.

"China’s economy is very large and so is its population. So we can say that changes in the exchange rate will have some impact on domestic prices, but the impact will not be that big compared with that in smaller, open economies," Zhou said.

"Against that backdrop, the main policy tool used to manage inflation is not the exchange rate," he added.

Outside economists have long said that faster yuan appreciation would help China blunt imported inflation stemming from soaring commodity prices, but Zhou’s comments made clear that the central bank does not quite see it that way.

That’s a particularly interesting interpretation, since blunting the impact of higher commodity prices was not really the reason being given for how RMB appreciation could defuse inflation. In fact, it confuses cause and effect. As Yi Gang so effectively pointed out, maintaining the currency peg fuels inflation directly by forcing the PBOC to issue more money, which it can only counter for so long and at significant cost. Inflated Chinese demand caused by the expansion of China’s money supply is what’s boosting many global commodity prices, not the other way around.

Nevertheless, at his closing NPC news conference Sunday, Premier Wen confirmed that Zhou’s latest comments reflected official policy:

China’s premier on Monday ruled out allowing a faster rise in the value of its tightly controlled currency to fight surging inflation, citing the danger of possible job losses and the impact on Chinese businesses … Wen echoed China’s central bank governor, Zhou Xiaochuan, who said Friday that Beijing would not use currency policy to fight inflation. Zhou said the government has more effective tools to control prices.

I realize that economists are famous (infamous) for saying "on the one hand this, on the other hand that," and that central bankers are often self-consciously cryptic. But it seems to me that the contradictions not only in the content but direction of these statements cannot simply be explained away, and that a real reversal took place.

In my experience, when Chinese officials publicly stake out a somewhat controversial position, then suddenly change their tune, it’s usually a sign that they have fought and lost a very high-level policy battle, and have been instructed to get back with the program. My guess is that the PBOC came into the NPC (not the NPC itself, I should clarify, but all the senior party meetings surrounding it) pushing for permission to use RMB appreciation as a tightening tool — and got shot down, because of the feared impact on growth. The PBOC’s fall-back policy — at least for now — will be to contain (through sterilization) rather than resolve (through currency appreciation) the underlying cause of inflation (excessive liquidity due to forex purchases). Forced to continue supporting the peg, that’s the best it can do.

Even that, however, is a step in the right direction, compared to the unrestrained monetary expansion of the past two years. Figures released yesterday indicate that China’s money growth slowed in February, to 15.7% year-on-year — still well above real GDP growth, but down from its previous rate of nearly 20%. Ultimately, though, freezing up more and more money into bank reserves in order to counter all the new money being injected by forex purchases is an endless and costly game of catch-up. Zhou hinted as much in his comments Friday:

As for banks’ reserve requirements, Zhou said the central bank had been forced to use the policy tool to mop up liquidity due to the rapid expansion of base money in the economy.

"If base money normalizes and comes under control, we will not need to rely more on banks’ reserve requirements to adjust liquidity," he said.

And how would base money "normalize?" Possibly by reining in credit demand with drastic interest rate hikes. But more probably by letting the RMB appreciate to a true equilibrium that eliminates the need for inflationary PBOC intervention.

Source: Reading the People's Bank of China Tea Leaves