Reserve Accumulation and Money Supply in China: A Time-Varying Analysis

Abstract

This study investigates the causal relationship between reserve accumulation and money supply in China over the period of 1999 M1–2015 M6. First, we use a Granger causality test and find that there is a unidirectional relationship from money supply growth to reserve accumulation growth; however, taking structural changes into account, we assess stability of parameters of the estimated vector autoregressive models. We find both the short-run and long-run relationships between money supply growth and reserve accumulation growth estimated using full-sample data are unstable over the sample period. This suggests that full-sample causality tests cannot be relied upon. We turn to propose a time-varying (bootstrap) rolling-window approach to revisit the dynamic causal relationship between the two variables. We find that two variables have causal relationships in some sub-periods. We argue that reserve accumulation growth has put pressure on money supply growth. However, in general, sterilization is effective, but not in few months 2006–2007. And money supply has a positive reserve accumulation from the second half of 2001–2003 because RMB was undervalued under the fixed exchange rate regime. We argue that the improvements of monetary policy and the exchange rate regime are crucial to break the relationship between reserve accumulation growth and the money supply growth.

Key Words:

• Reserve accumulation
• money supply
• rolling window
• structural change

JEL Classification:

• E51
• F39
• E58

Acknowledgements

This research is supported by the National Social Science Foundation [grant number 15BJY155]; Ministry of Education’s Humanities and Social Science Research Project [grant number 14YJA790049]; and the Chinese Fundamental Research Funds for the Central Universities [grant number 201413072].

Notes

1 Capital flows into emerging markets appear to be unstable and volatile (Agosin & Huaita, 2010). They are at least partially driven by global factors, on which emerging markets have no control (Ghosh et al., 2014).

2 Large reserves held by central banks may protect a country from domestic crises, it may also increase the instability of the international financial system and could generate a global crisis originating from the home country (Steiner, 2014).

3 The divergence between the market liquidity originating from the fixed exchange rate regime and the relatively tight monetary policy became increasingly obvious.

4 During 1994–2005, China maintained a combination of a fixed exchange rate regime, an independent monetary policy and capital control. Despite this policy, there were restrictions on the free movement of capital, and capital inflows were non-ignorable. Federal funds rate is significant in explaining international capital inflows (Bouvatier, 2010). The U.S. interest rate decreased in 2001 and remained low until 2005, whereas the Chinese interest rate remained at approximately 2% over this period. In addition, exchange rate expectations are the second most important factor in explaining international capital inflows. The new exchange rate regime that was announced in July 2005 clarified that China's exchange rate would move gradually toward more flexibility. On 21 July 2005, China announced a 2.1% appreciation of the RMB against the dollar and a transition to a managed float with reference to a basket of currencies.

5 The currency appreciated from RMB 8.27 per dollar to RMB 6.15 per dollar in 10 years. The steady strategy of appreciation attracted numerous international capital inflows.

6 Though an interpretation for the selection of 24-month window size has been mentioned earlier, we still implemented different bootstrap rolling-window causality tests using 20-, 30- and 36-month window size and estimated the magnitude of the effect of FER on M2 and that of M2 on FER. The results are proved much similar to those from the causality test based on 24-month window size, which further indicates that the results based on 24-month window size are robust. Specifically, the details of these results are available upon request from the authors.

7 In Figures 2 and 4, the middle curve represents the sum of coefficients, and the lowest curve represents lower bound for coefficients, and the highest one represents the upper bound for coefficients. When the lower bound for coefficients is higher than zero line during the period existing the structural change, the coefficient for this period is positive. While the upper bound for coefficients is lower than zero line during the period existing the structural change, the coefficient for this period is negative.

8 According to the report of State Administration of Foreign Exchange (SAFE), current accounts have exceeded 249.87 billion U.S. dollars and the financial accounts have exceeded 10.04 billion U.S. dollars.

9 According to the data of SAFE, the volume of FDI drop by 4.1% in 2006.

10 In fact, the finding of Granger causality could potentially be evidence of a causal impact of one variable on the other variable. However, it can still be possible that an un-modeled third variable is causing both, but the responses are staggered over time (Schwert, 1979). For example, in our study probably exchange rate cause both foreign reserve and money supply. So we use exchange rate as control variable (Worswick, 1981). We get similar results.