Hot money inflows and monetary stability in China: how the People's Bank of China took up the challenge

Abstract

Non-foreign direct investment capital inflows in China were particularly strong in 2003 and 2004. They have led to a rapid accumulation of international reserves and they may have provided excess liquidity to the Chinese economy. This paper investigates how the central bank of China managed the rapid build-up of international reserves in 2003 and 2004. The relationship between real international reserves and real domestic credit is examined with a Vector Error Correction Model (VECM), estimated on monthly data from January 1997 to March 2006. Empirical results show that this relationship was negative, which suggests that the central bank succeeded in slowing down real domestic credit when real international reserves increased. Direct and indirect Granger causality tests are implemented to show how the People's Bank of China (PBC) proceeded to control domestic credit.