China’s fight against economic gravity

Foreign reserves in China have been falling since mid-2014, as capital has been flowing out of China in excess of net revenues from the current account surplus.

The loss of reserves was driven by lower economic growth and – as a response – the easing of monetary policy by the People’s Bank of China. If foreign reserves continue to fall, China’s immediate response is likely to be a tightening of capital controls.

However, history shows that capital controls are a blunt instrument in a developed economy. Given the state of development of China’s economy, the government will eventually have to let the exchange rate adjust.

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