Hot Money Inflows and Monetary Stability in China: How the People's Bank of China Took up the Challenge

Non-foreign direct investment capital inflows in China were particularly strong in 2003 and 2004. They were even stronger than current account surpluses or net foreign direct investment inflows. As a result, the pace of international reserves accumulation in China increased significantly. This paper investigates if the rapid build up of international reserves in 2003 and 2004 was a source of monetary instability in China. The relationship between international reserves and domestic credit is examined with a Vector Error Correction Model (VECM), estimated on monthly data from March 1995 to December 2005. Empirical results show that this relationship was stable and consistent with monetary stability. Direct and indirect Granger causality tests are implemented to show how the People's Bank of China (PBC) achieved this monetary stability