As discussed here a fortnight ago, China ran double surpluses in both the current account and capital account for basically the past 15 years (see …a Refresher on the Lingo for a reminder of what that means). To satisfy the massive demand for local currency arising from these surpluses, China printed yuan (CNY) and used it to buy foreign currency, accumulating an enormous pile of reserves. Now this process is partially running in reverse, with reserves shrinking to meet capital outflows. An important question is whether this reserve depletion is loosening or tightening monetary policy. This is where it gets tricky, as any sort of money printing will directly and dramatically impact onshore monetary policy, and, well, the Wikipedia entry for “Monetary Policy of China” is only 49 words long (!).
During the reserve accumulation phase, increasing the size of the outstanding CNY cash to such an extent in a vacuum would be wildly stimulative and potentially quite inflationary – remember the CNY was printed to satisfy demand for Chinese exports and for local Chinese investments, so the vast majority of the CNY remained onshore in China, potentially in circulation. The Peoples Bank of China (PBOC) undoubtedly had plans for domestic monetary policy, independent of the potentially giant foreign-exchange related increase in the monetary base. So the PBOC, like other central banks in similar situations before them, engaged in at least some sterilization of the CNY. This much we know. , 
To “sterilize” is to actively remove the CNY from circulation once it has been printed to offset the inflationary effect of foreign reserve accumulation, and this can be done in a number of ways. Traditionally, central banks issue bills, effectively borrowing the cash back onto the balance sheet, and paying interest to the bill purchaser, which the PBOC has done. Bill issuance does reduce the monetary base, replacing the CNY currency liability on the PBOC balance sheet with a bill liability. Additionally the Chinese banking system is at least partially constrained by minimum reserve requirements in an old-school fractional reserve system. The PBOC dramatically raised the reserve requirement ratio (RRR) during its foreign currency reserve accumulation phase. This action by itself didn’t reduce the total amount of CNY in existence (the monetary base), but it did cap the total amount of deposits in the system (CNY in circulation), restraining credit growth. Slowing credit creation is an effective tightening move to offset the stimulus of larger CNY reserves. When foreign currency accumulation is so large, the sustainability of sterilization can be called into question. The interest earned on foreign reserves is typically much less than the interest the central bank must pay in order to drain local currency via the various sterilization techniques. The central bank can and would print to pay interest, but this in turn requires further sterilization. As local interest rates rise, capital inflows intensify, which can result in explosive levels of local currency indebtedness.
Just how much of the foreign currency reserve accumulation was de facto sterilized in China’s case is a matter of debate. Serious academic studies have sought to calculate the “sterilization ratio,” meaning the fraction of the reserve inflows which were sterilized, and hence whether or not reserve accumulation itself was a net provider of monetary stimulus to the economy, or not. Results are varied, and surely debatable given the complexity of the calculations. At this point though, the real answer may be moot because the reserve accumulation trend has of course flipped to the other direction.
The PBOC is depleting foreign currency reserves, which necessitates the sterilization process to run in reverse in order to prevent the shrinkage of CNY in circulation (and commensurate tightening of monetary policy). The PBOC has indeed cut the RRR as reserves have declined, but the RRR cuts may not be by themselves a net stimulus as many commentators have suggested. The cuts, together with other reverse-sterilization measures such as bill maturities, buybacks, and asset purchases, have to be of sufficient magnitude to more-than-offset the shrinkage of the monetary base resulting from foreign currency reserve depletion. The good news is that reverse-sterilization shouldn’t have the same sustainability concerns that were so intense during the accumulation phase, at least not for a while. In fact, on some level the ability to deplete reserves and reverse some of the sterilization could be viewed as a positive, insofar as observers were worried on the way in. For now, if monetary policy calls for more CNY in circulation, that ought to be doable, even with the FX headwind. In my view the PBOC will lean toward easier monetary policy in light of their desire to maintain moderate levels of growth, and if reserve depletion persists, this should still be possible to achieve.
The bad news can be summed up in two words: Impossible Trinity. More on this in the next post.