RENMINBI CONTROVERSIES the full cost of sterilization is higher than meets the eye. It should include any subsequent capital loss on Chinas reserves if the RMB later appreciates strongly relative to reserve currencies, as well as any (shadow)costs imposed on the banking system by inducing state owned banks to hold government bonds at less than an arms-length rate of return. If reserve accumulation and the scale of sterilization operations increase in the future, these costs will only become larger The contention that an undervalued RMB makes it possible for China to attract large amounts of incoming foreign direct investment (FDI)and that such large FDI inflows, in turn, permit Chinese firms to circumvent the weaknesses of the domestic banking system is equally fallacious. As pointed out in Goldstein and Lardy(2005b), FDI has financed less than 10 percent of Chinas total investment in recent years-far too small a figure to obviate the need for serious bank reform Turning from the level of the exchange rate to the currency regime, the"fixed"nature of China's regime has likewise increasingly become the enemy--not the ally--of domestic financial stability. As illus trated in Figure 1, long-term stability of the RMB against the U. S dollar has not translated into stability in Chinas real effective ex- change rate(since the dollar has moved markedly against the curren cies of China's other trading partners)-and it is the real effective exchange rate that matters most for Chinas trade and competitive ness. Just as important, the rigid link of the RMB to the dollar has meant that China has had much less monetary policy independence than would be desirable--its controls on capital flows notwithstand ing. For example, while it made good sense for the U.S. Federal Reserve to be reducing short-term policy interest rates in 2003 to deal with conditions in the U.S. economy, the overheating of the Chine economy during that period called for the opposite stance of mor etary policy. Yet the Chinese authorities may well have been discour aged from making timely upward adjustments in interest rates by the their problems with large capital inflows. Such constraints on the ate worry that, given the rigid link to the dollar, this would exacerbate of monetary policy related to the currency regime continue. For example, the People's Bank of China(PBC)allowed (in the latter part of 2005 ) base money to grow more rapidly than would otherwise be called for on domestic stabilization grounds--perhaps out of concern that lower levels of liquidity and higher short-term interest rates would, in concert with the July 21 currency reform, stoke higher capital inflows. Taking a longer-term perspective, while the Chinese economy has continued to deliver impressive average growth performance over thethe full cost of sterilization is higher than meets the eye. It should include any subsequent capital loss on China’s reserves if the RMB later appreciates strongly relative to reserve currencies, as well as any (shadow) costs imposed on the banking system by inducing state￾owned banks to hold government bonds at less than an arms-length rate of return. If reserve accumulation and the scale of sterilization operations increase in the future, these costs will only become larger. The contention that an undervalued RMB makes it possible for China to attract large amounts of incoming foreign direct investment (FDI) and that such large FDI inflows, in turn, permit Chinese firms to circumvent the weaknesses of the domestic banking system is equally fallacious. As pointed out in Goldstein and Lardy (2005b), FDI has financed less than 10 percent of China’s total investment in recent years—far too small a figure to obviate the need for serious bank reform. Turning from the level of the exchange rate to the currency regime, the “fixed” nature of China’s regime has likewise increasingly become the enemy—not the ally—of domestic financial stability. As illus￾trated in Figure 1, long-term stability of the RMB against the U.S. dollar has not translated into stability in China’s real effective ex￾change rate (since the dollar has moved markedly against the curren￾cies of China’s other trading partners)—and it is the real effective exchange rate that matters most for China’s trade and competitive￾ness. Just as important, the rigid link of the RMB to the dollar has meant that China has had much less monetary policy independence than would be desirable—its controls on capital flows notwithstand￾ing. For example, while it made good sense for the U.S. Federal Reserve to be reducing short-term policy interest rates in 2003 to deal with conditions in the U.S. economy, the overheating of the Chinese economy during that period called for the opposite stance of mon￾etary policy. Yet the Chinese authorities may well have been discour￾aged from making timely upward adjustments in interest rates by the worry that, given the rigid link to the dollar, this would exacerbate their problems with large capital inflows. Such constraints on the use of monetary policy related to the currency regime continue. For example, the People’s Bank of China (PBC) allowed (in the latter part of 2005) base money to grow more rapidly than would otherwise be called for on domestic stabilization grounds—perhaps out of concern that lower levels of liquidity and higher short-term interest rates would, in concert with the July 21 currency reform, stoke higher capital inflows. Taking a longer-term perspective, while the Chinese economy has continued to deliver impressive average growth performance over the RENMINBI CONTROVERSIES 261