Abstract
While much has already been achieved, monetary policy implementation in China is still in transition. The effectiveness of the current framework, which still relies intensively on rules-based measures, is likely to diminish over time as the sophistication of the economy increases. The authorities are faced with the following challenges: (i) the choice of a nominal anchor; (ii) the choice of an operating target; (iii) the choice of operating instruments; and (iv) the right timing to introduce greater flexibility of the exchange rate. This chapter reviews the framework for monetary policy implementation in China by summarizing the practice of monetary policy over the past 30 years and by discussing the way forward.
Opinions in the paper are those of the authors.
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- 1.
See in particular Mehran, Quintyn, Nordman and Laurens (1996).
- 2.
The Third Plenary Session of the 14th Central Committee of the Communist Party of China laid down the goals of establishing a socialist market economy, hence allowing the market to play a decisive role in resource allocation (see Mehran et al., 1996). In December 1993, the State Council indicated that the goal of the monetary policy is to maintain the stability of the value of the currency and thereby promote economic growth, ending a period during which it pursued the dual goals of currency stability and economic development.
- 3.
The growing openness of the Chinese economy and the liberalized current account will make it increasingly difficult to insulate the economy from international financial markets. In particular, leads and lags in trade payments and remittances can be a channel for circumventing capital controls. Ma and McCauley (2005) suggest that capital controls in China have been rather leaky, leading to nonforeign direct investment capital flows in response to relative yields as well as currency expectations.
- 4.
Commercial banks intermediate about ¾ of the capital in the economy (McKinsey Global Institute 2006). For the first three quarters of 2007, bank loans represented more than 80% of the volume of financing, equities 8% and corporate bonds 3% (PBC, Q3 2007 Monetary Policy Report).
- 5.
Evidence that the state-owned banks have substantially changed their behavior and become market oriented is unclear; see Karacadag (2003), Barnett (2004) and Podpiera (2006).
- 6.
McKinsey Global Institute (2006) suggests that China’s investment efficiency has declined: investment needed to produce US$1.00 of GDP increased from US$3.30 in the first half of the 1990s to US$4.90 since 2001 (40% more than required by other Asian emerging market economies).
- 7.
During that period, monetary policy was aimed at achieving the dual goals of currency stability and promoting economic development. In December 1993, the State Council established that the goals of monetary policy were to maintain the stability of the value of the currency and thereby promote economic growth.
- 8.
Autoregressive models show that the sum of the coefficients for AR(1) and AR(2) is about 1, suggesting that the half-life of inflation shocks is about 2–3 quarters.
- 9.
In March 2005, the PBC eliminated the preferential interest rate on housing loans and it raised the down payment on consumer housing loans from 20 to 30% in cities and areas where real estate prices are considered to be rising too fast. In June 2006, banks were allowed to lend only 70% of house value, down from 80%. Regarding stock market prices, the ability of securities houses to get interbank funding is more restrictive than for other financial institutions (see below, section on China’s interbank market).
- 10.
The supply of liquidity resulting from foreign exchange purchases was sterilized in the range of 80–90% over the period 2003–2007. At end 2007, central bank bills amounted to 3.5 trillion yuan, to which is to be added 0.6 trillion of repo operations, compared to a sterilization of liquidity through reserve requirements of about 4.3 trillion yuan (see, PBC, Financial Work of the PBC Since 2003, March 2008).
- 11.
See Monetary Policy Report, People’s Bank of China, 2008 Q1.
- 12.
If reserve requirements are changed frequently and without warning, banks will have s greater incentive to hold excess reserves to use as a buffer and to invent substitutes for deposits that are not subject to this uncertain imposition. Hence, the money multiplier may become less sensitive to variations in reserve requirements, and the link to ultimate targets will be weakened.
- 13.
For instance, the PBC regulation for interbank lending that came into effect as of August 6, 2007 limits to one year the maximum maturity of interbank transactions for commercial banks; 3 months for insurance companies, and seven days for securities companies. Commercial banks can trade up to 8% of their liabilities; and foreign funded banks and securities companies respectively up to twice and 80% of their capital.
- 14.
At the end of March 2006 trading in the OTC market stood around 30 times trading in CFETS.
- 15.
See BIS Triennial Survey on Foreign Exchange Markets, 2007.
- 16.
The primary dealer system is expected to help strengthen the transmission of the central bank’s policy intentions in its foreign exchange operations as well as the effectiveness of those operations.
- 17.
The liberalization of lending rates was not always smooth. In 1987 banks were allowed to charge higher rates on working capital loans up to 20% above the respective ceilings. In May 1996 the margin was reduced to 10% to alleviate financial costs to enterprises. In April 1999, the margin was expanded to 30% for loans to SMEs but remained at 10% for large enterprises (see People’s Bank of China, 2005).
- 18.
Zhou (2005) argues that removing the limits may result in improper market competition.
- 19.
A nominal anchor is a nominal variable that policymakers use to tie down the price level: it helps promote price stability, and limit the time-inconsistency problem of discretionary monetary policy. A credible nominal anchor is important to control inflationary expectations and provide confidence in monetary policy whereby agents can distinguish between movements in relative prices (necessary for consumption and investment decision making) and those associated with the price level.
- 20.
Data corresponds to the International Financial Statistics, various issues. A smooth estimate of the long-term trend component of inflation is obtained by means of a Hodrick-Prescott filter.
- 21.
The limited data set used for the study might have caused significant standard errors urging us to adopt a cautionary tone in presenting the results.
- 22.
A level of excess reserves of more than 10% of required reserves stands particularly high compared, for instance, to the Euro area, where excess reserves amount to less than 1% of required reserves.
- 23.
Arnone et al. (2007) present indices of central bank autonomy for a broad representation of central banks around the world.
- 24.
Article 2 of the PBC law stipulates The People’s Bank of China shall, under the leadership of the State Council, formulate and implement monetary policy. Additional information provided in the PBC website indicates that the PBC needs to report to the State Council its decisions concerning the annual money supply, interest rates, exchange rates and other important issues specified by the State Council for approval before they are put into effect. The PBC is also obliged to submit work report to the Standing Committee of the National People's Congress on the conduct of monetary policy and the performance of the financial industry.
- 25.
See Ferguson (2002) for a discussion on financial stability as an explicit central bank objective.
- 26.
See Appendix 5 for a short review of the ECB experience, and Mishkin (2000) for a review of the experience of selected industrialized countries with monetary targeting.
- 27.
See Goodfriend and Prasad (2006).
- 28.
See Appendix 4 for an evaluation of the relevance of an interest rate as the operating procedure.
- 29.
The exact specification of the target should be such as to avoid strictly committing the PBC to control the short term interest rate very precisely. The PBC could announce that its short-term bills rate (for instance a maximum bid rate) would communicate the stance of monetary policy and explain that it would normally expect short-term interbank rates to remain on average close to this policy rate. Alternatively, it could declare its short-term bills rate to be its operational target, mentioning, however, that this does not mean that this rate cannot fluctuate to some extent around the pre-announced target level.
- 30.
See Laurens (2005) for a discussion on ways to create a structural liquidity shortage.
- 31.
The dotted lines represent 90% confidence intervals. The vertical axis shows the deviation from the baseline level of the target variable in response to a one standard deviation (SD) change to the shock variable, while the horizontal axis presents the number of quarters elapsed after the shock.
- 32.
Reversing the ordering of the variables does not affect qualitatively the results. Hence, ordering the variables for the impulse response functions has little effect and the Cholesky responses are similar to unrestricted ones. We also note that the correlation matrix of the VAR residuals is close to diagonal.
- 33.
The dotted lines in the figures represent 90% confidence intervals. The vertical axis shows the deviation from the baseline level of the target variable in response to a one standard deviation (SD) change to the shock variable, while the horizontal axis presents the number of quarters elapsed after the shock.
- 34.
The ADF tests (not shown here) cannot reject the null hypothesis of the presence of a unit root in all series suggesting the existence of a stochastic trend thus implying that they are stationary in first differences.
- 35.
If the variables involved are not cointegrated, then the differences among them could become larger as time goes by, without a tendency to return to a stable path together.
- 36.
We use the benchmark rate for RMB denominated deposit rate.
- 37.
The level has been normalized to equal 1. Hence the log of the price level is zero (p = 0).
- 38.
See Bruggeman et al. (2005).
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Laurens, B.J., Maino, R. (2009). Monetary Policy Implementation in China: Past, Present, and Prospects. In: Barth, J., Tatom, J., Yago, G. (eds) China’s Emerging Financial Markets. The Milken Institute Series on Financial Innovation and Economic Growth, vol 8. Springer, Boston, MA. https://doi.org/10.1007/978-0-387-93769-4_4
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