Understanding China’s monetary policy: an institutional perspective

ABSTRACT

Given China’s status as a large transitional economy, analysing the country’s monetary policy requires an understanding of the institutional and policy environment within which monetary policy operates. As China’s monetary policy has multiple objectives and the central bank is subordinate to the State Council in monetary policy decisions, addressing deep-rooted structural issues and improving governance and institutions are essential so that monetary policy can be more focused and effective. Confronted with the Impossible Trinity dilemma, China faces daunting challenges in tackling the inevitable policy choice between monetary autonomy and exchange rate control as its capital account increasingly liberalises. This article analyses China’s unique and evolving monetary policy framework from an institutional perspective and evaluates the challenges to monetary management and reforms. Relevant policy implications for monetary policy implementation are also discussed.

KEYWORDS:

• Monetary policy
• money supply
• monetary autonomy
• credit
• interest rate corridor
• liquidity

Acknowledgements

This paper is dedicated to the memory of Professor John Wong. The author is indebted to him for his mentorship and support in her research.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. Macroeconomic and monetary policy targets as well as the use of monetary policy instruments such as interest rate adjustments and credit targets, are formally decided at the State Council level, with conflicting interests from various ministries and agencies having a large influence on the process. Other stake holders such as local governments and state-owned enterprises often influence macro policy as well through the Party structure.

2. According to Geiger (2006), window guidance can be effective because the PBOC governor ranks above officials in charge of the commercial banks in the Chinese political hierarchy.

3. The PBOC has said it will use differentiated RRR adjustment in 2011 (see UBS, 2011).

4. The PBOC controlled the benchmark deposit and lending rates that commercial banks would pay for deposits and charges on lending. Since 1998, it has gradually liberalised interest rates, starting with interbank rates and finishing with the abolishment of its deposit rates ceiling in October 2015. However, in practice, the PBOC still publishes benchmark deposit and lending rates which to a large extent still guide commercial banks’ pricing behaviour.

5. The Tinbergen rule states that each independent policy target should be delivered by at least one independent policy tool for monetary policy to be effective in achieving the policy goals. If there are fewer tools than targets, then some policy goals will not be achievable.

6. Policy tools such as SLO, SLF and PSL are typically conducted off the market, and due to the lack of signaling effect, sends no policy messages to the market. This suggests that the PBOC is still stuck with an outdated (non-transparent) practice whereby the central bank moves in secrecy to shock the markets in order to maximise the policy impact (Lo, 2015).

7. According to Zhou, if a central bank has multiple objectives, it may be harder to be immune from the political reality. Michel Camdessus Central Banking Lecture (2016).

8. The implementation of monetary policy targets often needs the support of other government agencies; for instance, at times of credit control, local governments’ investment projects need to be brought under control through the National Development and Reform Commission and Party structure, while at times of monetary expansion, such as in 2009, the involvement of local governments plays a key role in ramping up investment.

9. A study by Chang, Liu, and Spiegel (2015) demonstrated empirically that China’s limited capital mobility and pegged exchange rate regime present a trade-off between sterilisation costs and domestic price stability. In the aftermath of the global financial crisis, the fiscal cost of sterilising capital inflows increased; hence, the use of reserve requirements may therefore be understood as a useful alternative tool for the PBOC to alleviate inflation pressures while reducing the pace of sterilisation. The lack of exchange rate flexibility implies that China’s monetary policy faces additional constraints in stabilising inflation and output fluctuations. The inability of the PBOC to employ market-oriented instruments such as interest rates as a primary tool of monetary policy implies that credit growth has to be controlled by blunt and nonmarket-oriented tools, including targets or ceilings for credit growth as well as non-prudential administrative measures, which effectively amount to moral suasion (refer to Eswar, 2007).

10. See UBS (2017).

11. As property prices rose significantly in 2016, the PBOC also used loan-to-value (LTV) and debt-to-income (DTI) assessments to manage credit expansion in the property market. Further, the China Banking Regulatory Commission has tightened supervision since late March 2017 with a slew of measures to examine financial institutions’ shareholding structure, funding source and internal risk management and governance. Rules were also tightened for local government financing, with the Ministry of Finance issuing a directive in early May 2017 restricting local governments from guaranteeing debt issued by local government financing vehicles (LGFVs) and other public–private partnerships. It also prohibits local governments from injecting public assets or land reserves into these financing vehicles, or pledging future land revenue as sources of LGFV debt payment.

12. M1 in Mainland China does not include demand deposits from households. Instead, household demand deposits are included in household saving deposits as part of M2. M2 includes a wider set of deposits such as corporate time deposits, household saving deposits, as well as deposits of non-depository financial institutions, in addition to M1.

13. WMPs are short-term in nature and money is typically kept in demand deposit accounts in-between transfer from maturing WMP products to the next WMP product, further inflating the trend for more money to be kept in demand deposits at every month-end. Hence, the increasing shift of corporate deposits into WMPs has likely also been driving up M1 growth.

14. Other policy initiatives, like the ‘One Belt, One Road’ project to encourage outward direct investment as well as the stock-connect schemes, would also add on to pressures on capital outflows and RMB depreciation. Weaker growth momentum and the government’s ongoing anti-corruption campaign will further trigger capital flight and outflows.

15. From 2006 to 2011, the PBOC raised the RRR several times to ‘freeze’ (or sterilise) most of the base money liquidity that arose due to rising foreign exchange (FX) reserves. This was partly reversed in 2014–2015 when multiple RRR cuts were used to replenish liquidity drained by declining FX reserves.

16. Technological advances improve the efficiency of payments and therefore may reduce money demand, while monetisation of the economy tends to increase it.

17. In the PBOC’s management of base money liquidity, the most important short-term rate is the 7-day repo rate traded by depository financial institutions (backed by rate product collateral). The repo rate also serves as an important guide for China’s average WMP yield, long-term government bond yields and discount rate for banker’s acceptance bill rate. Although over half of China’s outstanding credit comes from bank loans priced off benchmark lending rates, the rest and more variable part of credit is increasingly linked to repo rates.

18. Yu, Zhang, and Zhang (2017) proposed introducing an exchange rate regime that involves pegging to a wide-band currency basket.

19. Refer to People’s Bank of China and IMF Joint Conference, New Issues in Monetary Policy: International Experience and Relevance for China (2014).

20. Measures conducted by other regulatory authorities such as the CBRC can also have an impact similar to monetary easing or tightening. For instance, when the Chinese economy became overheated from the stimulus package after the 2008–2009 Great Financial Crisis, the CBRC used ‘window guidance’ to influence commercial banks’ lending behaviour, indirectly affecting the PBOC’s monetary policy efforts (see Xu, 2017).

21. Since the second half of 2016, the PBOC has tightened liquidity in money markets and pushed up rates to reduce leverage in the bond market. China’s supervisory tightening has also been extended to local government financing; in May 2017, China’s Ministry of Finance issued a directive restricting local governments from guaranteeing debt issued by local government financing vehicles (LGFVs) and other private–public partnerships. It also prohibits local governments from injecting public assets or land reserves into these financing vehicles, or pledging future land revenue as sources of LGFV debt payment.