Effectiveness of Chinese Monetary Policy. Greg Madonia November, 2006

Transcription

1 Effectiveness of Chinese Monetary Policy Greg Madonia November, 2006

2 Table of Contents 1.1 Statement of the Issue Suggested Change for Chinese Monetary Policy Market Economies and Monetary Policy Open Market Operations Reasons for Ineffectiveness of Open Market Operations in China Excess Reserves Issue Paths to Independence Control of Bank Reserves Willingness to Use Bank Reserves Foreign Exchange Problem of Removal from Fixed Foreign Exchange Rate Conclusion...6 References 7

3 Effectiveness of Chinese Monetary Policy 1.1 Statement of the Issue Currently, the Peoples Republic of China (PRC) is the third largest economy in the world, behind only the United States and the European Union. The PRC is in the process of moving to a market based economy, as opposed to the centrally planned economy that it has been traditionally. Part of the incentive for this move to a market based economy is the PRC s commitment to the World Trade Organization (WTO). In a market economy, the central bank typically has a significant role in the economic growth that a country experiences. However, in the PRC, the central bank has proved to be inefficient in providing a significant role in the economy. The cause for the PRC s central bank s diminished role is due to state control of the bank, which limits the central bank s independence. Currently, the Peoples Bank of China (PBC) is the central bank and four state-owned commercial banks (SCBs) are the commercial branches of the government. This paper will examine how state control has negatively affected the power of the central bank. If followed, the corrective actions suggested in this paper will lead to an independent, and more effective, central bank in China. 1.2 Suggested Change for Chinese Monetary Policy This paper suggests, that as the PRC moves towards a more market based economy, that the central bank of the PRC should gain more independence from the state. Without central bank independence, monetary policy is not as effective as its potential. Currently, the PRC has mainly used its central bank to fund state-owned enterprises and control the foreign exchange rate. The central bank must be liberated from these duties, so that they may use control of the money supply to promote economic growth. The opportunity cost of the PRC s goals is the effectiveness of monetary policy enjoyed by more independent central banks around the world. 1.3 Market Economies and Monetary Policy Monetary policy, the management of money supply and interest rates, usually has five goals. These goals are high employment rates, economic growth, stability in financial markets, interest-rate stability and stability in foreign exchange markets. The difficulty with monetary policy is that central bankers do not possess the ability to directly control all of the money supply.

4 Central banks indirectly control money supply using three tactics. The monetary policy tactics that a central bank posses are: open market operations (OMOs), variance of the rates at which banks can borrow funds from the central bank and required reserves at the central bank. 2.1 Open Market Operations Open market operations are the buying and selling of securities by the central bank. In a market economy, OMOs are typically the most effective tool that a central bank has. In the PRC, OMOs have been unable to provide the effectiveness that they provide in market economies, such as the United States. This paper will examine why OMOs in the PRC are not as effective as they are in market economies. Currently the PRC uses the bond market as its means of open market operations. When the central bank purchases bonds from an agent in the economy, it increases the monetary base and therefore shifts the money supply curve to the right. This rightward shift in the money supply curve means that the new equilibrium interest rate will be lower than before. To contract the money supply, and therefore raise the equilibrium interest rate, the central bank will sell bonds to agents in the economy. 2.2 Reasons for Ineffectiveness of Open Market Operations in China The reasons that open market operations have limited effectiveness include: commercial bank insensitivity to the central bank s discount rate (the rate at which the central bank loans to other banks), lack of ability to assess risk of loaning funds and consumer insensitivity to the price of money. Due to commercial banks high levels of excess reserves, the discount rate issued by the central bank has little to no effect on commercial banks. Commercial banks in the PRC, at the end of the first quarter in 2005, held 4.25% of all assets in excess reserves. Commercial banks in the U.S., on the other hand, held between 1 to 2% of all assets in excess reserves. One of the reasons that PRC banks hold so much in excess reserves is that they are able to earn interest on reserves held by the central bank. In the U.S. reserves held at the Fed earn no interest. Therefore, the opportunity cost of holding reserves in the PRC is much less than holding excess reserves in the U.S. This buffer caused by large excess reserves in the PRC, makes money markets (and their respective rates) ineffective. Secondly, because of commercial banks inability to assess risks, OMOs have no power to transfer the changes in costs of the money market to consumers. Although banks in the PRC are gaining the ability to assess risk and therefore manage it, it will take time to learn how to use this information. During this transition period, OMOs will still be limited in their effectiveness. Finally, the lack of power for OMOs is attributed to agents in the economy being insensitive to the price of money. Like the area of risk assessment, this is situation that

5 has been improving in the PRC. Previously, state-owned enterprises (SOEs) were the only entities that had access loans in the PRC. In addition to them being the only ones with access to loans, SOEs did not have to repay these loans. Obviously in this situation, OMOs had no effectiveness because of the complete insensitivity to the price of money Excess Reserve Issues Because the relatively high rate of excess reserves in the PRC is detrimental to the effectiveness of OMOs, it is of some importance to look at why excess reserves remain such a large part of total assets held by banks. As mentioned previously, the lack of incentives to not hold excess reserves is one of the main issues. As long as interest is being paid on reserves held by the central bank, commercial banks have little incentive to invest their excessive reserves into riskier ventures (i.e. loans). Another reason why excessive reserves make up such a large portion of a commercial bank s assets is the lack of alternative investment possibilities. Currently, the PRC has a small bond market. Therefore, commercial banks have fewer opportunities for investment. Excess reserves in commercial banks also remain high due to seasonal demands. During the Chinese New Year, many firms and households give out cash gifts. To prepare for this increase in the demand for money, commercial banks held onto reserves instead of making additional loans. 3.1 Paths to Independence Currently in the PRC, four state commercial banks (SCBs) account for more than half of the total assets in the Chinese banking system 3. According to the Dallas Federal Reserve, private estimates have deduced that impaired loans make up 50% of bank assets. Additionally, the ratio of nonperforming loans to total loans of the SCBs is 15%. Obviously, this is an indicator that the SCBs are not performing optimally. This is especially apparent considering that foreign banks in the PRC have a ratio of 1.3% of nonperforming loans to total loans 3. China s SCBs need to gain independence from the state so that the central bank s monetary policies gain effectiveness. Because of state control and state interests the central bank in China is unable to be as effective in controlling the money supply as needs be. Without independence from the government, SCBs cannot use monetary policy to effectiveness levels that are possible. 3.2 Control of Bank Reserves

6 The problems created by excess reserves may be solved through the central bank having the ability to fully control commercial bank reserves. This control of excess reserves allows the central bank to manipulate the amount of the reserves found at commercial banks. When the central bank determines that the demand in the economy is excessive, a central bank would want to decrease the amount of excess reserves held by commercial banks. By decreasing the excess reserves held by any given bank, this will increase the interest rate for the economy. When the economy is experiencing lower than desired demand, the central bank s ability to increase excess reserves, and therefore lower interest-rates, becomes necessary. Without complete control of aggregate reserves in the economy, the central bank becomes less effective. In the PRC complete control has been conceded by the state. The government of the PRC, uses the central bank to achieve goals other than effective monetary policy. In particular, the forced funding of state-owned enterprises (SOEs) by the central bank has led to some of the inefficiency problems of the central bank. By financing 3.3 Willingness to Use Bank Reserves At the end of 2003, the PRC used foreign-currency-denominated-reserves to bailout two of the SCBs. In doing so it injected $45 billion (denominated in dollars and other currencies) into these banks. This was the third bailout in six years for the PRC s SCBs. Without this recapitalization of the SCBs, the central bank loses its power to control short-term interest rates. This occurs because banks may be unable to handle the wide fluctuations of short-term interest rates without the proper capital. Without the proper capital, banks would be unable to pay depositors the interest rates that the market may require. Another reason for recapitalization is the need to fund regulators. Without proper regulation, moral hazard situations may arise and bank managers may make loans that are not in the best interests of the economy. With properly funded regulators and bank managers, moral hazard problems are less likely to arise. 4.1 Foreign Exchange Until recently, the PRC had maintained a pegged exchange rate to the U.S. dollar at 8.23 yuan (the name of the PRC s currency) per dollar. The PRC has since allowed the yuan to appreciate by 2% and moved to a basket peg of undisclosed currencies. The PRC has maintained tight control on the value of its currency using financial resources. By maintaining a fixed foreign exchange, the state takes away complete control of the central bank over aggregate bank reserves. When a central bank has to maintain a fixed exchange rate, it is forced to purchase foreign assets so that the exchange rate

7 remains at a given value. The PRC maintains its fixed exchange rate to maintain its trade surplus with the U.S.. Since the yuan is undervalued, goods produced in the PRC are relatively cheaper than the same goods produced in the U.S.. Therefore, entities in the U.S. are more likely to purchase cheaper goods that were produced in the PRC. Foreign exchange controls also strip the central bank from control over the interest rate. This occurs because financial resources are dedicated to controlling the exchange rate. This non-control over the interest has two implications: open market operations are less effective and non-market tools, government officials wanting to have a fixed foreign exchange rate, are thus controlling the interest rate. 4.2 Problem of Removal from Fixed Foreign Exchange Rate By removing itself from the basket peg for exchange rate, the PRC s currently undervalued currency will appreciate. The appreciation of the yuan will decrease the trade surplus that the PRC currently has with the U.S. This will occur because the yuan will appreciate relative to the U.S. dollar and Chinese goods will become more expensive to U.S. consumers. Although the appreciation of the yuan relative to the U.S. dollar, and negative effect it will have on the trade surplus that the PRC enjoys with the U.S., is of some concern to the Chinese economy; the benefits gained from the removal of a fixed exchange rate far outweigh any costs incurred. The benefits of central bank control over reserves and better control over the interest rate are key components to effective monetary policy. 5.1 Conclusion Monetary policy is an important tool used by central banks to control certain factors of the economy. The goals of a central bank (high employment, economic growth, stability of financial markets, stability of interest-rates and stability in foreign exchange markets) are met using correct monetary policy. Without effective monetary policy central banks are less likely to have influence over the economy and therefore less likely to achieve their goals. The effectiveness of monetary policy in the PRC is limited due to multiple factors. These factors include: state ownership, state dictation that the central bank control the exchange rate, state dictation that the central bank fund state-owned enterprises that are not financially responsible and the central bank being undercapitalized. Due to the compromising of the central bank s independence, the tools of monetary policy (open market operations, control over the discount rate and control of the excess reserve ratio) are not as effective as they could be. Therefore, it is suggested that the PRC, after recapitalizing the central bank, grant the central bank independence.

8 After these two goals are met, then the central bank can increase the effectiveness of monetary policy and then achieve the goals of monetary policy in a market economy.

9 References 1 DeLong, J. Bradford and Martha L. Olney, Macroeconomics: Second Edition, 2006, New York, McGraw-Hill Irwin 2 Economist staff, A Great Big Banking Gamble, The Economist, October 27 th, Fu, Dong, Foreign Exchange Policy and Banking Reform in China, Southwest Economy: July/August, 2005, Dallas, Federal Reserve Bank of Dallas 4 Goodfriend, Marvin and Eswar Prasad, A Framework for Independent Monetary Policy in China, 2006, IMF Working Paper 06/11 5 Green, Stephen, Making Monetary Policy Work in China: A Report for the Money Market Front Line, 2005, Stanford Center for International Development Working Paper No. 245 Mishkin, Frederic S., The Economics of Money, Banking and Financial Markets: Eighth Edition, 2007, Boston, Pearson Addison-Wesley