New Features of China s Monetary Policy Jie XU, October 2006 The past decade has seen significant improvement in China s monetary policy (MP, for simplicity). China s central bank (People s Bank of China, PBC) plays more and more important role in macro economy regulation, and policy effectiveness increases steadily. Some new features in MP operation emerge in the past few years, which can be found in more flexible exchange rate regime, deliberate employment of policy instruments, more transparent operations of policy, market agents more sensitive to monetary policy change, and market-oriented reform enhancing effectiveness of MP. Feature one: more flexible exchange rate system enhancing independence of MP Until July 2005, a quite rigid exchange rate regime had been in use in China since 1949. China s currency, Renminbi, kept a stable exchange rate with US dollar, the formally so-called managed floating exchange rate regime is virtually a fixed system. Although China gains in many ways from this fixed system (reduction of currency risk, foreign investors stable yield expectation, etc), it also pays a heavy cost. According to Krugman s Theory of Open Economy Trilemma, the following three factors can not coexist: fixed exchange rate regime, free flow of capital, as well as independent monetary policy. It means that to keep a fixed exchange rate system, and free flow in and out of capital, monetary policy has to lose its independence. The reason underlying is that under a fixed exchange rate regime, monetary policy is at a subordinate position and has to yield first when they are in conflicts. Chinese scholar Xie Ping et al (2002) has studied the relationship of monetary policy and exchange rate policy from 1994 to 2000. They found that three fierce conflicts happened during that period: From 1994 to 1996, China was undergoing an economic overheating. CPI kept increasing at a high speed, central bank faced heavy inflation pressure which required 1
it take a tight monetary policy: increase interest rate, decrease money supply. Contrary to this, China also faced a big surplus international balance of payments. According to purchasing power parity theory, high inflation pressure may lead to devaluation of RMB. While on the other side, big amount of surplus international balance of payments required central bank issue more domestic currency to buy back surplus dollars, which prevented central bank to carry out tight monetary policy. The problem was finally dissolved with sharp increase of China s foreign currency reserve, which was a financial burden on PBC. In 1998, Asian financial crisis happening from 1997 affected China, causing temporary economic recession. Due to decrease of export, international balance of payments changed to negative. To keep RMB exchange rate stable, PBC had to sell US dollars and buy back RMB, which caused foreign currency reserve to decrease sharply, inflation rate also started to drop at the same time. If central bank wanted to stimulate consumption, it needs to supply more money, while fixed exchange rate regime made it impossible. To curb deflation from 1998 to 2000, PBC decreased interest rate 7 times, 6-month interest rate drop from 9% to 2.16%. While American economy was in a heating situation, FED increased federal fund rate 6 times, from 4.75% in June 1999 to 6.5% in mid 2000. Adverse trend of interest rate adjustment caused much trouble for China s monetary policy, PBC had to carry out exchange rate operations regularly to keep fixed exchange rate regime work. To increase independence of china s monetary policy, relaxation of fixed exchange rate system is a must. In July 2005, PBC issued an announcement on reform of existing exchange rate regime, aiming at establishing a more flexible and elastic regime. The width of RMB exchange rate adjustment would be broadened gradually, the currency target to which RMB was pegged changed from US dollar to a basket of currencies, including US dollars, Euros, Japanese Yen, etc. Although central bank still needs to intervene in foreign exchange market, RMB exchange rate would be decided mainly by market demand and supply. With time passing, RMB exchange rate will be more and more flexible, although it is still too early to say whether and when it turns 2
to free floating. More flexible exchange rate system leaves more space for monetary policy operation. It soon paid off in 2006 when China s macro economy growth accelerated too fast. Too much bank loan and public and private investments in the first half of 2006 are clear signals of future inflation. Appreciation of RMB relieved some inflation pressure PBC faced. Under a more flexible exchange rate system, when conflicts emerge between exchange rate policy and monetary policy, better coordination of policies will be taken, leading to a better outcome. Feature two: deliberate use of effective monetary policy instruments As a transitional economy, China has very different economic characteristics from developed countries. Changing from planning economy to market economy, two mechanisms function together in China, sometimes cause contradictions. For example, bank lending interest rate is still regulated by central bank, while saving and lending are totally decided by individuals, firms and commercial banks. Contradiction appears when money demand is quite high while lending interest rate is controlled and can not increase to equalize money supply and demand. In this transitional scenario, PBC tries to make a compromise in setting up a set of effective monetary policy instruments. The employment of market based policy instruments (indirect instruments) is a popular trend among central banks in both developed and developing countries. Advantages of indirect monetary policy instruments are obvious. They respect and abide by market rules, balance money supply and demand without distorting market prices. The main representative of indirect instruments is open market operations. Since 1998, PBC has made great efforts in developing inter-bank bond market and capital market, which are essential infrastructure of open market operations. In less than a decade, a rather mature bond market has been developed, with various and plentiful market participants (mainly big financial institutions), different types of bonds, as well as relatively good rules. Open market operations have already take the most important position in the basket of policy instruments for PBC, and seemed 3
effective in achieve money supply target. Despite disadvantages of planning policy instruments, they have good sides like highly efficient, low cost and more precise sometimes. Especially interest rate control can not be avoided presently in China. In the past years, many interest rates have already been relaxed gradually, including domestic foreign currency lending and saving interest rate, inter-bank market and bonds market interest rate. Even bank lending and saving interest rate has been relaxed to some extent, different financial institutions can increase or decrease the rate within a regulated range around the benchmark according to different quality of loans and savings. The next step is to confer pricing rights to banks based on their performance and risk endurance strength, as well as internal control system. Other planning instruments may be taken in some specific scenarios. Economic structure distortion is a long run problem in China. For example, when some industries are over heating, absorbing too much investment, some other industries may be too cold, mainly some low-return industries like fabric manufacturing, heavy mechanic industry, etc. Imbalance of economic structure may cause waste of financial resources, specific monetary policy instruments need to be taken to deal with it. PBC accumulates some experience in this issue, choosing differential lending interest rate and ratio lending mechanism. Banks may increase lending interest rate to over-heating industries and firms, reduce the temptation of borrowing and investing, and decrease lending interest rate to industries which need to be supported. The quantity of money lending to over-heating industries can also be decreased by strict ratification mechanism. Although the two approaches are mainly direct instruments, they are effective in curing China s characteristic structural problems. Feature three: more transparent MP operations Transparency in monetary policy is a popular trend all over the world. MP transparency has two advantages: firstly, it can meet the urgent needs of public to get 4
more information about MP formulation and implementation, it is also a part of public administration transparency, embodying the spirit of human rights and democracy; secondly, it can help public form rational expectation of monetary policy, especially inflation rate, which is helpful for central bank to establish reputation and monetary policy credibility, as well as achieve ultimate goal, i.e. price stability. More and more central banks are trying to make their MP more transparent, not only monetary policy target, but also instrument employment as well as relevant policy knowledge. In countries employing inflation target as their monetary policy regime, such as New Zealand, Canada, Sweden, transparency of MP has legal grounds, which stands for the highest binding power. Federal Reserve publishes whether and how the interest rate will be changed on the very day of FOMC meeting. Meeting minutes and toll rate of specific measures will be published two weeks later. Chairman also delivers speeches on monetary policy and macro economic performance. Even Bundesbank (Central Bank of Germany) tries many ways to explain policy to public. Honestly speaking, PBC was not transparent enough in the past, mainly due to high dependence on central government. Government preferred more secrecy in monetary policy which could leave more flexibility to manipulate economy. In the past decade, PBC tried a lot to increase transparency, the measures are as follows: Since 1994, PBC has started to publish the data of money supply, standing for the beginning of long journey of policy transparency. In 1995, Law of PBC was issued, which stated explicitly that monetary policy objectives are price stability as well as economic growth. From 1996 PBC has published monthly actual growth rate of M0, M1 and M2, short and long-term loans of financial institutions, enterprise loans, as well as saving and foreign reserve. It also announces the target of different money supply levels. In 1999 monetary policy committee in PBC was established, responsible for monetary policy formulation and coordination with other macro economic policies. The committee will hold meetings quarterly, meeting resolutions will be published shortly after. 5
Since 2001, PBC has started to issue the report of monetary policy implementation via website and paper. The report includes information on bank loans, policy implementation, financial market analysis, economic forecasts, etc. In 2004, a timetable of publishing financial statistic data was announced by PBC, which could help citizens monitor the progress of central bank s work, and evaluate its performance. The above measures enhanced transparency of monetary policy, increased market confidence of price stability and central bank credibility. It also contributed to central bank success in maintaining price stability in past years. But many things still need to be done. PBC only publishes meeting reports, not the whole procedure; does not explain the economic data based on which monetary policy is formulated. Compared with central banks in some developed countries, there is a long way for PBC to go to achieve more transparency, although arguments can always be heard about the appropriate degree for a developing country like China. Feature four: more effective transmission mechanism Low efficiency of MP is always confusing and embarrassing China s central bankers as a result of bad policy transmission mechanism, which can be found in two ways: firstly, different levels of money supply, M0, M1, M2, are always out of control. In 1998, the actual growth rate of M1 was 5.1% lower than the target, and 3.7% higher in 1999. For M2, the actual growth rate was 5.7% lower in 1997, and 2.7% higher than target. If central bank can not control money supply, obviously it can not control inflation. Secondly, monetary policy can not affect real economic variables and lead real economy to the right direction. In the first three years of new century, despite enough liquidity in financial markets and individuals, the incentive of consumption and investment is very disappointing, and money policymakers were worrying about deflation. Monetary policy and real economy are disjointed due to low efficient transmission mechanism. Clearly recognized the importance of policy transmission mechanism, since long 6
before PBC has tried to improve it. In the current years, long term efforts have been paid off. Success is made mainly in credit market, i.e. bank lending market. Four biggest state-owned commercial banks (Big Four) have been transformed to more market-oriented, the color of state owned, i.e. synonym of low efficiency and bad performance, has been reduced significantly. The introduction of foreign big banks after entry into WTO, such as Citigroup, HSBC, etc, stressed market competition. To be listed one by one also means that bank management of Big Four is much closer to foreign counterparts. To survive means that China s banks have to win in fierce competition, and governments can not be depended anymore. All these changes require Big Four and other medium sized commercial banks to operate according to market signals, improve internal control mechanism and risk evaluation skills. Market supply and demand is highly respected and monitored by banks, which is the pre-requirement of good MP transmission mechanism. Capital market is also an important way of policy transmission. Due to systematic drawbacks of China s capital market, the change of share price is not closely linked with macro economy and firm s performance, sometimes even negatively correlated. Due to too much speculation, capital market may be very hot while macro-economy is not optimistic and firms return on investment is low. When capital market is in an irrational exuberance, too much liquidity may flow into the market, causing financial bubbles, while CPI and investments (excluding equity investment) drop oppositely. After strengthening supervision of market and market participants (mainly financial institutions), as well as reduction of political intervention and manipulation of market, China s capital market made great progress, and turned gradually to be barometer of macro economy. Mature capital market also contributes to more efficient monetary policy transmission. Market agents are more sensitive to interest rate change. Besides commercial banks, firms and individuals are two main financial market participants. More investment vehicles induce individuals to dissipate their savings from banks, reliving pressures on commercial banks and central bank caused by too much savings. Various investment choices help individuals be more sensitive to interest rate change and 7
make most of investment opportunities. Gradual privation of previous state-owned enterprises also enhances firms sensitivity to cost and interest rate. The above changes all increase monetary policy transmission efficiency. Feature five: market-oriented reform of MP As monetary policy formulation and implementation take time, when certain MP starts to affect economy, usually half a year even two years passed, while economy has already changed dramatically. So to reduce time delay and operation errors, monetary policy has to be made by forward-looking, not backward-looking. In the past few years, PBC put sufficient emphasis on economic data collection, analysis, and forecast. For example, from 2005 to the first half of 2006, CPI in China was mild and did not show the symptom of high inflation. But PBC noticed that two trends were obvious and not welcoming. One was too much bank lending. In the first quarter of 2006, bank lending already reached half of the target for the whole year. Although bank lending target of central bank is not a strict rule, it still provides a standard for evaluation. Another trend was too much investment, both private and public. Fixed capital investment grew 29.8% in the first half of 2006, the growth rate also increased 4.4% compared with last year. Recognized the coming inflation pressure, a series of contracting monetary policy were taken by PBC to cool off over heating economy. Forwarding-looking is also an objective for China s future MP. As mentioned above, although PBC has made great efforts to reform interest rate system, bank lending benchmark interest rate is still under control. Free of bank lending interest rate is a primary task for PBC. The first step is to broaden the floating range around benchmark interest rate for financial institutions, establish a sound term structure. The second step is to relax all interest rate, and transfer the right of deciding interest rate to individual banks, which is not far away. As most of big financial institutions have state-owned shares, when they are in operation difficulties or near bankruptcy, PBC always give a help hand, and play the role of last resort. This may cause moral hazard behavior for financial institutions and 8
potential financial risk. This makes it difficult for PBC to keep a strict money supply when implementing a contracting monetary policy. PBC is now trying to strengthen bankruptcy mechanism for bad financial institutions, reduce bail-out activities. In this way PBC will be more independent from government, and achieve primary objective successfully. Conclusions After entry into new millennium, significant progress has been made in China s MP operations. The new features can be concluded as follows: More flexible exchange rate system creates more space for MP implementation. Contemporary Renminbi exchange rate system reform increases the elasticity of Renminbi, which enhances the independence of China s monetary policy. Deliberate choice of policy instruments are made, which is especially effective in solving the serious economic structural problems China is facing and will face in the near future. More transparent operations of monetary policy increase policy credibility and reputation of central bank. Sensitivity of various market agents to interest rate change is enhanced, which improves the effectiveness of monetary policy transmission. Market-oriented reforms in monetary policy are carried out, including interest rate liberalization, reduction of last resort role, etc. Despite the above achievements, more efforts need to be made for PBC to achieve a higher objective: more transparent and scientific monetary policy; better communication with public and economists; higher reputation of PBC to stabilize public s inflation expectation. In addition, some potential worries exist. Although it seems that inflation is quite far from us presently, price stability is very popular around the world, it is too early to say that we have known and controlled inflation completely. PBC needs to be more vigilant, independent and skillful in monetary 9
policy operations. Author: Jie XU PhD in finance, associate professor in China National School of Administration Email:xujiejie@hotmail.com 10