Reforming the Transmission Mechanism of Monetary Policy in China

Reforming the Transmission Mechanism of Monetary Policy in China By Wang Yu*, Ma Ming* China's reform on the transmission mechanism of monetary policy has advanced dramatically, especially since 1998, with credit ceilings eliminated, required reserves system reformed and open market operations strengthened, China's monetary policy basically finished the transition process from direct control to indirect regulation. This paper attempts to analyze the causes, process, and implication of the reform of regulation and transmission mechanism of China's monetary policy in recent years, and to discuss some existing issues. The analysis and discussion will focus on the following aspects: the goal of monetary policy, the intermediate target system, the operation of monetary policy and the transmission mechanism of monetary policy. I. The Goal of the Monetary Policy Before 1993, China's monetary policy pursued dual goals of currency stability and economic development. Due to the ambiguity of the final goals, the short term goals in practice were largely discretionary. December 1993, the State Council of China ascertained that the goals of monetary policy is to maintain the stability of the value of the currency and thereby promote economic growth. Since then, the People's Bank of China (PBC), China's central bank, has made great efforts to pursuing the stability of Renminbi. In 1994, China's inflation roared to the highest ever since 1949 when China was established, the retail price index reached 21.7 percent and the consumer price index reached 24.1 percent. Under the serious circumstances, the PBC firmly implemented moderately tight monetary policy and adopted various measures to curb inflation. By 1996, China has succeeded in soft landing. Since 1998, China's price level had been continuously going down. By December 1999, the retail price index and the consumer price index had suffered negative changes for 27 months (Mar. 1997-Dec. 1999) and 21 months (Sep. 1998-Dec. 1999) respectively. Although the decrease of prices has reacted to and adjusted for the over-high prices of the past, China indeed has shown some evidence of deflation. To turn back the tendency of deflation, in concert with aggressive fiscal policy, the PBC has been implementing sound monetary policy and moderately increasing money supply to support economic growth. Ⅱ. The Intermediate Targets of Monetary Policy

For China's monetary policy, another important symbol of the reform of the transmission mechanism is the perfection of intermediate target system. On one hand, credit ceiling once imposed on commercial banks is eliminated, new intermediate target system has been established which bases on monetary base as operating target and money supply as target of effect. On the other hand, open market operations have replaced central bank lending and become primary channel for monetary base injection. But interest rate currently has not been chosen to be an intermediate target due to the fact that interest rate hardly accurately reflects the relationship between funds demand and supply, and it hardly changes with the of market forces. 1. Monetary base Monetary base, as the basis of deposit and credit creation, induces money supply to expand or contract. The primary channel of monetary base injection has experienced three shifts since the reform and opening up: First, the central bank lending was the earliest channel adopted. From 1984 to 1993, the central bank lending to commercial banks was the main channel for the central bank to inject monetary base, which accounts for more than 80 percent of the total annual increment of monetary base, this portion stands at 84 percent in 1993. In recent years, this scenario has changed substantially. From 1994 to 1999, the increment of the central bank lending to the four state-wholly-owned banks has increased drastically (see Table 1). The second channel of monetary base injection is foreign exchange purchase. Since China's reform of foreign exchange control system in 1994, the PBC has pledged to stabilize its currency. Though China has gained sustained surplus of balance of payments, the nominal exchange rate of RMB has remained stable. This arrangement of exchange rate causes dramatic changes in the monetary base supply. Foreign exchange purchase becomes primary channel of monetary base injection. After 1997, this tendency was reversed. In 1998, foreign exchange purchase increased by 44 billion RMB only, standing for 13 percent of the increment of monetary base. In 1999, foreign exchange purchase resumed but was still lower than the level of 1996 and 1997 (see Table 1). In fact, constrained by the target of exchange rate stabilization, foreign exchange purchase can not be adopted as an active instrument of the central bank to control monetary base. The third channel of monetary base injection is open market operations. In 1999, on the basis of normalization and perfection of money markets, the PBC enhanced the open market operations and the channel of monetary base injection is fundamentally changed, that is, open market operations become an primary channel of monetary base injection. In 1999, through 60 operations in the open market, the net injection of monetary base amounted to 192 billion RMB, which was 121.8 billion more than that of 1998, and accounted for 52 percent of increment of monetary base (see Table 1). The development of open market operations facilitates the central bank with flexibility of adjusting monetary base and controlling money supply through financial

markets, and eventually rationally allocating the funds in the whole society. 2. Money supply During the period of planned economy system, China did not define any definite and clear intermediate targets for monetary policy, but implemented credit planning and cash planning instead. In 1996, the PBC began to adopt money supply as an intermediate target and promulgated M0 (currency in circulation), M1 (narrow money) and M2 (broad money) indicators. To correctly define the target of annual additional money supply is an important task for the PBC. As far as the implementation of monetary policy in 1999 was concerned, money supply met the preset goals and monetary liquidity was promoted. (1) The money supply reached the preset targets. In the beginning of 1999, the PBC set yearly targets of money supply as follows: M2 grew by 14-15 percent and M1 by 14 percent or so, net issuance of bank notes 150 billion RMB. As a result of implementation, M2 grew by 14.7 percent and M1 by 17.7 percent, currency in circulation grew by 20.1 percent, which reached the preset targets on the whole. (2) The monetary liquidity was promoted. Since the reform and opening up, as a result of financial deepening and dramatic increase of household monetary income, the liquidity of money has gradually been weakened. The ratio of M1 to M2 decreased from 63 percent in 1986 to 37 percent in 1998. The annual average drop was nearly 4.5 percent and the accumulative drop was 26 percent for the past 12 years. In the first half of 1999, the liquidity of money decreased month by month, it fell to 34.53 percent as the lowest level since 1996. 3. Interest rates Since 1998, interest rate cuts has been most frequently quoted term in newspapers and it has become the topic among ordinary people. Indeed, interest rate policy was most frequently exercised and most heavily operated by the PBC during 1998-1999 (see Table 2). But, as far as interest rate policy is concerned, the PBC has not only cut interest rates several times to boost the domestic demand, but also deregulated interest rates of money market and widened the floating range of interest rates for loans, thus paved the path for the marketization of interest rates. (1) The implication of seven rounds of interest rate cuts First, interest rate cuts relieve enterprises of heavy interest burden. From May 1, 1996 to June 10, 1999, in the seven rounds of rate cuts, the average interest rates of deposits were decreased by 5.73 percent and that of loans dropped by 6.47 percent, thus the interest spread was narrowed to 0.71 percent. The seven rounds of rate cuts decreased interest expenditures of enterprises by 250 billion RMB and lowered their financial costs substantially.

Second, interest rate cuts condition the marketization of interest rates. According to the sequences experienced of some transition economies, the marketization process of interest rates generally follows the order of flexibility then deregulation. Therefore, the marketization process of interest rates may begin with lowering interest rate levels, then approaches gradually to nearly competitive market rates. Thus we can prevent interest rates from rising too fast to stumble the economic growth. (2) The progress of the marketization of interest rates and difficulties encountered The reform of interest rate control system in China has made breakthrough in three aspects: First, the interest rates of financial markets are deregulated. Money market rates, such as inter-bank rate and bond repurchased rate, are the most important indicators of the conditions of funds demand and supply in money market. China started its reform of interest rate control system in money market. In June 1996, the PBC unlocked the ceilings for inter-bank rates and the rates became market determined, thereafter the inter-bank bond rate and discount rate of bills were deregulated. Second, financial markets were fostered. The prerequisite of the marketization of interest rates is the central banks ability to influence interest rates of deposits and loans, this requires financial markets to conduct monetary policy. Since 1997, the PBC has established the inter-bank market and inter-bank bond market. Currently, the daily transaction volume amounts to 10 billion RMB. Third, the floating ceiling of loans is enlarged. Since 1998, in consideration of gradual widening of floating ceiling of loans, then deregulating completely, the floating ceiling for interest rates on loans to small- and medium-sized enterprises and of loans granted by financial institutions below county level, has been enlarged to 30 percent, while the floating rates ceiling on loans granted by the rural credit unions has been enlarged to 50 percent. Currently, there still exists some problems in China's reform of interest rate system. The first problem is that the interest rate can not yet act as intermediate target of monetary policy. Theoretically speaking, interest rate, as price of funds, should vary with market demand and supply and should be an endogenous variable. But due to the imperfection of financial markets and interest rate control, interest rate can neither reflect demand and supply for funds, nor vary with market demand and supply. it is rather an exogenous variable. The phenomenon of more exogenous than endogenous shows the more controllability of the PBC on interest rates. Meanwhile, interest rate is less relevant to economic activities, so it is not proper to be chosen as an intermediate target of monetary policy. The second problem is that the microeconomic foundation is not so stable. Interest is return for a lender to consign the right to use the funds to a borrower, so marketization of interest rates must be originated from the market behaviors of lenders and borrowers. Currently, SOEs and state-wholly-owned commercial banks predominate China's economy. As far as the feature of property rights is concerned, they are not genuine business firms and genuine commercial banks, they aim at dual targets of operation and give attention to both economic benefits and social benefits, so their behaviors of lending and borrowing are not

completely conducted by market force. From this point of view, the reform of SOEs and state-wholly-owned commercial banks is a prerequisite of marketiztion of interest rates. III. The Instruments of Monetary Policy In recent years, China has made rapid progress for instruments of monetary policy. The first progress is the reform of reserve requirement system, the second is the promotion of rediscounting operations, the third is the rapid development of open market operations and the fourth is the guidance of credit orientation. 1. Reserve requirement In 1984, China launched its reserve requirement system. The initial purpose was not to use it as an instrument of monetary policy, but for the PBC to pool funds statutorily from banks to control and balance the credit position of commercial banks. First, the statutory reserve could not used for payment or clearing, commercial banks were required to open another account of excess reserve with the PBC to keep abundant funds for payment or clearing. Second, contrary to the practice of no interest payment of statutory reserve, the PBC paid relatively high interest on statutory reserve. Third, the statutory reserve ratio was too high. Since 1989, the average ratio of statutory reserve imposing on depository institutions has been 13 percent, additionally, the excess reserve ratio has been between 5-7 percent. The sum of these two ratios amounted approximately to 20 percent. In 1998, the PBC reformed the reserve requirement system, consolidated the statutory reserve account and excess reserve account to singe legal reserve account, and the legal reserve ratio was decreased from 13 percent to 8 percent. Meanwhile, the PBC lowered the interest rates of deposits and loans with financial institutions. The interest rates of former statutory reserve and excess reserve were lowered from 7.56 percent and 7.02 percent respectively to the same level of 5.22 percent. In 1999, the PBC lowered the interest rate of reserve requirement from 8 percent to 6 percent. The reform changed the status that statutory reserve could not be used to clear, and facilitated financial relationships between the central bank and commercial banks, and helped to further strengthen the role of reserve requirement in the conduct of monetary policy. 2. Rediscount policy In 1980, China began to try on the bill discounting business. In 1986, the PBC formally opened the rediscounting business. In 1995, the PBC promulgated Notice on Further Regulating and Developing Bill Discount Business, which marked the beginning of bill discount as an instrument of monetary policy. In 1998, the instruments of bill discounting was further perfected and regulated. First, the pricing method of rediscount rate was changed. Since the beginning of bill discounting

operations, rediscount rate was depended on and pegged to the interest rates of central banking loans, and might be floated down to a certain level. This constrained the effect of rediscounting operations to some extent. In March 1998, the rediscounting rates became independent of the rates of central banking loans, and promulgated alone as a benchmark rate. Second, the pricing mechanism of discount rate was improved and its floating range was widened. In March 1998, the old method that the discount rate was linked and pegged to the rates of comparable loans and floated down according to some stipulated principles, was replaced by a new method that the discount rate was added on the basis of rediscount rate. By this way, the central bank might directly influence discount rate by adjusting rediscount rate, and had impact on the credit behaviors of commercial banks, and on the trend of interest rates and money demand. At the same time, the PBC widened the floating range, allowed commercial banks to flexibly determine the discount rates according to the risk and creditworthiness of enterprises, thus helped to develop the bill market. 3. Open market operations In April 1996, the PBC tried on open market operations with treasury bills issued in the same year by the Ministry of Finance, which symbolized the start-up of open market operations. In 1996, the PBC established the nation-wide united inter-bank market. Next year, the PBC established the bond market for inter-banks. In the same year, the PBC promulgated Provisional Rules for Open Market Operations and for Primary Dealers, approved 25 institutional dealers as primary dealers. It was not until 1998 that open market operations achieved its real development. In this year, under the condition of sharp decreases of central banking loans and foreign exchange purchase, the central bank put in more than 70 billion RMB of monetary base through open market operations, as 21 percent of total annual injection of monetary base. In 1999, with open market operations further developed, the PBC injected 192 billion RMB of monetary base and accounted for 52 percent of total annual injection of monetary base. In the future, the open market operations will be the most important instrument of monetary policy of PBC. 4. Guidance of credit orientation Credit policy is one of selective monetary policies. In recent years, China's credit orientation has shifted substantially: first, the PBC pays the emphasis on both production and consumption rather than simply on production. Second, while keeps on supporting SOEs, it enhances financial supports for non-state-owned enterprises (non-soes). (1) Supporting non-soes to develop business Since the reform and opening up, the non-soes have developed remarkably. Currently, the non-state-owned economy accounts for more than 70 percent of added value in China's industry, and more than 80 percent of economic growth rate, and provide more than 95 percent of new jobs. To adapt to the situation, since 1998, the PBC has promulgated some policies to support the non-soes' development. By the end of 1998, the outstanding loans to non-soes account for 41.82 percent of total

outstanding loans. (2) Supporting consumer credit to expand Consumption demand accounts for approximately 60 percent of aggregate demand in China. Since the reform and opening-up, consumption demand has grown at a average annual speed of more than 10 percent and has been a key force to pull the economy soar. Since 1998, the PBC has successively promulgated some policies to promote the consumer's credit. By the end of 1999, the consumer's credit outstanding of the state-wholly-owned commercial banks has reached 160 billion RMB. In the first half of this year, nation-wide consumer credit outstanding amounts to 250 billion RMB. Ⅳ. The Transmission Mechanism of Monetary Policy In recent years, with the argument about the efficacy of monetary policy, the transmission mechanism of monetary policy attracts more attention than ever. Since 1998 China has made its two greatest achievements in the reform of transmission mechanism of monetary policy in China, one was the establishment of the indirect transmission mechanism which is conducted by monetary instruments operation targets intermediate targets ultimate goal; another is the establishment of the indirect transmission system which is linked by central bank financial institutions (via financial markets) enterprises and households national income. Currently, the most difficult problem is that the reform of the transmission mechanism of monetary policy has not improved on the transmission efficiency of monetary policy efficiently. Theoretically speaking, the transmission mechanism of monetary policy is an important category of monetary policy. In fact, in western countries, market economy are much developed and their monetary policies are faced mainly with the problems of aggregate. But in China, it is undergoing the transition process from planned economy to market economy, and its monetary policy is faced with not only the problems of aggregate, but also the problems of economic system and economic structure. It is obvious that the transmission mechanism of monetary policy in fact is involved in two sectors: the financial sector and the real sector. When central bank exercises the instruments of monetary policy and adjusts monetary base, in the first instance, there will be changes of money supply and interest rates in the financial fields, then followed by the lending activities of commercial banks and financial conditions of financial markets. In these ways, the changes then will be transmitted to the real economy and influence enterprises and households to adjust their assets and change their investments and consumption expenditures, thereby to influence the output and price in the whole society. Concretely speaking, the transmission process in fact includes three bodies and two channels: the three bodies are central bank, institutions (financial markets), enterprises and households. Two channels are from central bank to commercial banks, and from commercial banks to enterprises and households. Any body or any channel, if fails, will disturb the transmission process and weaken the

effectiveness of monetary policy. In this point, the transmission efficiency of monetary policy is determined not only by the marketization of monetary policy tools of the central bank, but also by the market behaviors of financial institutions, enterprises and households as rational reactions to market symbols such as indirect control by monetary policy. These behaviors are originated from the incentives of profit maximization under the proper arrangement of property right system. It is obvious that this kind of arrangement of property right system does not exist in SOEs and state-wholly-owned commercial banks. The special arrangement of SOEs and state-wholly-owned commercial banks makes them to pay close attention to both economic and social benefits, and can not take profit maximization as sole objective of operation. Their operations are not completely based on market rules and they can not make rational reactions to the symbols of policy adjustment based on the market by the central bank, and therefore the central bank may not achieve the goal, and the transmission of monetary policy may be hampered and its effects may be weakened. In fact, monetary policy is a policy of aggregate demand, whereas currently the main problems of transmission mechanism of monetary policy are originated from economic system and economic structure. In this sense, although the marketizaton of the macro transmission mechanism of monetary policy is very important to perfect the transmission mechanism of monetary policy, it can not solve all problems in the transmission process of monetary policy. As to the arguments about the efficacy of China's monetary policy, it further reveals the conflicts between the marketization reform of macro-control mechanism of monetary policy and the traditional economic system. It implies that China needs not only to perfect market-based instruments of monetary policy actively, but also to create the institutional conditions and the microeconomic foundations actively so that these instruments can function effectively in order to establish the market-based transmission mechanism of monetary policy. Source: China & World Economy Number 6, 2001 http://www.iwep.org.cn/