The Monetary and Exchange Rate Policy of China

Professor Joseph Yam

Former Chief Executive, Hong Kong Monetary Authority Distinguished Research Fellow, Institute of Global Economics and Finance, The Chinese University of Hong Kong

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Monetary Policy of China Intermediate Targets

Money supply (M2) growth: current target 16% Scale of financing in society (): a new focus. With diversified channels of financial intermediation, bank credit cannot fully reflect the total financing needs of society Focusing only in bank credit may affect the final results of macro adjustment and control New loans extended by banks: perhaps not an intermediate target any more; no formal target this year, unlike in previous years. Interest rates: caps for deposit interest rates and floors for lending interest rates, but there has been repeated emphasis recently of interest rate liberalization Exchange rate: maintaining basic stability at a reasonable and balanced level, but a highly politicized matter Relationship between monetary objectives and intermediate targets unclear; Goodharts Law
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Monetary Policy Approach in China

Policy making: socialist, market economy versus capitalist, free market economy Administrative measures versus market measures Effectiveness of policy transmission mechanism and efficiency in resource allocation Administrative measures: controlling the overall scale of financing in society window guidance in credit expansion differential application and dynamic adjustment control on interest rates and exchange rate Market measures: traditional control over the supply and price of base money
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Monetary Policy Instruments The Peoples Bank of China

Monetary Policy Instruments Affecting the supply of base money (quantity instrument) Affecting the price of base money (price instrument)

Open Market Operation Reserve Requirement Ratio Central Bank Lending and Rediscounting Central Bank Base Interest Rates

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Open Market Operations

The Peoples Bank of China buys assets to increase base money; sells assets to reduce base money Asset classes: treasury bonds, financial paper of policy nature 40 commercial banks serve as Primary Dealers Repurchase transactions: repo and reverse repo Transactions in secondary market Issue of central bank bills [Cash management for the Treasury] No target interest rate announced (unlike the US Federal Reserve Bank, which announces a Fed Funds Target Rate)
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Open Market Operation and Effect on Base Money

Open Market Operation Repurchase transactions: repo (sell and buy back) reverse repo (buy and sell) Secondary market transactions: buy sell Issue of central bank bills: issue redemption [Cash management for Treasury]: accepting deposits repayment of deposits
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Effect on Base Money Decrease, then increase Increase , then decrease Increase Decrease Decrease Increase Decrease Increase

The Peoples Bank of China Central Bank Bills Outstanding

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Yields of PBC Bills at Issue

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Reserve Requirement
Originally for the prudential purpose of ensuring the commercial banks meet deposit withdrawals of customers by requiring banks to place a proportion of the total amount of customers deposits with the central bank Later developed into a monetary policy tool (a) to regulate the supply of credit by banks and (b) to sterilize the increase in base money resulting from foreign exchange intervention when there is capital inflow Reserve Requirement Ratio (RRR) last raised for large banks to 21.5% effective on 20 June 2011; but scope of customers deposits extended recently (end August) Policy of Differential Management (differential RRR for different banks) and Dynamic Adjustment The Peoples Bank of China pays interest on required reserves (1.62%) and excess reserves (0.72%), last adjusted 27 November 2008
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Reserve Requirement Ratio

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Central Bank Lending

Article 28 of The Peoples Bank of China Law: The Peoples Bank of China may, as needed in its monetary policy implementation, decide on the amount, maturity, interest rate and modality of its lending to the commercial banks. The maturity of such lending shall not be longer than one year Instrument not actively deployed for monetary policy, presumably because of credit risk concerns

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Interest Rates
Peoples Bank of China base interest rates: re-lending rate re-discount rate interest paid on reserves interest paid on excess reserves Base deposit and lending interest rates for financial institutions Floating scope for deposit (downward) and lending rates (upward) Maturity structures of various interest rates
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Current Base Interest Rates (taking account of adjustments up to 7.7.2011)

Item Deposit interest rates of PBOC for financial institutions Interest paid on reserves Interest paid on excess reserves Lending interest rates of PBOC for financial institutions Twenty days Three months Six months One year Re-discount interest rate Financial institutions RMB benchmark deposit interest rates Demand deposits Three months Six months One year Two years Three years Five years Financial institutions RMB benchmark lending interest rates Within six months (inclusive of six months) Six months to one year (inclusive of one year) One year to three years (inclusive of three years) Three years to five years (inclusive of five years) Above five years 6.10 6.56 6.65 6.90 7.05 0.50 3.10 3.30 3.50 4.40 5.00 5.50 2011-07-07 3.25 3.55 3.75 3.85 2.25 2011-07-07 1.62 0.72 2010-12-26 Interest Rate (Annual %) Adjustment Date 2008-11-27

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Emphasis on the Interest Rate Tool (Statement on Website of The Peoples Bank)
Interest rate policy an important component of monetary policy and is one of the main instruments of monetary policy implementation The Peoples Bank of China in recent years strengthened the usage of the interest rate tool Along with the gradual liberalization of interest rates and as one of the main instruments of monetary policy, interest rate policy will gradually be transformed from one of direct to indirect adjustment and control Interest rates, being an important economic lever, will play a more important role in the system of macro adjustment and control of the country The Peoples Bank of China will uninterruptedly expand the scope for self-determination of interest rates by financial institutions, perfect interest rate management and, through indirect adjustment and control by the central bank, guide interest rates in further refining their roles in the allocation of financial resources and in the adjustment and control of the functioning of the macro economy http://www.igef.cuhk.edu.hk/

Some Thoughts on Interest Rate Liberalization (Governor Zhou: 17 December 2010)

Interest rate liberalization is an important manifestation of the use of the market in resource allocation Interest rate liberalization has a focus in realizing the self-determination authority of financial institutions in a competitive market Interest rate liberalization also reflects the authority of customers to choose Interest rate liberalization reflects the relationship between the supply of and demand for the diversity and multiplicity of financial products and services, and the risk judgment and price determination of financial enterprises Interest rate liberalization reflects the need for macro adjustment and control. Especially under the conditions of the socialist, market economy of the country and the monetary policy of the central bank being characterized by indirect adjustment and control, there is a need for a smooth and effective transmission mechanism to bring about the necessary influence in market price discovery
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The Interest Rate Tool Work in Progress

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The Renminbi Exchange Rate System

PBC Website: on the foundation of market supply and demand, and making adjustments by reference to a basket of currencies, a managed floating exchange rate system Three elements: 1. floating on the foundation of market supply and demand enables the exchange rate to serve as a price signal 2. dynamically adjust the floating scope of the exchange rate on the basis of conditions in the current account in particular trade balance enables the advantages of a managed system to be realized 3. making references to a basket of currencies means looking at the exchange rate in that basket context and not giving excessive attention to the bilateral exchange rate against a particular currency Temporary measure to cope with financial crisis: fixed exchange rate against the US dollar
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Renminbi Exchange Rate against the US Dollar

Asian Financial Crisis

Global Financial Crisis

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The Basket
Governor Zhou on 10 August 2005: The main determinant for the choice of currencies and their weights is trade in goods and services (Governor Zhou mentioned the currencies of countries such as US, euro zone, Japan, Korea, Singapore, UK, Malaysia, Russia, Australia, Thailand, Canada; also mentioned a bilateral trade threshold of US$5 billion; basket possibly contains over 20 currencies, including the HK dollar) Suitably consider the currency structure of external debt Suitable consider the sources of foreign direct investments Suitably consider unrequited transfers in the current account
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Renminbi Trade Weighted Exchange Rate Index (Proxy of the Basket)

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Exchange Rate and the Trade Balance

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Reform and Liberalization and the Renminbi Exchange Rate

As China continues in reform and liberalization and embrace globalization, there will be price convergence between the lower price level in China and the higher price level in its trading partners In technical terms, this requires the real effective exchange rate to appreciate, which may be manifested in either a high inflation rate or appreciating nominal exchange rate or both Choice is clear Deputy Governor Hu Xiaolian on 26 July 2010: a more flexible exchange rate system is helpful in curbing inflation and asset bubbles exchange rate adjustments help in moderating the pressures of imported inflation Renminbi exchange rate highly politicized President Hu Jiantao on 18 January 2010: changes in exchange rate are a result of multiple factors, including the balance of international payments and market supply and demand. In this sense, inflation can hardly be the main factor determining the exchange rate policy
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Exchange Rate and Inflation

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Monetary Policy Calibration Five Levels (Governor Zhou in January 2011)

Tight Suitably tight Stable Suitably easy Easy During a period in which the economy is functioning normally, monetary policy should be stable. In coping with the global financial crisis, suitably easy monetary policy was deployed; thereafter monetary policy should return to stable
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Monetary Policy Stance over the Years (1997-2011)

97: stable monetary policy 98-02: stable monetary policy; but with deflationary pressure, tendency was to increase money supply 03-07: stable monetary policy; but in order to limit excessive economic growth, there was some liquidity tightening State Council meeting in June 2007: stable monetary policy, should lean towards suitably tight End 2007 economic working meeting: requested the implementation of tight monetary policy Mid 2008: Confronting a worsening international financial crisis, The Peoples Bank adjusted monetary policy stance State Council meeting at end 2008: requested the implementation of suitably easy monetary policy 2009 economic working meeting; March 2010 government working report; July 2010 Politburo meeting: suitably easy monetary policy December 2010 Politburo meeting and economic working meeting: stable monetary policy
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Current Focus of Monetary Policy - Inflation

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Monetary Policy Making in China Recent Experience

Before formal change of stance by Politburo in December 2010: Six occasions of 0.5%-increase in Reserve Requirement Ratio, first occasion as early as January 2010 Introduced differential application of Reserve Requirement Ratio in October 2010 One interest rate hike on 20 October 2010 Deputy Governor Hu Xiaolian on 24 November 2010: next stage in accordance with the direction of the Party and the State Council guide monetary and credit policies back towards normal levels
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Monetary Policy Making in China Recent Experience

Formal change of monetary policy stance: 3 December 2010 Politburo Meeting: implement stable monetary policy 12 December 2010 Economic Working Meeting: implement stable monetary policy 13 December 2010 Party Meeting in The Peoples Bank of China: implement stable monetary policy Deputy Governor Hu Xiaolian on 24 December 2010 in meeting with cadres in leadership positions of financial institutions: should correctly capture the underlying meaning of stable monetary policy
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Monetary Policy Making in China Recent Experience

After formal change of monetary policy stance: Seven more 0.5% hikes in Reserve Requirement Ratio during the period from mid December 2010 to end August 2011) Expansion of definition of customers deposits in Reserve Requirement Ratio to cover deposits placed as security for off balance sheet activities Four more hikes (of around 0.25%) in deposit and lending interest rates over the same period Pro-active policy communication by The Peoples Bank of China
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Policy Communication by The Peoples Bank of China

Deputy Governor Hu Xiaolian: Growth rate of money supply, as measured by M2, should be lower than during the period in which monetary policy was suitably easy; target for 2011 is 16% Control effectively the main gate of liquidity to guide money and credit growth onto a reasonable and suitable path Use of the established monetary policy tools of interest rates, Reserve Requirement Ratio (with dynamic adjustment) and open market operations
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Governor Zhou: Policy time lags are inevitable and there will be side effects. In achieving great success coping with the global financial crisis, the negative consequences of inflation and asset price increases will slowly emerge; policy adjustment must therefore be timely so that upsurges in prices could be quickly suppressed (27 January 2011) The value of money in the hands of the people should not be allowed to be eroded (27 January 2011) Taking a longer term view, income to safeguard and enhance the value of assets in the hands of the people, and the overall average deposit interest rate should be higher than the inflation rate (27 January 2011) As the economy recovers from the global crisis, inflation would be elevated; under the circumstances interest rate policy must be an important policy tool that needs to be deployed (11 March 2011) Expected that suitably tightened monetary policy would be sustained for a period of time (16 April 2011) http://www.igef.cuhk.edu.hk/

Policy Communication by The Peoples Bank of China

State Council on Inflation

Premier Wen (5 March 2011): stabilization of overall price level should be the prime objective of macro adjustment and control economic and legal means should be deployed, supplemented by administrative measures, to comprehensively strengthen adjustment and control, and supervision of prices limit the rate of increase in consumer prices to about 4% Effectively manage market liquidity and control monetary conditions Forcefully develop production to safeguard the supply of main agricultural products and basic necessities Strengthen logistics for agricultural products proactively develop green channel between farm and supermarket Strengthen supervision of prices and maintain market order Refine the system of subsidy
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Policy Communication by The Peoples Bank of China

Deputy Governor Hu Xiaolian (19 April 2011): suppressing inflation is currently the prime objective of stable monetary policy Rate of consumer price increase has been continuously higher than the one-year deposit rate The situation of negative real interest rate has eased somewhat after successive interest rate hikes Negative interest rate sustained for a long time will affect savings and consumption behavior Needs to take further steps to allow the interest rate lever to take effect in moderating total demand and manage inflation expectation
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State Council on Inflation

Premier Wen in interview with Financial Times (23 June 2011): Headline: Chinese Premier declares inflation victory China has made capping price rises the priority of macro-economic regulation and introduced a host of targeted policies. These have worked We are confident price rises will be firmly under control this year The overall price level now is within a controllable range and is expected to drop steadily There is concern as to whether China can rein in inflation and sustain its rapid development. My answer is an emphatic Yes
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Policy Communication by The Peoples Bank of China

Monetary Policy Committee (4 July 2011): inflationary pressure still at a high level thoroughly implement stable monetary policy Governor Zhou (5 July 2011): the slow recovery in the global economy sovereign debt crisis of some countries not yet resolved, large fluctuations in commodity prices, heightened inflationary expectation domestically, relatively strong pressures in capital inflow intensified the difficulty in macro adjustment and control. Consequently, The Peoples Bank of China is firmly placing emphasis on stabilizing overall prices and implement stable monetary policy Governor Zhou (5 July 2011): The problems that stand out in the macro economy are the relatively strong inflationary pressure and heightened inflationary expectation needs to take further steps to implement stable monetary policy Governor Zhou (11 July 2011): China does not have the conditions for adopting inflation targeting can tolerate a certain degree of inflation arising from economic transformation Statement of The Peoples Bank of China (1 August 2011): inflationary expectation is still strong, the foundation for stabilizing prices not yet solid, any policy lapse may lead to a rebound
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Inflation Rate The Base Effect

CPI (y-o-y) CPI (m-o-m) Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 1.5 2.7 2.4 2.8 3.1 2.9 3.3 3.5 3.6 4.4 5.1 4.6 4.9 4.9 5.4 5.3 5.5 6.4 6.5 0.6 1.2 -0.7 0.2 -0.1 -0.6 0.4 0.6 0.6 0.7 1.1 0.5 1.0 1.2 -0.2 0.1 0.1 0.3 0.5

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Base Effect in Coming Months

2011 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec CPI (y-o-y) 4.9 4.9 5.4 5.3 5.5 6.4 6.5 6.1 5.5 4.8 3.6 3.1

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Current Monetary Policy Stance

Three aspects to focus on (Premier Wen on 1 September 2011): Reaffirm the implementation of stable monetary policy The growth rate of money supply fell in recent months but it is not low compared with that in normal years Adequately to focus on the lags and accumulative effects of monetary policy, and to raise policy foresight Monetary policy often have lags Should strengthen policy foresight and avoid the lagging effect of monetary policy interacting with the cumulative effect of other factors to generate excessive influence on the real economy in the next stage Reasonably to make use of different policy instruments and raise the targeted nature of policy PAUSE? Monetary conditions already normalized? Tight enough?
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