Download Monetary Policy Cooperation between China and the

Monetary Policy Cooperation between China and the US under
Bretton Woods II System
Xiang Lia1
And
Jianhua Gangb
Abstract
By analyzing the Bretton Woods II system, the current international monetary system we conclude that
the current exchange rate regime between China and the U.S. can last for the near future. The
smoothness of the current system depends on the close cooperation between the major economies in the
world. The exchange rate arrangement between China and U.S. will remain relatively stable in the next
3 to 5 years. In addition, the monetary policy in the two countries tends to convergence. The current
account deficits and surplus cannot be solved fundamentally. China tends to buy more assets in the U.S.,
either real or financial, which is an alternative route channeling the capital flow back. We also advocate
that an inflation target (IT) regime is the most suitable alternative regime to the BWII.
Key words: Bretton Woods system II (BWII), Monetary policy, inflation target
1. Introduction
In these paper, we explore the Bretton Woods system II, the current international
monetary arrangement between China and the U.S. The monetary policy implications
under this system for China and the U.S. are also analyzed. This paper tries to find the
answer whether current system can be maintained in the future? If not, what is the
reason for the collapse of the system? What is the suitable alternative regime to the
current one? We argue that current BWII regime can be maintained in the crisis time
but when the global economy fully recovers in the 3-5 years, China will face the
enormous inflation pressure and have to switch to another monetary policy regime. In
the longer term China has to liberties its capital account and let renminbi to free float.
In addition by switching to the inflation targeting regime, China can further deepen its
1
a. Xiang Li, Lecturer of Finance, Department of finance, Shanghai University, 200444. [email protected]
b. Jianhua Gang, Lecturer of Economics, Beihang University, 100191. [email protected]
financial system reform and readjust its economic structure to the potential challenge.
The rest of the paper is arranged as follows. Section 2 describe the specifications of
Bretton Woods system II and analyze its implications to China and the U.S. Section 3
describe the monetary policy implementations in China. Inflation targeting regime is
also introduced in this section. Section 4 concluds.
2. Bretton Woods system II Specification and Beyond
a. The specifications of the Bretton Woods system II
Recently, an school of scholars put forward the idea that the current international
monetary and financial system as Bretton Woods System II (or Bretton Woods System
Reborn. Dooley et al. (2003) shows that countries in the international monetary
system can be divided into two blocks: the core (center) or periphery. Countries in the
core block have the rights of issuing the currency which is used as the international
currency by the periphery countries. Because of this privilege, countries in the core
can consume more than they produce. These so called periphery countries can
upgrade themselves into the core block by engaging in so called export-led growth
supported by undervalued exchange rates, capital controls and official capital
outflows in the form of accumulation of reserve asset claims on the center countries.
They argue that this pattern can be sustained for the foreseeable future and determines
the international monetary order.
Dooley et al. (2003) decomposes the main economies in the world into three principal
economic and currency zones. The criteria to categorize these countries are mainly on
the functions of these countries rather than geographic region. The three regions in the
framework developed by Dooley et al. (2003) include trade account region, Asia; a
center country, the United States; and a capital account region, Europe, Canada and
Latin America.
The three regions mentioned above are of different characteristics. The main concern
of countries in trade region is exporting to the U.S. i.e. the central region. For these
countries, export increases can be interchangeable with the term “growth”.
Consequently they are more prone to manage float their own exchange rates to
promote the export. Even if it means the huge accumulation of U.S. dollar
denominated assets. These countries do not care too much about the risk/return profile
of the U.S. securities. In addition, memories of the 1997-1998 have driven the central
banks in the Asia to accumulate U.S. dollar assets as reserves working as the
rainy-day funds.
For countries belong to capital account region countries like Europe, Canada and
Latin America, they care more about the risk/return characteristic of their investment
position and become more worried about their U.S. exposures. Generally, countries in
the capital regions do not intervene frequently and significantly in the FX market to
control their own exchange rates with the aim of promoting export to central region. It
is naturally to find that capital account region countries rarely accumulate reserve
assets as trade account region countries do.
The central region countries like the U.S. are the intermediary of the system. The U.S.
does not try to manage its exchange rate, which is unlike the trade region countries.
They do not accumulate the official reserves as well. But the U.S. has the motivations
for growth by promoting export, which makes the U.S. share some common
characteristics with the trade region countries as well.
The following graphs are listed in Dooley et al. (2003).
Figure 1. Weighted dollar exchange rates and International reserves (Dooley et al. 2003)
From the Figure 1, it is obviously that in term of the trade weighted dollar exchange
rate, trade account countries demonstrate more inertia, but they accumulate more
international reserves when compared with the capital regions countries.
In addition, Dooley et al. (2003) distinguishes the different motivations of the
two-region countries for financing the U.S. current account. Dooley et al. (2003)
concludes that the growth of the U.S. current account deficit has being the growth
engine for the growth for the rest of the world.
Trade region countries especially in Asia, as their main concern is the successful
export-led growth strategy, has virtually unlimited demand for the U.S. financial
assets in the form of official reserves. Capital region countries’ capital flow into the
U.S. is mainly driven by private sector. The nature of these funds can better be
approximately termed as “safe haven” motivations. The recent data have it that
direction of European private sector is still into the U.S. but the capital flow from the
Latin America seems being reversed, which is mainly due to the low yields and
uncertainty in the U.S..
When it comes to whether the above system is sustainable in the foreseeable future at
least, Dooley et al. (2003) gives a relative optimism view. Their confidence mainly
comes from the empirical observations that despite soaring U.S. current account
deficit, U.S. dollar has been maintained relative stably and the yield in the U.S. is kept
low as well.
Dooley et al. (2003) finally concludes that the Bretton Woods system does not evolve,
it just occasionally reloads a periphery. Bordo and Flandreau (2003) has analyzed the
link between financial development and the choice of exchange rate regime in the
periphery. The bottom line is that although the relationship between the periphery and
the center is stable periphery can affect center sometimes significantly.
Eichengreen (2004) gives a different view towards the above system. Due to the
conflicts among the periphery countries, he argues that Bretton Woods system II
cannot exist or is not suitable for the current world.
b. How is the Bretton Woods system II in the subprime crisis?
Based on the current economic observation especially in the reaction to the Subprime
crisis, China and the U.S. have strengthened the ties between them rather than
weakened it let alone broken it. From September, 2008 to March, 2009 U.S. dollar has
appreciated more than 15 percent. On the other hand, China’s official reserve is more
than 2.1 trillion U.S. dollar, among which around 800 billion of U.S. government debt.
This is the best evidence that Bretton Woods system II works properly in the current
context. However, there are some constraints binding the China’s monetary policy
implementation once the major economies start to exit current monetary expansion
and fiscal stimulus environment.
China has already engaged itself on are path towards greater financial openness in the
past few years. Since July, 2005, China has allowed more exchange rate flexibility.
But the path of Renminbi since then, domestic currency of China is still a managed
float exchange rate. Consequently, Chinese monetary authority had to intervene in the
FX market and to accumulate huge foreign reserve. At the end of 2007, prior to the
Subprime crisis, China held over than USD 1.5 trillion in official reserve (more than
45 percent of its GDP). Both monetary base and inflation rate increased hugely in
2007. The monetary base grew over 30 percent and CPI inflation rose above 8 percent
(Glick and Hutchison, 2009). Although the CPI inflation has been curbed in the
following Subprime crisis, the further accumulation of foreign reserve occurred even
with the collapse of export. Now it is reported that China has more than USD 2.1
trillion foreign reserves.
Table 1 Decomposition of China’s BOP
Source: Glick and Hutchison (2009)
It seems that China still sticks to its position in the periphery region. It means that
relative stable exchange rate policy still is the nominal anchor of China’s monetary
policy. Mundell’s impossible Trinity theory that fixed exchange rate, free capital flow
and independent monetary policy cannot be realized at the same time. Even under the
China exerts capital account controlling policy, the monetary policy scope of China is
still severely restrained.
In fact, a relative fixed nominal exchange rate regime borrows the nominal anchor
from abroad. Obstfeld and Rogoff (1995) points out that: “…For all of the above
reasons, fixed exchange rate regimes have tended to be fragile in practice, even when
supported by capital controls; so a fixed nominal exchange rate has proven to be an un
reliable nominal anchor for monetary policy.”
In the Bretton Woods system II, China has to maintain its exchange rate relatively
stable in exchange for the export-led growth. But it is unsuitable when world
economy now at the stage of post crisis. We consider that the international imbalances
between China and the U.S. are unsustainable and have to be corrected. The monetary
policy implementation in China has to be switched to another regime away from the
Bretton Woods system II. We propose the suitable candidate can be the inflation target
regime. Details are discussed in the following sections.
3. Monetary Policy Implementation in China
a. Some Common Principles of Monetary Policy
Goodfriend and Prasad (2006) put forward some common principles of monetary
policy. They are as follows.
The fundamental Principles of Price stability: Modern monetary theory has
fundamentally toward sustaining low inflation must control aggregate demand
effectively so that production cost rise at the targeted rate of inflation. Such a aim is
either explicitly or implicitly expressed in the various statements of the central banks
across the world.
The stabilization of Employment: In the short term monetary policy tends to face a
trade-off between inflation and employment with respect to shocks to the flexible
price sector. The U.S. monetary policy practices suggest such problem can be relieved
by focus on the so called “core inflation” which excludes prices of oil and food. Core
inflation is more suitable to act as the nominal monetary policy anchor than CPI
inflation. This aim is of more importance to the decision makers in China especially
in the crisis time. The stability of employment seems interchangeable with the
stability of the whole society. Thus, the expansionary monetary policy is viewed as
the natural selection by the central bank in China and it is expected to be held for
quite a long time. We do not expect China will engage on the exit path to current
monetary policy any sooner in the foreseeable future.
The Accommodation of Productivity Growth: Productivity growth is the most
concerned policy objective in China. In the past several decades growth-oriented
policy preference is the ultimate driving factor of the monetary policy regime decision.
Especially in the Bretton Woods system II setting, growth concerns explains why
monetary authority in China is glad to accumulate the foreign reserves at the expense
of the non-sterilization monetary base expansion and the independent policy towards
the domestic policy aims.
In order to use independent monetary policy instruments that are consistent with
above three principles, China needs qualified banking and financial systems. We
briefly assess the adequacy of the Chinese financial systems before we examine the
monetary policy implementation there.
b. The banking and financial systems in China
State owned banks play a dominated role in Chinese financial systems. Compared
with western counterparts’, especially financial system in the U.S., capital markets
like stock and bond markets do not exert dominant influence due to their limited size.
Total deposits in the banking system amount to about 160 percent of GDP, compared
to an outstanding stock of government debt of about 25 percent in 2005 (Goodfriend
and Prasad, 2006). In the 1980s and 1990s, these banks were arranged to lend to the
stated-owned enterprises (SOEs). Consequently, the nonperforming loans (NPLs)
were a serious problem in Chinese banking system. In terms of the size of the NPLs,
there were various estimates by different researchers. In order to solve the problems,
some NPLs were carve-out from SCBs to asset management companies. In the past
several years enormous efforts are given to the reform of these state controlling banks
by the Chinese authority. Three of the biggest four SCBs, e.g. Bank of China, China
Construction Bank and Industrial and Commercial Bank of China all successfully
attracted foreign strategic investors and got IPO to the public. Due to the more strict
corporate governance measures, these SCBs are much stronger financially. But the
recent government 4 trillion yuan stimulate package has raised enormous concerns
that NPLs could surge again in the future. To have a healthy banking system acting as
the efficient financial intermediaries is the necessary condition of an effective
monetary policy China still has a long way to go to improve the efficiency of these
banks.
c. Monetary Policy Instruments in China
Variou s monetary instruments are adopted by the Chinese monetary authority. The
primary instruments include open market operations, changes in the discount rate,
reserve requirements and so-called window guidance to banks (Xie, 2004). Yi (2001)
reports that reserve requirements, the rediscount rate, instructive credit plans and
policy as complementary instruments. Recently People’s bank of China (PBoC) has
also been using growth rates of both money and bank lending as explicit intermediate
targets. Historically the growth rate of M2, the broad definition of money, is
consistently a few percentage points higher than nominal GDP growth which consist
inflation pressure in the middle- to long term in China.
There are several challenges for Chinese monetary authority to implement monetary
policy independently and effectively. Unless such challenges are addressed suitably,
monetary policy in China cannot realize its aims.
First, the fragile bank system exerts huge pressure on the transmitting channel of the
monetary. Despite the several measures have been taken by China to improve its
banking system, and there are some big achievements e.g. liquid bank reserves market,
a flexible, market determined interbank offer rate (CHIBOR), it is still too early to
claim that China has already has a robust banking system which can illustrate
financial robustness when experiencing shorter term interest rate fluctuations. Bank
managers must be the prudent and professional lenders and are working in the sound
risk management system. The fact is that market participants are more concerned
about the next wave of NPLs under the government four trillion rmb stimulus plan
and expansionary monetary policy environment. In order to have a safe banking
system more strict governance measurements should the regulators used to control the
total level of slackness in the lending process of the SCBs. The total scale of the
projects especially those run by the local governments should be checked under
scrutiny.
Second, China’s current exchange rate regime exerts additional burden to the effective
of monetary policy implementation. On 21st July, 2005 the renminbi broke away the
fixed parity relative to the U.S. dollar, which was maintained for almost a decade. The
first 2.3 percent appreciation against the U.S. dollar gave a brand new signal to the
rest of the world. The government hence announced that the renminbi would be set
with reference to a basket of currencies. Although the composition of the basket lately
revealed by the government, the relative weights of each component currency are still
kept unknown to the outside. Some empirical studies have found that renminbi was
tightly correlated with the U.S. dollar in the new exchange rate regime.
In order to insulate the monetary policy effects from such a relative stable fixed
exchange rate regime, People’s bank of China has to sterilize the reserve
accumulation. Until 2002, government bonds were the primary instrument for
sterilization of foreign inflows. Due to the limited size of such bonds, Central bank
replaces them with PBoC bills. Recently PBoC bills have become a more important
instrument of PBoC.
However, the lack of exchange rate flexibility has impaired the effects of sterilization
policy of PBoC. We conclude that given the Bretton Woods System II, China still has
the tendency of accumulating foreign reserves. Unless China gives up the exchange
rate as the nominal anchor for monetary policy or mops 100 percent of the liquidity
caused by purchasing of foreign reserves via sterilization, China cannot focus its
monetary policy towards domestically. Some important timing of implementing
reforms on the China’s economic structure and financial systems could be delayed,
which has serious for the long term prospects of China’s economy. Furthermore, the
increasing liquidity flushing in the financial system poses huge inflation pressure and
has the possibility of giving birth asset bubbles e.g. an equity market and real estate
frenzy. As China’s economy just recovered from the crisis, such a flush of liquidity
seems harmless at the moment. But China’s authority has to take specific measures as
precautions. In addition, the sterilization process imposes additional costs on the
financial intermediation in China. To some extent, the commercial banks will use
liquidity to by the PBoC bills rather than engage in making loans to corporations. In
this regard, sterilization crowds the bank lending. This explains partially why the
PBoC could not fully sterilize the foreign reserves it accumulated.
One possible solution is to reinvest the liquidity back to the U.S. China Investment
corporation (CIC), China’s sovereign wealth fund (SWF),
has launched several
deals oversees to increase the return of its reserves. Just name a few, CIC had
acquired some equity shares of U.S. financials e.g. Morgan Stanley and Citi group in
the subprime crisis. The purchase of U.S. dollar denominated by the periphery
countries like China did surely can help to maintain the current Bretton Woods system
II (BWII). The willingness of China to hold U.S. assets can help finance the current
deficit of U.S.. But in the long term it would not help to solve the huge imbalances
between China and the U.S.. The ultimate corrections of the current BWII between
China and the U.S. require that China has to give up its relative fixed exchange rate
regime and switch its monetary policy to the inflation targeting regime. The
sustainability of the current Bretton Woods system II can only be expected last in the
recent 3-5 years. Once the world goes through the current crisis and on the fully
recover path again, China will face enormous inflation pressure. We conclude that
once the scenario is realized, China’s monetary authority has to switch another
monetary regime: inflation targeting regime (IT).
d. The Inflation Targeting (IT) regime: the Suitable Alternative to
BWII
The inflation targeting regime emerged in the early 1990’s. Inflation targeting can be
thought as the diametric opposite to the Bretton Woods system II, and is accompanied
with flexible exchange rates. Mishkin (2004) sets the five components of an inflation
targeting regime:
1) The publilc announcement of medium-term numerical targets for inflation,
2) An institutional commitment to price stability as the primary goal of monetary
policy,
3) An information-inclusive strategy to set policy instruments,
4) Increased transparency of the monetary policy strategy, and
5) Increased accountability of central bank for attaining its inflation objectives.
Taylor (2001) points that an inflation targeting regime accompanied with floating
exchange rates. Ross (2006) finds that countries involved in the inflation targeting
regimes place few restrictions on capital mobility and grant more flexibility on the
exchange rates. By using a 42 countries sample, Ross (2006) indicates that countries
focus on the domestic monetary policy incurs no additional international costs and
requires no coordination with foreign monetary authorities. When the IT regime is
assessed in terms of stability, Rose (2006) also finds that IT regime is quite durable.
Inflation targeting countries have lower exchange rate volatility and less frequent
“sudden stops” of capital flows than similar countries that do not target inflation.
The inflation targeting countries do not hold international reserves and generally have
no control of capital flows.
We put forward that inflation targeting regime with the flexible exchange rate is more
suitable to China economy’s long term health. The inflation targeting regime can be
used more efficiently to trade off between inflation and economic growth.
4. Conclusions
In this paper, we analyze the so-called Bretton Woods system II and its implications
on both China and the U.S.. We find that BWII system cannot help to correct the huge
imbalances between the emerging market countries e.g. China and the U.S.. We also
illustrate how China lost its independent monetary policy under the BWII system and
advocates that an alternative monetary regime: Inflation targeting regime should be
used as the replacement of the current regime in China.
The switch of the monetary regime to the inflation targeting is consistent with China’s
long term development strategy in reforming its economic structure and improving its
financial system. The quantitative studies on the relationship between monetary
regime and China’s financial system are a promise research area worth carrying out in
the future.
Reference
Aizenman, J. & Glick R. (2008a, June) Pegged exchange rate regimes, a trap? Journal of Money, Credit
and Banking.
Aizenman, J. & Glick, R. (in press). ‘‘Sterilization, monetary policy, and globalfinancial integration,’ ’
NBER No. 13902. in press Review of International Economics.
Burdekin, R., & Siklos, P. (2008). What has driven chinese monetary policy since 1990? Investigating
the People’s Bank’s Policy Rule. Journal of International Money and Finance, 27(September (5)),
119–141.
Cheung, Y.-W., Dickson, T. & Matthew, S.Y. (2006, December). Does the Chinese interest rate follow
the U.S. rate?. Hong Kong Institute for Monetary Research
Working Paper No. 19/2006.
Dooley, Michael, Folkerts- Landau, David and Peter Garber. (2003) An essay on the Revived Bretton
Woods System. NBER Working Paper, No. 9971.
Edwards, S., & Levy-Yeyati, E. (2005). Flexible exchange rates as shock absorbers. European
Economic Review, 49(8), 2079–2105.
Eichengreen, B. (1999, March). Kicking the habit: moving from pegged rates to greater exchange rate
flexibility. Economic Journal, C1–C14.
Frankel, J. (1999, September). No single currency regime is right for all countries or at all times,
NBER Working Paper 7338.
Gerlach, S., Kong J. (2005, March). Money and inflation in China, Hong Kong Institute for Monetary
Research Memorandum No. 04/2005.
Glick, R., & Hutchison, M. M. (2003). Foreign reserve and money dynamics with asset portfolio
adjustment: international evidence. Journal of International Financial Markets, Institutions, and Money,
10, 229–247.
Glick, R., & Hutchison, M. M. (2009). Navigating the trilemma: Capital flows and monetary policy in
China. Journal of Asian Economics (20), 2009, 205-224.
Goodfriend and Prasad. (2006). A framework for Independent Monetary Policy in China. IMF working
Paper wp/06/111.
Johansen, S. (1991). Estimation and hypothesis testing of cointegration vectors in gaussian vector
autoregressive models. Econometrica, 59, 1551–1580.
Mishkin, Frederic S. (2004) “Can Inflation Targeting Work in Emerging Market Countries?”
NBER
Working Paper No. 10,646.
Mishkin, Frederic S. and Klaus Schmidt-Hebbel (2001) “One Decade of Inflation Targeting in the
World” NBER Working Paper No. 8397.
Mohanty, M. S., & Turner, P. (2006, September). Foreign exchange reserve accumulation in emerging
markets: what are the domestic implications? BIS Quarterly Review, 2006.
Obstfeld, Maurice and Kenneth Rogoff, 1995, The Mirage of Fixed Exchange Rates, Journal of
Economic Perspectives, Vol. 9, Fall, pp. 73-96.
Obstfeld, M., Shambaugh, J. C., & Taylor, A. M. (2005). The trilemma in history: tradeoffs among
exchange rates, monetary policies, and capital mobility.
Review of Economics and Statistics, 3,
423–438.
Ouyang, A., Rajan, R. & Willett, R. (2006, October). China as a reserve sink: the evidence from offset
and sterilization coefficients. Mimeo.
Prasad, E. & Wei, S-.J. (2005a). Understanding the structure of cross border capital flows: the case of
China. Mimeo.
Prasad, E. & Wei, S-.J. (2005b). The Chinese approach to capitalflows:
in patterns and possible
explanations. NBER Working Paper 11306.
Prasad, E. (2007, October). Monetary policy independence, the currency regime, and the capital
account in China. Paper presented at the Conference on China’s Exchange Rate Policy. Peterson
Institute for International Economics
Rose, K, Andrew (2006).
A stable International Monetary System Emerges: Inflation Targeting is
Bretton Woods, Reversed. NBER working paper No. 12711
Rogoff, K. (2008, February 4). What if China sputters? Financial Times.
Woodford, Michael, 2003, Interest and Prices: Foundations of a Theory of Monetary Policy, Princeton,
N.J.: Princeton University Press.
Xie, Ping, 2004, “China’s Monetary Policy: 1998-2002,” Stanford Center for International
Development Working Paper No. 217 (Stanford, CA: Stanford University).
Xie, Ping, and Xiong Luo, 2001, “Taylor Rule and China’s Monetary Policy,” manuscript, People’s
Bank of China (Beijing, China).
Yi, Gang, 2001, “The Framework of China’s Monetary Policy,” manuscript, People’s Bank of China
(Beijing, China). Presented at the PBC-IMF International Seminar on Monetary Policy Operations,
May 2001, Suzhou, China.