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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.. 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