Download 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 bank s 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/