Download The Role of Credit Market in Monetary Policy Transmission Mecha-

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The Role of Credit Market in Monetary Policy Transmission Mechanism in China
LI Dan
School of Finance, Renmin University of China, P. R. China, 100872
Abstract: This paper documents the influences of credit channel in the monetary transmission mechanism of China. VAR model is used to test two indicators of Chinese credit market development: the
loan-to-deposit ratio (DC) and total credit (CREDIT). And the basic model also includes real output
(real GDP), the price level (CPI), which are assumed to be the measurement of monetary policy. In addition, since some other markets with rapid development have affected the operational efficiency of credit
markets, weakening the impact of the credit channel in the monetary transmission mechanism, the empirical analysis can be applied to validate the credibility of the indicators we adopt, in order to provide
suggestions on the indicator which could be occupied by the government to examine the changes of influence on credit channel in transmission.
Keywords: Credit Market, Monetary Policy, VAR Model
1 Introduction
Financial crisis swept across the globe with devastating influences during 2007 and 2008. China views
this global financial crisis as a product of American making, which was made possible by flaws in the
international economic and financial architecture as well as policy mistakes within the US including
relaxed financial regulation and excess financial engineering on Wall Street. Faced with financial crisis,
the priority of China’s monetary policy has shifted from keeping guard against inflation to appropriate
easing of credit controls. The new policy regime has a consistent mission in its own right and by way of
supplementing the fiscal stimulus package, to stir up growth through stimulating domestic demand.
Monetary policy is an important macro-economic policy measure carried out by the governments and
central banks to divine intervention in the economy. Simultaneously, the central bank administers monetary policies for the purpose of acting on the real economy to achieve economic goals through the implementation of monetary policy transmission mechanism.
The monetary transmission mechanism describes how policy-induced changes in the nominal money
stock or the short-term nominal interest rate impact real variables such as aggregate output and employment. Mishkin (1995) usefully describes the various channels through which monetary policy actions, as summarized by changes in either the nominal money stock or the short term nominal interest
rate, impact real variables such as aggregate output and employment. In open economies, additional real
effects of a policy-induced increase in the short-term interest rate come about through the exchange rate
channel. Additional asset price channels are highlighted by Tobin’s (1969) q theory of investment and
Ando and Modigliani’s (1963) life-cycle theory of consumption. According to Meltzer (1995), asset
price movements beyond those reflected in interest rates alone also play a central role in monetarist descriptions of the transmission mechanism. Two distinct credit channels, the bank lending channel and
the balance sheet channel, also allow the effects of monetary policy actions to propagate through the real
economy.
Although there are multiple channels of monetary transmission mechanism, the channels do not all apply to china under the background of the special situation on Chinese market-oriented economy. Chu
(2006) took a different approach by conducting empirical analysis on monthly date from 2000~2004 in
our country and came up with the conclusion that the impact of the money supply to exchange rate and
the effect of the exchange rate to the increasing number of industry are not effective. And then Chu
(2007) continued to make the point that according to the empirical analysis on monthly date from
2000~2005 in our country, the change of M2 of central bank make little effect on the change of the real
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interest. The change of the real rate is not the main cause, which leads to the change of the investment in
the fixed assets and has little effect on the consumption. So it proves that there is “hard obstruction” in
the interest transmission tunnel of the monetary policy. Dong and Hu (2008) performed grangercausality test and co-integration test to conduct empirical research on the Chinese market. The results
show that although the asset prices can affect consumption and investment, the wealth effect of consumption and Tobin Q-effect of investment are not obvious, resulting in asset prices conduction channel
in our country which is not unobstructed enough. Therefore, china should take effective measures to
dredge the asset price transmission channels, especially the stock market channel, in order to enhance
the effectiveness of monetary policy.
In summary, since the marketization of interest rate has not been completed, capital market is imperfect,
floating exchange rate mechanism is not sound, as well as the lack of relevant conditions, our interest
rate transmission channel for monetary policy, asset prices and exchange rate transmission channel for
transmission channels are confined due to the lack of market mechanisms and micro – basis. But at this
stage, as bank loans occupy mainly large proportion of indirect financing, bank credit is main form of
corporate finance in China in current and future period of time. Commercial bank credit behavior will
have a significant impact on the number and structure of the money supply, therefore, the credit transmission mechanisms, in particular, bank credit channel of monetary policy transmission, will play an
important role and have great influences.
Based on the above research, this paper will explore the effect of Chinese credit channel of monetary
policy transmission mechanism. With the focus, the paper will be organized as following. Section II
documents theoretical statements of the credit channel in monetary policy transmission mechanism. By
combining with the circumstances of Chinese credit market, the paper points out the possible interaction
process of the transmission mechanism from the view of credit market in China. Based on the discussion of Section II, Section III first makes a Granger Causality test and then constructs a VAR model, in
which development indicators of credit channel become an endogenous variable in buttressing the
transmission system. In Section IV the paper provides concluding remarks and policy implications.
2 Credit Channel for Monetary Transmission in China
2.1 The Credit Channel of Monetary Policy Transmission Mechanism
Credit transmission mechanism holds the opinion that completely substitutes does not exist between
bonds and loans. Because of the existence of asymmetric information and other factors, there is a difference between the cost of capital on external raise and opportunity cost of internal raised. The difference is known as external finance premium, it represents a net loss cost. Monetary policy, which has an
influence in the general level of interest rates, also affects the size of the external finance premium. External finance premium can explain the effects of monetary policy, the strength, time and composition
better than the changes in interest rate. Monetary policy transmission mechanism through the credit
channel mainly achieve through credits channels (including the possibility of credit supply and credit
rationing) and channels of the balance sheet. The theory of possibility in credit supply suggests that
changes in interest rates led to the variety in government bond prices, impacting on the price of capital
the lender holds, affecting the will of lenders to provide financing (through the effects of the liquidity of
assets that people hold), at last, making a difference on the supply of credit. Credit rationing theory:
With the information asymmetry of financial markets (adverse selection and moral hazard), the interest
rate is usually lower than the equilibrium level, the market can not run up automatically, which leads to
the phenomenon of credit rationing. The theory of balance sheet: Monetary policy assets by influencing
the status of the borrower and liabilities affect the investment (or consumption), thereby affecting output.
In general, the balance sheet channel is tenable with significant, but the establishment of the credit
channel need two prerequisites: first, the central bank can affect the supply of commercial bank loans;
second, specific lender must rely on bank loans. With the financial deregulation and the emergence of
innovative tools, there is a declining trend on the proportion of indirect financing and the lending capac31
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ity of central bank. However, owing to the advantages of the bank on overcoming the information
asymmetries and other market frictions, credit is still a major means of financing, especially for small
enterprise or residents who have limited access to information and costly external finance. It is an inevitable choice to hold the reliance on bank financing, and we can make the conclusion that credit channels
remain valid to a certain extent.
In China, according to People's Bank of China (PBOC), China’s monetary target is M2, a direct instrument via which PBOC controls the money and credit supply to banks and the policy transmission objective is the real output (real output growth rate) and inflation. Zhang (2009) attributes interest rates to
indirect instrument for monetary policy in China and regards the so-called quantity-based tool as the
direct instrument by which the People’s Bank of China (PBOC) controls the money and credit supply to
banks. The quantity-based instrument is implemented in conjunction with the three major monetary policy tools, which are open market operation, reserve ratio and window guidance. Figure 1 describes traditional China’s monetary transmission mechanism.
M2
PBOC
Banks
Credit fund
Policy transmission
Real output
Firms
objective
Inflation
Fig.1 Monetary Policy Transmission Mechanism in China
The central bank, PBOC, controls the supply of M2, which will simulate banks to adjust credit funds
available for firms for their investments. This will affect the real output, which sequentially causes
changes in inflation. (Zhang, Denise and Dong, 2008) Then inflation and real output will be sent to central bank as economic measures, and policy instruments will be used to re-adjust the money supply. The
interest rate, however, no longer plays a key role in this traditional monetary policy transmission
mechanism. One of the reasons is that the process of interest rate mercerization in China is still moving
slowly that it is the PBOC who sets the benchmark interest rate and banks adjust the interest rates in a
limited range. In addition, some literature concludes that the Chinese firms’ demand for credit funds is
rigid. So the interest rate cannot reflect the real demand and supply of credit funds, nor will it work effectively in adjusting firms’ investments.
And based on the statement mentioned above, the credit channel in monetary policy transmission
mechanism can be summarized in Figure 2.
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Interest rates ↑
Output ↓
Asset prices↓
Bank lending channel
External finance
premium on investment ↓
Consumption↑
Net wealth ↓
Financial situation
↓
Balance sheet channel
Fig.2 Credit Channel of Monetary Policy Transmission Mechanism in China
2.2 The Actual State of Credit Market in China
2.2.1The scale of the development of credit market in China
Products of the credit market that we research on conclude bank loans and bank deposits. The recent
decades witnessed dramatic credit market developments in China. The scale of loans has a leap of five
times during the past 10 years, which can be observed in the figure 3 below.
1000000
800000
600000
400000
200000
0
00
01
02
SUM
03
04
05
LOAN
06
07
08
09
DEPOSIT
Figure 3 The Raising scale of credit supply in Chinese Credit Market
2.2.2 The performance of the development of credit market in China
With a leap in the growing scale of loans, the amount of deposit is also increasing at the same time. Simultaneously, the rate of deposits grows faster than the speed of the loan, and trend is obvious that the
gap between them is expanding. Another manifestation of the expansion of the difference between deposits is the decrease of the loan-to-deposit ratio (loans / deposits). It is clear in the Figure 4 below that
there is a drop on the lending capacity of banks deposits. The figure also presents the ratio of loan to the
sum of credit and deposit to the sum, which will offer us a better understanding of the development of
the credit market in china.
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.9
.8
.7
.6
.5
.4
.3
00
01
02
DC
03
04
05
LOAN_SUM
06
07
08
09
DEPOSIT_SUM
Figure 4 The trend of change in the DC
Due to the above statements and data analysis theory, it is clear that at this stage, as bank loans occupy
mainly large proportion of indirect financing, bank credit is main form of corporate finance in china in
current and future period of time. Commercial bank credit behavior will have a significant impact on the
number and structure of the money supply, therefore, the credit transmission mechanisms, in particular,
bank credit channel of monetary policy transmission, will play an important role and have great influence. At the same time, some other markets, such as the financial market with rapid development, has
affected the operational efficiency of our credit markets, weakening the impact of the credit transmission
channel in the monetary transmission mechanism. So empirical analysis, at the same time, can be applied to validate the credibility of the indicators we adopt, in order to provide suggestion on the indicator
which could be occupied by the government the to examine the influence of credit channel in transmission.
In Section III proper indicators and model will be constructed to test the impact of credit channel mentioned above on monetary transmission mechanism and explore explanations for the test results.
3 Empirical Evidence and Analysis
3.1 Weights that Measure the Variation of the Credit Market and Output
The first measure that weighs the development of credit market is loan-to-deposit ratio (DC) of monthly
frequency, which equals the quantity of loan in one month in Chinese credit market to the quantity of
deposit in the same month. Loan-to-deposit ratio reflects the capacity of credit markets to issue loans
with the borrowed deposit. Now the most important feature of commercial banks is the credit conversion
capacity, fluctuations in the deposit-loan ratio, present the core competence of the bank and industry
operational efficiency, which reflecting the running performance of credit markets. The second measure
that weighs the development of credit market is total credit (CREDIT) of month frequency, which measures the scale of the credit in China. As M2 is the monetary target while real output and inflation are
government’s policy target, they together build up a monetary transmission system. As to the measure of
the output, the real GDP and CPI are occupied to judge the effect on the economic development.
At the very beginning, we have to get the data from the website of The GTA Research Service Centre. In
order to make the first-order difference meaningful, we transfer the data into its logarithmic form. Hence,
the first-order difference of these two series means the growth rate of these data, which state as M2GR,
DCGR, CREDITGR, RGDPGR and CPIGR in the following model.
3.2 Model and Methodology
3.2.1 Unit Root Test
Before further investigation, there is a necessity to conduct unit root test to make sure the measures are
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stationary time series. All the data mentioned in this paper covers from 1999Q11 to 2009Q10. The results of augmented Dicker-Fuller (ADF) test and Phillips-Perron (PP) test are summarized as follows in
table 1.
Table 1 The Results of Root Tests
Augmented Dickey-Fuller test statistic
t-Statistic
Test critical values:
-2.5389
M2GR
CREDITGR
-2.0394
DCGR
-2.2421
RGDPGR
-2.9572
CPI
-3.0579
*MacKinnon (1996) one-sided p-values.
Phillips-Perron test statistic
Test critical values:
Adj. t-Stat
M2GR
-6.3811
CREDITGR
-8.1839
DCGR
-8.2612
RGDPGR
-7.5946
CPI
-9.5353
*MacKinnon (1996) one-sided p-values.
The results show that based on the ADF test, RGDPGR, M2GR and CPI are stationary. Even though
ADF test shows that CPI and CREDITGR have a unit root, PP test suggests that CPI and CREDITGR
are stationary. The difference between the two unit root tests lies in their treatment of any "nuisance"
serial correlation. The residual error is not required to be stationary in the P-P test. The P-P test tends to
be more robust to a wide range of serial correlation and time-dependent heteroskedasticity. (DeJong,
Nankervis, Savin and Whiteman, 1992) So in this paper, we assume that CPI and CREDITGR are stationary.
3.2.2 Modeling
In investigating the impact of credit market on monetary transmission system, a multivariate dynamic
model should be constructed to mimic standard monetary policy analysis framework and capture the
dynamics involved in the monetary policy transmission mechanism for China. Following the work of
Stock and Watson (2002), a reduced form of vector autoregressive (VAR) model can be derived as:
(1)
Yt = C + Φ ( L ) Yt −1 + ε t
Where Yt is a vector containing IPI, M2GR, DCGR(or CREDITGR) and CPI; C denotes a vector of
constants, Φ(L) denotes vector polynomial of lag operator with optimal lag order determined by
Schwarz information criterion (SC); and εt is assumed to be vector Gaussian white noise (VGW). Then
the paper will compare impulse responses of RGDPGR to shocks associated with the policy instruments
(M2GR) and undulation of credit market.
It should be noted that determining the most reasonable order of the endogenous variables is particularly
important to identify structural shocks in a VAR model. In order to decide the order of the variables, we
first make a Granger Causality test. The results of the tests are presented in the following table 2 and 3.
Table 2 shows that at 10%level, M2GR Granger Causes DCGR and CREDITGR and GREDITGR and
DCGR Granger Causes RGDPGR. According the order regulation, RGDPGR is ordered first because it
is unlikely affected contemporaneously by any other shock, while RGDPGR shock will likely affect two
out of the three other variables
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Table 2 Granger Causality Test of RGDPGR, M2GR, DCGR and CPIGR
Lags: 2
Null Hypothesis:
CREDITGR does not Granger Cause M2GR
M2GR does not Granger Cause CREDITGR
CPI does not Granger Cause M2GR
M2GR does not Granger Cause CPI
RGDPGR does not Granger Cause M2GR
M2GR does not Granger Cause RGDPGR
CPI does not Granger Cause CREDITGR
CREDITGR does not Granger Cause CPI
RGDPGR does not Granger Cause CREDITGR
CREDITGR does not Granger Cause RGDPGR
RGDPGR does not Granger Cause CPI
CPI does not Granger Cause RGDPGR
F-Statistic
0.00614
6.77877
1.13603
0.03129
0.27894
1.48065
1.61735
0.40963
3.84903
0.49291
0.79429
4.76899
Probability
Table 3 Granger Causality Test of RGDPGR, M2GR, CREDITGR and CPIGR
Lags: 2
Null Hypothesis:
DCGR does not Granger Cause M2GR
M2GR does not Granger Cause DCGR
CPI does not Granger Cause M2GR
M2GR does not Granger Cause CPI
RGDPGR does not Granger Cause M2GR
M2GR does not Granger Cause RGDPGR
CPI does not Granger Cause DCGR
DCGR does not Granger Cause CPI
RGDPGR does not Granger Cause DCGR
DCGR does not Granger Cause RGDPGR
RGDPGR does not Granger Cause CPI
CPI does not Granger Cause RGDPGR
F-Statistic
1.11003
8.42348
1.13603
0.03129
0.27894
1.48065
1.60766
0.18588
2.49418
1.91341
0.79429
0.49291
Probability
0.33311
0.00039
0.32473
0.96920
0.75711
0.23195
0.20491
0.83063
0.02187
0.15241
0.45446
0.61218
3.2.3 Impulse Response Function
Based on the VAR lag order selection criteria one order lag is optimal. With focus on the main objective of investigating to what extent and in which direction that credit market influence the monetary policy transmission mechanism, the impulse response functions (IRF) of RGDPGR is compared to the
shocks of DCGR/CREDITGR and M2GR. The results of the IRF are reported in Figure 6 and 7.
，
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Response to Cholesky One S.D. Innovations ± 2 S.E.
Response of RGDPGR to M2GR
.04
.03
.02
.01
.00
-.01
-.02
-.03
-.04
1
2
3
4
5
6
7
8
9
10
Response of RGDPGR to CREDITGR
.04
.03
.02
.01
.00
-.01
-.02
-.03
-.04
1
2
3
4
5
6
7
8
9
10
Source: Chinese Economic Information Database and WIND
Fig.6 IRF of RGDPGR to the Shocks of CREDITGR and M2GR
Response to Cholesky One S.D. Innovations ± 2 S.E.
Response of RGDPGR to M2GR
.04
.03
.02
.01
.00
-.01
-.02
-.03
-.04
-.05
1
2
3
4
5
6
7
8
9
10
9
10
Response of RGDPGR to DCGR
.04
.03
.02
.01
.00
-.01
-.02
-.03
-.04
-.05
1
2
3
4
5
6
7
8
Source: Chinese Economic Information Database and WIND
Fig.7 IRF of RGDPGR to the Shocks of DCGR and M2GR
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Figure 6 compares the impulse responses of RGDPGR to M2GR and to CREDITGR. It makes clear that
RGDPRG is more responsive to M2GR than to CREDITGR. Interestingly, this graph suggests that
RGDPGR responds to CREDITGR in a negative direction. The weak negative response may indicate
that the current output does not increase correspondingly. These factors tend to dampen current investment and in turn reduce economic growth.
Figure 7 suggests that the role of credit market in China monetary policy transmission mechanism becomes important over the last decade. The credit market provides an important addition to the banking
system. It enhances the efficiency of lending activities of financial market, which consequently accelerates the effects of monetary policy changes on interest rates.
The development of financial markets in China has indeed reshaped its conventional monetary policy
transmission mechanism. The financial market channel should be involved into the policy transmission
system. Figure 8 tries to describe the foregoing descriptions on the new channel of monetary policy
transmission. It shows clearly the interactions between the central bank, financial market, banks and real
economic performance with a complete circle flow. However, some interactions remains blurred.
4 Conclusion
Based on the above research, this paper explore the effect of Chinese credit channel of monetary policy
transmission mechanism, and documents theoretical statements of the credit channel in monetary policy
transmission mechanism. By combining with the circumstances of Chinese credit market, the paper
points out the possible interaction process of the transmission mechanism from the view of credit market
in China. Further more, we obtain the following conclusion.
At the very first, The credit market provides an important addition to the banking system. It enhances
the efficiency of lending activities of financial market, which consequently accelerates the effects of
monetary policy changes on interest rates. It is clear that at this stage, as bank loans occupy mainly large
proportion of indirect financing, bank credit is main form of corporate finance in china in current and
future period of time. Commercial bank credit behavior will have a significant impact on the number
and structure of the money supply, therefore, the credit transmission mechanisms, in particular, bank
credit channel of monetary policy transmission, will play an important role and have great influence.
What is more, with the development of Chinese economy, the weights that adopted in the VAR model
can be used to obverse the changes in the credit market, which can offer us a help to examine the monetary transmission mechanism in China.
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