China's Monetary Policy Since the Turn of the Century
Central banker surveys the formation of monetary policy and highlights factors in maintaining financial institutions
RELATED POSTS
Ranging from inflation controls to past interest rate reforms and
the exchange rate regime, a recent speech delivered by Zhou Xiaochuan,
governor of the People's Bank of China since 2002, provides a rare
glimpse into how China's monetary policies were shaped in the last
decade and what will remain a priority in coming years.
The past decade has been extraordinary and brought a series of major challenges to China's monetary policy and macroeconomic management. Facing accelerated urbanization, industrialization and strong motivation to achieve fast growth on the part of localities, monetary policy needs to strike a better balance between growth and inflation. With state-owned banks operating in a planned economy and many sub-standard regulatory requirements, financial sector reform has reached the most difficult stage, and the tough tasks of reforming the interest rate and exchange rate regime and building market-based mechanisms have to be handled.
The greater openness as a result of China's WTO membership means that policymakers need to give more consideration to external coordination. Global imbalances triggered by the combination of overconsumption in the U.S. and high-savings in emerging Asia have increased the pressure on China to balance the three priorities of reform, development and stability. As China and other emerging economies give more priority to reserve build-up after the Asian Financial Crisis, the subsequent oversupply of liquidity has changed the environment of monetary policy conduct. With the sub-prime crisis in U.S. evolving into a global crisis, the problem of overheating in the real estate sector has emerged in China, challenging the traditional single objective monetary policy framework and making it necessary to introduce macro-prudential policies to the toolbox of policymakers. In response to the above challenges, China's monetary policy has focused on inflation control while supporting transition and reform, and has managed to keep both economic growth and prices basically stable.
Meanwhile, major progress has been made in improving the monetary policy framework, economic reform and transition, interest rate. Moreover, advances were made to exchange rate regime reform and the macro-prudential policy framework was further improved. The successes of monetary policy and macroeconomic management have been hard won and provide valuable experience for economies in transition. It is thus important to review these practices for the benefit of empirical and theoretical progress in the future.
I. Inflation Controls to Address Overheating
From a global perspective, most central banks have price stability and financial stability as their mandate and directly focus on keeping prices stable in the conduct of monetary policy. The Law on the People's Bank of China (the PBOC) stipulates that the objective of monetary policy is to keep the value of RMB stable to contribute to economic growth. Yet, because China is a transitional economy, compared with our peers, the PBOC pays more attention to the problem of overheating and has always regarded inflation control as a top priority.
Due to the transition that China is going through, Chinese monetary policy faces an environment distinctly different from other countries. On the one hand, with per capita income at a low level, the economic take-off has started and localities are keen to develop. This has sometimes led to overly optimistic expectations. On the other hand, as China is moving toward a market economy, the continued existence of soft fiscal constraints has meant that localities have strong incentives to borrow and launch big projects. They hope to see the continuation of a loose monetary stance. In the process of accelerating urbanization, the share of urban residents in the total population rose from 36.2 percent in 2000 to 51.3 percent in 2011. Local governments hope to maintain access to easy financing to develop infrastructure projects. In general, localities are all eager to raise living standards and turn their towns, villages and cities into better places. Yet, the aggregation of local and individual behaviors might cause overheating and produce large inflationary pressure. In addition, against the background of rapid economic growth at home and the reshaping of the global value chain, pressure has weighed heavily on domestic price levels as a result of the chronic twin balance of payments (BOP) surplus, large inflow of foreign exchange and the oversupply of liquidity.
So far, in most of the elapsed time in the new century, the Chinese economy has been prone to overheating and inflation is the major macroeconomic risk. The PBOC has always used monetary policy as line of major defense to maintain the overall price level as basically stable. The conduct of monetary policy has been forward looking and effective. In April 2003, when the SARS epidemic was at its worst and against the uncertainties in the outbreak of war in Iraq, the PBOC launched the innovative tool of the Central Bank Bill to drain liquidity, which has since been used as an effective instrument for flexible liquidity management. In September 2003, the PBOC began to use changes to deposit reserve requirements. It gradually became a conventional, neutral tool for freezing liquidity in the banking system.
Against the backdrop of oversupply of liquidity and rapid urbanization, in June 2003, the PBOC started to issue risk warnings for real estate financing in an increasingly stronger tone and established a market-based mechanism through LTV ratio adjustment and the lever of interest rates, to enhance macro-prudential regulation. Generally speaking, the PBOC has successfully addressed the challenges and problems arising from the country's twin surplus with a combination of large-scale sterilization operations and incremental currency appreciation, kept both the price level and growth basically stable, and created a fairly appropriate monetary environment for economic structural adjustment.
II. Multiple Objectives Based on National Conditions
As a developing country in transition, China needs to handle the two tasks of reforming and improving institutional arrangements and maintaining stable economic growth in the process of reform. These two tasks are mutually supportive. The degree of market sophistication, the conduct of monetary policy and transmission mechanism in China are different from that of developed countries and those more market-based emerging market economies, therefore the single objective monetary policy framework does not suit us. China's monetary policy has multiple objectives. The first is low inflation; the second is to promote economic growth; the third is to maintain full employment and keep the unemployment rate relatively low; the fourth is to keep a balanced BOP account. Among the four, keeping inflation at bay has always been the most important mandate of the central bank and has the heaviest weight.
This multiple-objective framework is related to the transition from a planned to market economy. In this transition, the major task has been to remove price distortion, shift to a market price mechanism that is more compatible with the international system and optimize resource allocation. For example, before 1999, workers, teachers and civil servants all had their housing allocated by the government, and received a salary excluding housing expenditure. After 1999, housing gradually became market tradable, and as a result both price and salary levels went up. Therefore, if the central bank overly emphasized the low inflation objective, this might hinder the government's price reform. In other words, monetary policy should leave room for price hikes caused by reform which helps optimize resource allocation. This is one of the reasons that China has not adopted a single objective monetary framework. Furthermore, due to the persistent and large twin surplus on the BOP account, liquidity supply has been abundant and has an important impact on money supply and inflation. It is inevitable that the central bank pays due attention to the BOP position. This is the current state of the monetary policy framework in China. In addition, the soundness of financial institutions and quality of the financial environment are both the key to the effective transmission of monetary policy. Thus, it is necessary to deepen financial sector reform, remove institutional factors that stand in the way of financial stability, and enable smooth transmission of the monetary policy. This means that monetary policy needs to provide necessary support to reform and stability, and in the medium and long run, this will contribute to price stability.
While focusing on price stability, China's monetary policy has always paid close attention to financial stability and reform, adopted measures to support the development and reform program, and managed to strike a balance among the various objectives, price, BOP, employment, growth and etc. In particular, since the outbreak of the Global Financial Crisis, the mainstream framework with the consumer price index level as the single objective has been seen as problematic. It is acknowledged that monetary stability is not equivalent to financial stability. The various reflections have deepened thinking on this matter. In my view, even after the global economy returns to normal, China will keep the framework of multiple objectives, and low inflation will have an even larger weight than the other three.
III. Maintaining Sound Financial Institutions
Based on the above considerations, the Chinese government continues to attach great importance to preserving financial stability, and regards financial stability as an important prerequisite of price stability. This has enabled the central bank to fulfill the mandate of preserving financial stability through on-line repairing of the financial system. The reason for "on-line repair" of the financial system is that economic activities cannot be stopped, and the central bank should repair the problem parts while keeping the machine running. In addition to the mandate of crisis management, a central bank should also devise rules and standards for financial markets, continuously repair and improve the financial system and strengthen its capacity to prevent systemic risks in a pre-emptive manner when there is no crisis.
In the aftermath of the Asian Financial Crisis, China accelerated the reform of state-owned banking system, and effectively solved the problems in the system judged as technically insolvent by some western media. First, the central bank balance sheet was expanded to absorb the NPLs from the stated-owned commercial banks. After stripping off bad assets, foreign exchange reserves were used to recapitalize commercial banks. Also, financial support was given to rural credit cooperatives in the form of special central bank notes and direct lending. Second, the principle of paying money to have good institutions was emphasized to bring moral hazards to a minimum level. After asset divestitures and capital injection, efforts were made to promote the restructuring and listing of state-owned banks, and to improve the regulatory, accounting and auditing standards. State-owned banks including the Industrial and Commercial Bank of China, Bank of China, China Construction Bank, Bank of Communications and Agricultural Bank of China have established a modern corporate governance structure and become listed companies. The special notes issued to rural credit cooperatives can only be redeemed in full by the central bank after they have met capital and other criteria. This underscores the principle of giving both incentives and restrictions. Third, the cost of bailout and reform is shared and recovered. After expanding the central bank balance sheet to repair the financial system, consideration was given to how to address potential losses and downsize the balance sheet again to ensure financial soundness.
With these reforms, the Chinese banking system rid itself of historical burdens, maintained a healthy balance sheet, regained robustness and competiveness, and performed fairly well in the Global Financial Crisis. A sound banking system has significantly improved monetary policy transmission mechanisms and environment, and increased the effectiveness of monetary policy. The Chinese experience has shown that, the necessary on-line repair measures of the central bank is of paramount importance to maintaining financial stability and improving macroeconomic management. However, it is vital to reduce moral hazards, design measures to provide positive incentives, and combine on-line repairs with reform measures to create a solid foundation for the sustainable operation of financial institutions. Attention must be given to cost sharing and the potential central bank balance sheet problems to maintain the reputation and credibility of the central bank.
This speech was originally prepared for the Per Jacobsson Foundation Lecture at the 2012 IMF/World Bank Annual Meetings in Tokyo in October. As Governor Zhou was absent from the Annual Meetings, Deputy Governor Yi Gang presented the English version to the audience at the Lecture in Tokyo. Zhou delivered the same speech at the Caixin Summit in Beijing November 17.
The past decade has been extraordinary and brought a series of major challenges to China's monetary policy and macroeconomic management. Facing accelerated urbanization, industrialization and strong motivation to achieve fast growth on the part of localities, monetary policy needs to strike a better balance between growth and inflation. With state-owned banks operating in a planned economy and many sub-standard regulatory requirements, financial sector reform has reached the most difficult stage, and the tough tasks of reforming the interest rate and exchange rate regime and building market-based mechanisms have to be handled.
The greater openness as a result of China's WTO membership means that policymakers need to give more consideration to external coordination. Global imbalances triggered by the combination of overconsumption in the U.S. and high-savings in emerging Asia have increased the pressure on China to balance the three priorities of reform, development and stability. As China and other emerging economies give more priority to reserve build-up after the Asian Financial Crisis, the subsequent oversupply of liquidity has changed the environment of monetary policy conduct. With the sub-prime crisis in U.S. evolving into a global crisis, the problem of overheating in the real estate sector has emerged in China, challenging the traditional single objective monetary policy framework and making it necessary to introduce macro-prudential policies to the toolbox of policymakers. In response to the above challenges, China's monetary policy has focused on inflation control while supporting transition and reform, and has managed to keep both economic growth and prices basically stable.
Meanwhile, major progress has been made in improving the monetary policy framework, economic reform and transition, interest rate. Moreover, advances were made to exchange rate regime reform and the macro-prudential policy framework was further improved. The successes of monetary policy and macroeconomic management have been hard won and provide valuable experience for economies in transition. It is thus important to review these practices for the benefit of empirical and theoretical progress in the future.
From a global perspective, most central banks have price stability and financial stability as their mandate and directly focus on keeping prices stable in the conduct of monetary policy. The Law on the People's Bank of China (the PBOC) stipulates that the objective of monetary policy is to keep the value of RMB stable to contribute to economic growth. Yet, because China is a transitional economy, compared with our peers, the PBOC pays more attention to the problem of overheating and has always regarded inflation control as a top priority.
Due to the transition that China is going through, Chinese monetary policy faces an environment distinctly different from other countries. On the one hand, with per capita income at a low level, the economic take-off has started and localities are keen to develop. This has sometimes led to overly optimistic expectations. On the other hand, as China is moving toward a market economy, the continued existence of soft fiscal constraints has meant that localities have strong incentives to borrow and launch big projects. They hope to see the continuation of a loose monetary stance. In the process of accelerating urbanization, the share of urban residents in the total population rose from 36.2 percent in 2000 to 51.3 percent in 2011. Local governments hope to maintain access to easy financing to develop infrastructure projects. In general, localities are all eager to raise living standards and turn their towns, villages and cities into better places. Yet, the aggregation of local and individual behaviors might cause overheating and produce large inflationary pressure. In addition, against the background of rapid economic growth at home and the reshaping of the global value chain, pressure has weighed heavily on domestic price levels as a result of the chronic twin balance of payments (BOP) surplus, large inflow of foreign exchange and the oversupply of liquidity.
So far, in most of the elapsed time in the new century, the Chinese economy has been prone to overheating and inflation is the major macroeconomic risk. The PBOC has always used monetary policy as line of major defense to maintain the overall price level as basically stable. The conduct of monetary policy has been forward looking and effective. In April 2003, when the SARS epidemic was at its worst and against the uncertainties in the outbreak of war in Iraq, the PBOC launched the innovative tool of the Central Bank Bill to drain liquidity, which has since been used as an effective instrument for flexible liquidity management. In September 2003, the PBOC began to use changes to deposit reserve requirements. It gradually became a conventional, neutral tool for freezing liquidity in the banking system.
Against the backdrop of oversupply of liquidity and rapid urbanization, in June 2003, the PBOC started to issue risk warnings for real estate financing in an increasingly stronger tone and established a market-based mechanism through LTV ratio adjustment and the lever of interest rates, to enhance macro-prudential regulation. Generally speaking, the PBOC has successfully addressed the challenges and problems arising from the country's twin surplus with a combination of large-scale sterilization operations and incremental currency appreciation, kept both the price level and growth basically stable, and created a fairly appropriate monetary environment for economic structural adjustment.
II. Multiple Objectives Based on National Conditions
As a developing country in transition, China needs to handle the two tasks of reforming and improving institutional arrangements and maintaining stable economic growth in the process of reform. These two tasks are mutually supportive. The degree of market sophistication, the conduct of monetary policy and transmission mechanism in China are different from that of developed countries and those more market-based emerging market economies, therefore the single objective monetary policy framework does not suit us. China's monetary policy has multiple objectives. The first is low inflation; the second is to promote economic growth; the third is to maintain full employment and keep the unemployment rate relatively low; the fourth is to keep a balanced BOP account. Among the four, keeping inflation at bay has always been the most important mandate of the central bank and has the heaviest weight.
This multiple-objective framework is related to the transition from a planned to market economy. In this transition, the major task has been to remove price distortion, shift to a market price mechanism that is more compatible with the international system and optimize resource allocation. For example, before 1999, workers, teachers and civil servants all had their housing allocated by the government, and received a salary excluding housing expenditure. After 1999, housing gradually became market tradable, and as a result both price and salary levels went up. Therefore, if the central bank overly emphasized the low inflation objective, this might hinder the government's price reform. In other words, monetary policy should leave room for price hikes caused by reform which helps optimize resource allocation. This is one of the reasons that China has not adopted a single objective monetary framework. Furthermore, due to the persistent and large twin surplus on the BOP account, liquidity supply has been abundant and has an important impact on money supply and inflation. It is inevitable that the central bank pays due attention to the BOP position. This is the current state of the monetary policy framework in China. In addition, the soundness of financial institutions and quality of the financial environment are both the key to the effective transmission of monetary policy. Thus, it is necessary to deepen financial sector reform, remove institutional factors that stand in the way of financial stability, and enable smooth transmission of the monetary policy. This means that monetary policy needs to provide necessary support to reform and stability, and in the medium and long run, this will contribute to price stability.
While focusing on price stability, China's monetary policy has always paid close attention to financial stability and reform, adopted measures to support the development and reform program, and managed to strike a balance among the various objectives, price, BOP, employment, growth and etc. In particular, since the outbreak of the Global Financial Crisis, the mainstream framework with the consumer price index level as the single objective has been seen as problematic. It is acknowledged that monetary stability is not equivalent to financial stability. The various reflections have deepened thinking on this matter. In my view, even after the global economy returns to normal, China will keep the framework of multiple objectives, and low inflation will have an even larger weight than the other three.
III. Maintaining Sound Financial Institutions
Based on the above considerations, the Chinese government continues to attach great importance to preserving financial stability, and regards financial stability as an important prerequisite of price stability. This has enabled the central bank to fulfill the mandate of preserving financial stability through on-line repairing of the financial system. The reason for "on-line repair" of the financial system is that economic activities cannot be stopped, and the central bank should repair the problem parts while keeping the machine running. In addition to the mandate of crisis management, a central bank should also devise rules and standards for financial markets, continuously repair and improve the financial system and strengthen its capacity to prevent systemic risks in a pre-emptive manner when there is no crisis.
In the aftermath of the Asian Financial Crisis, China accelerated the reform of state-owned banking system, and effectively solved the problems in the system judged as technically insolvent by some western media. First, the central bank balance sheet was expanded to absorb the NPLs from the stated-owned commercial banks. After stripping off bad assets, foreign exchange reserves were used to recapitalize commercial banks. Also, financial support was given to rural credit cooperatives in the form of special central bank notes and direct lending. Second, the principle of paying money to have good institutions was emphasized to bring moral hazards to a minimum level. After asset divestitures and capital injection, efforts were made to promote the restructuring and listing of state-owned banks, and to improve the regulatory, accounting and auditing standards. State-owned banks including the Industrial and Commercial Bank of China, Bank of China, China Construction Bank, Bank of Communications and Agricultural Bank of China have established a modern corporate governance structure and become listed companies. The special notes issued to rural credit cooperatives can only be redeemed in full by the central bank after they have met capital and other criteria. This underscores the principle of giving both incentives and restrictions. Third, the cost of bailout and reform is shared and recovered. After expanding the central bank balance sheet to repair the financial system, consideration was given to how to address potential losses and downsize the balance sheet again to ensure financial soundness.
With these reforms, the Chinese banking system rid itself of historical burdens, maintained a healthy balance sheet, regained robustness and competiveness, and performed fairly well in the Global Financial Crisis. A sound banking system has significantly improved monetary policy transmission mechanisms and environment, and increased the effectiveness of monetary policy. The Chinese experience has shown that, the necessary on-line repair measures of the central bank is of paramount importance to maintaining financial stability and improving macroeconomic management. However, it is vital to reduce moral hazards, design measures to provide positive incentives, and combine on-line repairs with reform measures to create a solid foundation for the sustainable operation of financial institutions. Attention must be given to cost sharing and the potential central bank balance sheet problems to maintain the reputation and credibility of the central bank.
This speech was originally prepared for the Per Jacobsson Foundation Lecture at the 2012 IMF/World Bank Annual Meetings in Tokyo in October. As Governor Zhou was absent from the Annual Meetings, Deputy Governor Yi Gang presented the English version to the audience at the Lecture in Tokyo. Zhou delivered the same speech at the Caixin Summit in Beijing November 17.
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