China: Monetary policy goals and tools for their implementation

By Agata Adamczewska

Abstract

The conduct of monetary policy in China is different from that in other countries. Low transparency makes this policy difficult to understand for many market participants. It is also difficult to draw a clear line between monetary and fiscal policy. Thus, macroeconomic analysis of the local economy is certainly an unusual task. In this text, the goals of the Chinese central bank will be presented, as well as the range of its tools.

China is the world's second-largest economy, so everything that happens there is important for global growth. Unfortunately, the transparency of the local economic data leaves much to be desired. This does not make analytical work easier. Moreover, unlike other economies, in China, it is difficult to distinguish between monetary and fiscal policy. (Chin, 2013) For this reason, the often repeated slogan "economic stability" takes on a new meaning in this case. At the same time, there is a lack of clear understanding of the functioning of the local monetary policy. This article aims to aid in understanding how the People's Bank of China (PBoC) operates, which is important, especially in the current environment.

A few words about PBoC

The PBoC is the body responsible for implementing monetary policy and regulating financial institutions in mainland China. Although monetary policy is, in principle, independent, the steps taken are often coordinated with those of the government. In this context, independence should rather be equated with the lack of "blind" following of the main central banks - external independence in the context of the so-called trilemma of the impossibility to maintain a constant exchange rate, free capital flow and an independent monetary policy at the same time. (Chan, 2017) However, one cannot talk about internal independence. In practice, the implementation of more important steps by the PBoC requires the approval of the State Council - the highest body of executive power. Therefore, all decisions of the monetary authorities that affect the money supply must obtain the consent of the above institution. (Yao, 2023) It can be concluded that PBoC is, in fact, the implementer of decisions made at the government level.

The China Monetary Policy Council consists of the president and a number of members and meets quarterly. The President or 1/3 of the members may propose a meeting on other dates. However, unlike other central banks, Chinese meetings are not closely followed by market participants. This is the result of the fact that actual decisions are usually made outside official meetings. (Chen, Ren & Zha, 2018) An interesting fact may be the fact that exactly the hundredth such meeting took place in April 2023. Due to the lack of strict deadlines for making decisions, it is clear that uncertainty among market participants in this context is much higher than in the case of other central banks.

Monetary policy goals of the Chinese central bank

In this area, PBoC is again clearly different from its counterparts in other countries, where price stability is usually the main and often only goal. In the case of China, there are multiple goals, and the president himself said a few years ago that China is not yet at the stage where it has a single goal of price stability. (Prasad & Zhang, 2014) In practice, the goal of the PBoC is often what the government sets for itself in a given year. We are therefore talking about price stability (inflation target set at 3%), achieving a given level of economic growth, increasing employment or developing the financial market and opening it to foreign investors. (Prasad & Zhang, 2014)

In the case of the Middle Kingdom, there is another important goal that must be taken into account by the PBoC in conducting monetary policy. We are talking about maintaining a stable exchange rate, which is critical to maintaining the entire balance of payments. China operates under a managed floating exchange rate regime. In practice, this means that the exchange rate may deviate from the level set by the central bank by no more than 2% each day. (Kennedy & Wang, 2021) Naturally, this exchange rate is determined every day and is generally intended to reflect macroeconomic conditions. We can, therefore, say that China influences the exchange rate and has an independent monetary policy.

We know well from economics lessons that this must be at the expense of the lack of free flow of capital (the previously mentioned trilemma). This is the case in China, where the authorities maintain capital controls. What we mean here are various types of steps limiting investment in China, blocking activity in the M&A sector or making disinvestment more difficult if the perception of risk increases. (Chan, 2017) It has its good and bad sides. In periods of increased risk aversion, China does not experience such a large scale of capital outflow. On the other hand, during good economic times, there is a certain fear among investors related to the possibility of "freezing" their capital for a certain period of time. (Chan, 2017)

Ultimately, China strives to adopt a fully floating exchange rate, which will enable the abolition of restrictions on capital flows. However, having an independent monetary policy (from other central banks), China already has a real influence on what this policy looks like in their country. It also has to be mentioned that the high degree of integration between fiscal and monetary policy makes measuring the effectiveness of both policies separately quite risky. (Yao, 2023) As a result, in China, we focus on the so-called total social financing as a measure of the expansiveness/restrictiveness of economic policy. In short, it is all the funds provided by the national financial system to the private sector. Therefore, we include not only various types of loans and credits but also bond issues and financing through the issue of shares. From a dynamic perspective, we try to analyse the degree of expansion of the local economic policy by referring to the so-called credit impulse (increase in total new financing as % of GDP). (Chen, Ren & Zha, 2018)

Causes and effects of changes in the PBoC balance sheet

Unlike the broadly understood "Western" countries, China's monetary policy is quite conventional. As a result, PBoC's balance sheet structure is relatively simple. (Kennedy & Wang, 2021) There are also no signs of the quantitative easing that has become widespread in recent years. The monetary authorities have not resorted to this type of solution so far and there is no indication that this will change in the foreseeable future. On the other hand, this does not mean a completely passive attitude of the PBoC in terms of measures that go beyond standard changes in interest rates.

The aforementioned graphs refer to PBoC's balance sheet from 2005 onwards. It has grown rapidly since then. At that time, the main and the only reason for this was the constantly growing surplus in foreign trade. (Chan, 2017) As a result, more and more foreign currencies accumulated in the Chinese banking system. A significant part of these funds ended up on the balance sheet of the central bank, which purchased foreign currencies from commercial banks. The entire operation increased liquidity in yuan. In order to better influence short-term interest rates, the PBoC tried to sterilise the excess liquidity in the local currency to some extent by issuing its own bonds (this can be seen on the liabilities side). It can be observed that the PBoC's activity in this area was the greatest during the period of increased accumulation of foreign exchange reserves. (Chan, 2017)

This situation lasted approximately until 2011. (China Monetary Policy Report, 2022) Although there was some growth over the next few years, there are no more steady upward movements as before. Due to the lack of further increase in yuan liquidity, the point of removing the excess liquidity expired.  PBoC, therefore, stopped issuing bonds any longer. In the meantime, there were some foreign exchange interventions, which pushed down the level of foreign exchange reserves held on the central bank's balance sheet. Since 2015, there has been an obvious change in the PBoC approach. (Prasad & Zhang, 2014) A stable level of FX reserves began to be maintained, and at the same time, various types of loans to the banking sector began to be more boldly offered. This does not mean that the inflow of foreign capital has stopped, although it must be admitted that the level of current account surpluses has decreased. (Prasad & Zhang, 2014) However, if capital was still flowing (also through the inflow of foreign investments - direct and portfolio), and the central bank was no longer involved in currency exchange, then this must have been reflected in the increase in net foreign assets held by the banking sector. Since 2017, these assets have been systematically growing.

As written above, the increasing importance of providing financing to the banking sector has become the main and only factor generating the growth of the entire PBoC balance sheet. However, this did not generate an increase in yuan liquidity. (Yao, 2023) On the liabilities side, it was reflected in the increase in demand for cash and the increase in deposits from government and other non-financial institutions (probably various types of quasi-government entities). In general, however, the increase in loans to the banking sector seems consistent with the desire to support economic growth by expanding lending and basing this growth more on domestic demand. (Kennedy & Wang, 2021) Recently, one more element has emerged - stagnation in the housing market and the desire to get it moving, which will be discussed in the next part of the article.

The ability of the banking sector to provide cheap financing is one thing, but so is the demand for this financing, without which the authorities will not be able to achieve the desired result. This is the situation currently in China, especially among households which - scared by the situation on the housing market - have clearly lost interest in taking out mortgage loans. 

Main PBoC tools

As in every central bank, one of the most important roles is played by open market operations. Thanks to them, the central bank can influence the level of liquidity in the interbank market on an ongoing basis. It is no different in China. PBoC typically provides liquidity via 7-day reverse repo operations. (China Monetary Policy Report, 2022)

After the June reduction, this rate is currently 1.9%. In practice, although you rarely hear about it in the media, it is one of the most important interest rates. It is in the middle of the interest rate corridor. The cost of obtaining short-term liquidity from the central bank determines the cost at which commercial banks borrow funds from one another. This is reflected in the 7-day repo rate, which fluctuates daily. This is nothing more than the effective lending rate on the interbank market within 7 days. 

In turn, the limits of the rate corridor in China are the excess reserves rate and SLF (Standing Lending Facility) - both within 7 days. (Chan, 2017) Thanks to this, a sudden shortage of liquidity in the banking sector should not result in the effective interest rate leaving the corridor (unless liquidity stress occurs in an institution that does not have access to the central bank's balance sheet). In such a situation, you can always obtain liquidity at the SLF rate (also for a shorter period, which we will return to in a moment). The "floor" function is played by the excess reserves rate, which, however, has not been tested for a long time due to the high level of liquidity in the system. In practice, however, this rate is no different than the excess reserve rate implemented by the Fed, which absorbs excess liquidity among depository institutions. (Chan, 2017)

The above-mentioned reduction in the reverse repo rate by 10 basis points to 1.9% in June was, however, only the first move, but not the last, made by the PBoC at that time. All tenors within the SLF were also reduced and were unanimously reduced by 10bps. Earlier we mentioned the 7-day rate, which is an effective cap on interbank rates. In practice, banks also have access to other tenants of this type of loan, however, due to the high cost, interest is mainly directed towards one-day operations. (Chen, Ren & Zha, 2017) For example, in June, PBoC delivered CNY 3.5 billion, of which CNY 3 billion were operations with the shortest maturity, and the rest were 7-day operations.

Another option for obtaining liquidity, although in a longer term than under SLF, is MLF (Medium-Term Lending Facility). These are liquidity operations carried out by PBoC with a maturity of 1 year, the cost of which after the last 10 bp reduction is 2.65%. Hence it is noticeably lower than the cost of obtaining liquidity under SLF. It should therefore come as no surprise that SLF is only used as an emergency option. Hence, the volume of such transactions cannot be high. (Chin, 2013)

Regarding MLF, the picture is different. At the end of June, the volume of this type of transaction amounted to nearly CNY 5.2 trillion, which is a significant sum considering the PBoC's nearly PBoC balance sheet. As a reminder, all types of operations increasing the liquidity of the banking sector are reflected on the assets side of the PBoC. (Kennedy & Wang, 2021) The chart clearly shows that since 2016 there has been a significant change in the level of MLF use. It coincided with a change in the PBoC strategy, the effects of which were already described when analysing the balance sheet of the Chinese central bank. Since then, MLF has been an important element of commercial bank financing.

This way we have reached the most important interest rate in China, LPR (Loan Prime Rate), which is already used directly by credit institutions to grant loans to enterprises and households. (Chan, 2017) It was introduced only in August 2019 and is a result of 18 qualified banks sending offers of the LPR rate, which is generally linked to the cost of medium-term financing under the MLF. Banks can submit their quotes in steps of 5bp. Then, after removing extreme values, the arithmetic mean of the submitted values is calculated, which is published around the 20th of each month by NIFC (National Interbank Funding Center) and PBoC.

It is therefore clearly visible that the cost of obtaining liquidity under the MLF has a significant impact on the subsequent level of LPR rates. This does not mean, however, that these feet move on exactly the same scale. One more noteworthy issue: LPR rates are applied by banks to customers with high credit scores. (Chen, Ren & Zha, 2018) In the case of borrowers with lower ratings, banks have the opportunity to add a margin to the LPR, and in the case of customers with extremely high ratings, they can reduce this margin. However, in each case, LPR is a benchmark for credit decisions. The one-year rate is used primarily for corporate loans and non-mortgage loans for households, while the five-year rate is used for mortgage loans. Lastly, it is worth noting that in recent months, more and more loans have been granted below the LPR rate, which seems to be in line with the PBoC policy aimed at revitalising lending. (Yao, 2023)

References

Chan, S. (2017). Policy Challenges in Maintaining Renminbi Stability in China. Asian Survey, 57(2), 297–322. https://www.jstor.org/stable/26367751

Chen, K., Ren, J., & Zha, T. (2018). The Nexus of Monetary Policy and Shadow Banking in China. The American Economic Review, 108(12), 3891–3936. https://www.jstor.org/stable/26562921

Chin, G. T. (2013). Understanding Currency Policy and Central Banking in China. The Journal of Asian Studies, 72(3), 519–538. http://www.jstor.org/stable/43553524

China Monetary Policy Report Q1 2022 Monetary Policy Analysis Group of the People’s Bank of China. (2022). http://www.pbc.gov.cn/en/3688229/3688353/3688356/4583781/4584048/2022062209443031445.pdf

Kennedy, S., & Wang, Y. (2021). Cheap Talk: China’s Central Bank Still Struggles to Speak to Markets. Center for Strategic and International Studies (CSIS). http://www.jstor.org/stable/resrep28767

Prasad, E., & Zhang, B. (2014). Monetary policy in China. In The Oxford Companion to the Economics of China (pp. 194–199). Cornell University. https://doi.org/10.1093/acprof:oso/9780199678204.003.0030

Yao, K. (2023, September 27). China’s central bank to use “precise, forceful” policy to bolster recovery. Reuters. https://www.reuters.com/world/china/chinas-central-bank-keep-policy-precise-forceful-support-recovery-2023-09-27/