This section discusses the agenda for further financial reform in China toward a fully market-based system. It starts with a brief assessment of the achievements against which the thrust of the agenda can be gauged in the subsequent subsections. Reference is made to the decision of the Third Plenum in March 1993, which set out a blueprint for reforms during the remainder of this century (Box 1), and the section measures the progress of the reform program against that decision, describing options, possible alternatives, and potential pitfalls for the reform program.
Assessment of Achievements and Directions for Future Reform
Assessment
Section II has referred to the triangle of institutions, instruments, and markets as a useful tool for analyzing financial sector development. Sections III through VIII have presented a detailed account of the developments in various segments of China’s financial sector. A summary overview of China’s achievements thus far along the three axes is presented in Chart 13. The chart demonstrates the emphasis on institutional development in general and on the simultaneous development of institutions and markets in the foreign exchange system and the capital markets. By the same token, it indicates that the major efforts for the near future lie in further developing markets and instruments to complete the market-based character of the financial system. Further institution building is also required, even though several projects, such as the payments, clearing, and settlement system, are already well under way.
Achievements in Financial Sector Development
(Institutions, Markets, and Instruments) and Agenda for the Future
The perceived discrepancy between the well-advanced institution building and the less-advanced development of markets and instruments has its origin in two main factors: (i) the starting position of the Chinese financial sector at the beginning of the reforms; and (ii) the preference for an intermediate macroeconomic control mechanism in which the interventionist strategy continued to dominate de facto.
With respect to the first factor, the financial industry, unlike other sectors of the Chinese economy, was nonexistent when the reforms started. Institution building thus received priority treatment through the establishment of a two-tier banking system: the licensing of new banks, including branches of foreign banks; the emergence of a sector of nonbank financial institutions (NBFIs); and attempts to enhance the payments and settlement system.
This financial sector could gradually have been allowed to operate more in a market-oriented way; however, this did not happen because of the second factor, the authorities’ preference for an interventionist strategy. The lack of equal progress in developing markets (and instruments, to a lesser extent) seems to reflect the authorities’ preference for, and reliance on, an intermediate macroeconomic control mechanism. The monetary sector, in particular, was the focus of this control mechanism, in which control techniques of a planned economy continued to dominate de facto and market-based techniques operated only in a complementary role. This outcome stemmed from the authorities’ desire to use the newly established financial sector as long as possible as the main vehicle for their economic development strategy and from the lack of market mechanisms in the state-owned enterprise (SOE) sector.
The decision of the Third Plenum implicitly recognized that the imbalance between institution building and market liberalization in the financial system, if protracted, could impede the further liberalization of the economy. Thus, the logical next step, as set out in the decision, was to put the creation of efficient markets at the heart of the reform strategy.
The picture presented above also explains why further reforms in China can now—more than in the first 15 rather unique years of reform—benefit from the experiences of other countries that liberalized their financial system and adopted market-based monetary policy techniques. China’s financial system has arrived at that juncture where liberalization will need the most attention. Issues familiar to many countries in similar circumstances, including money market development, interest rate liberalization, bank restructuring, and the need for effective bank supervision and regulation, are in the spotlight.
Some General Principles
In order to put the future financial reform program in a broader context and before discussing specific issues, it is imperative to note those general principles regarding liberalization strategies that have emerged from the experience of other countries. To avoid major pitfalls while moving toward a predominantly market-based financial system relying on indirect instruments of monetary policy and, thus, to limit the cost associated with the transition that lies still ahead, a set of concomitant and mutually reinforcing reform measures has to be -considered. Country experience (Alexander and others (1995)) indicates the need to take a number of actions:
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Insulate monetary policy from deficit financing. Large fiscal deficits, often accompanied by unlimited monetary financing of these deficits, generally put monetary policy objectives under strain and reduce the effectiveness of indirect instruments of monetary policy.
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Strengthen and integrate money markets, including the infrastructure. Control by the central bank over the supply of reserve money is the fulcrum of indirect monetary control. Thus, a smoothly functioning market—usually the interbank market—for short-term bank liquidity (central bank money) that can signal and transmit the central bank’s actions to all market participants is essential for market-based monetary policy instruments. A prerequisite for smoothly functioning money markets is the availability of a reliable payments, clearing, and settlement system.
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Restructure the banking system and foster competition. For the rapid and transparent transmission of monetary policy actions, it is necessary that the banking sector—and the financial sector in general—be sound and competitive. If commercial banks are not able to respond to monetary policy signals by altering interest rates or liquidity conditions, those signals will not have the desired effects. A bank’s ability to respond may be impaired by such factors as management that is not used to a commercial environment, the absence of a hard budget or liquidity constraint, or a financial position so bad that the bank is unable to respond or can respond only in a perverse way. Fostering competition and liberalizing interest rates, therefore, inevitably go hand in hand.
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Adapt the supervisory and regulatory framework to market conditions. Stimulating competition among banks and liberalizing interest rates presuppose the presence of an effective supervisory and regulatory framework to foster prudential behavior by financial institutions. A set of prudential ratios, norms for financial reporting, and disclosure standards are essential elements of such a framework.
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Bolster the technical capacity of the central bank. A minimum requirement for a central bank using indirect instruments of monetary policy is a capacity to project demand for, and supply of, reserves and their impact on broader credit and monetary aggregates. Without this capacity, the central bank will not be in a position to decide on the volume and timing of its interventions. The central bank should also have the legal capacity to use the widest range of indirect instruments of monetary policy to preserve its flexibility.
Directions for the Future
As this overview makes clear, completion of the transition to a market-based financial system in China requires actions along the following lines. As is indicated in Box 1, most of these areas have been explicitly or implicitly recognized by the decision of the Third Plenum.
Institution Building
The newly enacted laws on the People’s Bank of China (PBC) and the commercial banks provide the proper legal framework for embarking upon the “commercialization” of the banking system and supporting orderly financial development. The description in Section III has revealed that a major overhaul of the structure and administrative organization of the four state-owned banks is needed. These banks are still largely based on the former command economy system, with a branch structure and hierarchy organized along political-administrative lines. The branches’ high degree of independence from headquarters makes liquidity management at a bankwide level difficult and impedes the deployment of indirect instruments by the PBC. The accounting system is also still based on command economy principles, and renminbi and foreign currency accounting is separated in the state-owned specialized banks.
The PBC’s task in capacity building lies more in the area of bank supervision than of monetary policy. Work in the latter area will have to concentrate on formulating monetary policy and preparing the infrastructure for the conduct of open market operations. The PBC should be a driving force in implementing the other reform measures discussed below to create the appropriate environment for the use of indirect instruments of monetary policy, that is, an interbank market, liberalized interest rates, and a payments system. Bank supervision that fulfills the requirements of a market system is still in its infancy.
The payments system is still largely cash driven, and the clearing and settlement functions are not yet up to the standards and requirements of more sophisticated financial markets, instruments, and transactions. However, a large project was launched in the early 1990s that will result in the establishment of China’s National Automated Payments System (CNAPS), a state-of-the-art payments, clearing, and settlement system, by the end of the decade.
Markets and Instruments
Financial market development has been quite different from that of many other countries. China has fledgling capital markets that provide a solid starting point for the development of more mature markets. The most urgent task lies in developing money markets, that is, markets for short-term funds. Well-functioning, nationally integrated money markets would not only enhance the effectiveness of indirect instruments of monetary policy but also support the capital markets in providing liquidity or funding, or both, for bond portfolios through either loans or repurchase agreements. Money market development has to go hand in hand with institutional and organizational reforms in the banking system, and with improvements in the payments system.
Capital market development has been significant, even though the market and its operations show marked contrasts. While the trade volume has been growing dramatically and the market infrastructure boasts sophisticated, well-functioning electronic trading and matching facilities, the markets are not totally integrated at the national level, which results in persistent price differentials and liquidity shortages. The most important market segment, the government securities market, suffers from the absence of short-term paper. Short-term securities, mainly traded by wholesale agents, would contribute to money market development and the introduction of market-based methods of monetary policy.
It is important for the development of the foreign exchange market to ensure equal access to the market for domestic and foreign banks and enterprises, to modernize accounting standards, and to further improve supervision and prudential regulations.
Inherently related to all aspects of market development is interest rate liberalization. The weak financial position of many SOEs and the prospects of insolvency for an increasing number of them has presented a major obstacle to the liberalization of interest rates; however, differences in perceptions among the authorities on the sequencing and the risks of a liberalization of interest rates have also played a major part in slowing down the pace of interest rate liberalization. Consequently, competition in the banking sector, although increasing, is still limited. While there is some nonprice competition, competitive behavior remains constrained by the institutional structure, formal and informal rules and regulations (such as the limited choice of banking for several customers), and the credit plan and its accompanying quota. As is shown by the experience of several other countries, interest rate liberalization will stimulate the development of new financial instruments and thus the diversification of money and capital markets.
The subsequent subsections review in more detail the steps needed to complete the transition to a market-based financial system. These steps relate to interest rate liberalization, the shift to indirect instruments of monetary policy, and the reform of the foreign exchange system.
Interest Rate Liberalization
The liberalization of interest rates in China is undoubtedly a critical—and probably the most difficult—aspect of financial reform. The Third Plenum has set interest rate liberalization by the year 2000 as one of the key actions, and it has become generally recognized that interest rate liberalization should be expedited. The main reasons for liberalizing interest rates are discussed in the next subsection. The following subsection reflects upon some structural impediments to a fast liberalization, and the final subsection presents current thinking in China on the liberalization process.
Reasons for Liberalizing Interest Rates
The main justification for expediting the liberalization of interest rates is the need for a more efficient allocation of financial resources in the Chinese economy. Even though interest rates have remained close to market-clearing levels, it is now generally recognized that liberalization of the interest rates will contribute to more efficient resource allocation in a full-fledged market system.62 Other reasons relate to the operation of indirect monetary policy instruments, the liberalization of the foreign exchange system, and the growing inconsistencies between the present rate structure and setting and the other reforms in the financial sector.
The effectiveness of indirect instruments of monetary policy greatly depends on the central bank’s ability to influence the commercial banks’ market behavior and thus their setting of prices. In other words, to the extent that indirect instruments are to become the dominant force in China’s monetary policy, interest rates need to be liberalized or at least given greater flexibility.
The opening of the Chinese economy to the rest of the world and the liberalization of the foreign exchange system in 1994 broke the fence that partially shielded domestic financial markets in China from outside markets. This liberalization makes domestic interest rate flexibility not only desirable but also necessary to support the exchange rate and to achieve domestic policy goals, such as combating inflation.
Also, interest rate administration in China is becoming increasingly cumbersome as a result of the rapid changes in the financial system. First, administering the large number of different interest rates set directly by the authorities and trying to maintain their parities are very difficult and cumbersome tasks. Second, under the present rate structure, banks are facing very narrow margins between lending and deposit rates; this will certainly pose problems in the future, when banks will have to make more provisions for loan losses and competition in the market becomes fiercer. Third, the present interest rate structure gives little incentive for the commercial banks to try to raise funds by increasing the deposit base. By financing their credit operations for one year or more through the PBC, banks earn a larger spread and incur lower overhead costs than by using deposits. In such circumstances, the constant pressure on the PBC to extend credit to the commercial banks limits the PBC’s freedom to use its lending as a policy instrument.
Finally, the current dual system of interest rate setting—the coexistence of fixed interest rates to be used by the state banks and freer interest rate setting available to other financial institutions—is a source of distortions.63 The dual interest rate system, besides making arbitrages possible that can fuel speculative activities, results in a segmentation of the money market that will delay the contribution of interest rates to improving the allocative efficiency of financial resources.
Structural Impediments
SOE Impediments
For the liberalization of interest rates to be successful, other countries’ experiences suggest that the main economic players (enterprises and financial institutions) should be subject to hard budget constraints to avoid adverse selection problems. Without such constraints, credit could be directed to the most risky borrowers and projects. The recognition of these risks turns the reform of the SOEs into a crucial issue.64 Many SOEs are operating with extremely narrow profit margins or are incurring losses.65 Any significant increase in interest rates would rapidly erode those margins and make more enterprises unprofitable. Thus, there is the risk that, if interest rate liberalization is not accompanied by reform of the SOEs, more enterprises will become loss making.
Moreover, interest rate liberalization might fail because of the inverse reaction of insolvent and nonprofit firms to the higher rates that would follow from the liberalization process. Indeed, for SOEs with soft budget constraints, the availability of credit is more important than its cost. Such SOEs would not necessarily be deterred from borrowing at a higher cost; they would simply continue, if they could, to borrow whatever they needed to finance their losses. Some banks might continue lending to such firms, assuming that these loans were ultimately guaranteed by the Government. Raising interest rates in this situation would increase rather than decrease the quantity of credit and, therefore, not produce the desired monetary restraint. The increased demand for credit might drive the interest rates up to such high levels that the cost of borrowing exceeded the expected return on a firm’s assets by a significant margin, turning solvent, profit-making firms into insolvent ones. Interest rate liberalization might thus have the opposite of the intended effect: it might keep the insolvent borrowers in the market and push the solvent borrowers out of the market.
Reforming the SOEs also involves reforming large parts of the economic and social system. In order to ensure that enterprises are subjected to the discipline of the market, the heavy social burden imposed on them must be addressed, including the provision of employment, social security, and such services as housing and education.
Banking System Impediments
Banking system reform is closely related to SOE reform.66 Sustained monetary equilibrium requires not only an efficient mix of macroeconomic policies geared toward price stability but also a sound and competitive financial sector whose behavior can be influenced by interest rates signals. There is growing evidence that uncompetitive banking systems and inadequate regulatory frameworks weaken the efficiency of credit allocation, distort the structure of interest rates, and disrupt the transmission of monetary policy signals, with adverse consequences for macroeconomic stabilization.
Progress has been slow in the commercialization of the state-owned commercial banks. These banks continue to face serious structural problems, including significant portfolios of nonperforming loans extended to the SOEs. In the coming years, much progress in commercializing the four state commercial banks is to be expected from the separation of policy and commercial lending, the transfer of the existing stock of policy loans in the portfolios of the state commercial banks to the policy lending banks, the implementation of autonomous financing schemes for the policy lending banks, and the reform of the banks’ accounting and tax system.67 Competition in the banking sector will also improve with the growth of the NBFI sector. The separation of banking and security business activities—which will require the divestment of many NBFIs by the state commercial banks—and the possibility of allowing foreign banks to engage in domestic currency operations on an experimental basis will also stimulate competition.
The enhancement of PBC prudential supervision—a necessary complement to interest rate liberalization—will help strengthen the commercialization of banks. Initial steps already undertaken include the generalization of guidelines on asset-liability management and the requirement that banks meet capital adequacy requirements in line with the Basle standards.68 In addition, the adoption of a loan classification system to identify nonperforming loans and a prescribed gradual increase in provisions for loan losses will facilitate the assessment of the portfolio quality of banks at a later stage.69 All these reforms will most likely introduce or strengthen the emphasis on profitability in the banking sector and, hence, change the banks’ behavior toward interest rate signals.
Forces for Divergence Among Regions
Another legitimate concern regarding interest rate liberalization is its impact on the regions in China (see also Box 9). In a market-based financial system, the allocation of funds has a more anonymous character than in a planned economy. As the “market” sectors grow, the influence of the authorities on the sectoral and geographic allocation of resources through monetary policy will diminish, compared with a system in which a credit plan dominates. At present, the incomplete integration of the markets in China allows the central bank to intervene in one part of the country without spreading the effects of its intervention across the country. The de facto financial integration that will take place under financial liberalization will make money fully fungible and will bring into effect both converging and diverging forces among regions. Convergence will be supported by the tendency of the funds to flow to low-cost areas, while divergence could take place because funds will tend to flow to regions with higher return rates or because local borrowers in lagging regions do not meet the eligibility standards of the banks. Divergence trends will increase the present gap between rich and poor regions in the country and lead to more social and political tensions. As it is unclear whether converging or diverging forces will have the upper hand, the Chinese authorities prefer to liberalize interest rates gradually, as that approach will enable them to correct along the way any major increase in the existing divergences.
Plans for Interest Rate Liberalization
The decision of the Third Plenum called for a reform of interest rate policies and vested the power to formulate interest rate policy in the PBC under the direction of the State Council. This power has been confirmed in the 1995 PBC law. The decision also called for the establishment of a market-oriented rate system by the end of the year 2000.
Interest Rate Liberalization and Regional Disparities in China
The theory of regional development and disparities has been developed in the context of market economies: What will be the impact of freely moving production factors on the relative development of regions? This body of theory has also been applied to economic integration, more particularly in the context of the European economic integration: How will the removal of barriers to trade and to the movement of persons and capital across national borders affect the relative wealth of countries and regions in Europe?
By analogy, elements of this theory can also be applied to understand some of the mechanisms underlying the transition from a planned economy to a market economy. The transition from plan to market implies the removal of restrictions on trade of goods and services and on the mobility of people and capital. In general, an economy becomes less segmented when moving from plan to market, and the subsequent integration process can be compared with the economic integration of separate national states.
Economic theory can give some guidance regarding the likely effects of integration; however, it cannot give a clear-cut answer with respect to the emergence and disappearance of regional discrepancies in growth and wealth. It remains very much an empirical question as to whether convergence or divergence will have the upper hand in economic developments in any given country or group of integrating regions or countries.
The “convergence school” postulates that free movement of goods and services will equalize factor returns and living standards. However, this theory uses very strong assumptions that are embedded in the neoclassical theory of international trade. The “divergence school” emphasizes those mechanisms in the economy that will work toward greater divergence, rather than convergence. When barriers to trade and movement disappear, the attractiveness of highly industrialized centers for the location of new activities will increase, and, hence, the divergence among regions will increase. Nevertheless, some authors have stressed that, while these divergence factors may play a role, there will also be counteracting factors, such as enterprises’ willingness to take advantage of lower costs in backward regions.
One interpretation of recent developments in China would be that the planned economy has tried to overcome, through the planning mechanism, the tendency toward regional divergence that is visible in market economies. The reforms in China were meant to introduce market elements in the economy. This reform process has introduced greater disparities among regions. More particularly, the policy of establishing Special Economic Zones (SEZs) has favored economic development in such areas as the coastal regions to the detriment of other parts of the country. The removal of the barriers imposed on labor mobility has probably increased the polarization.
However, there were also countervailing forces at work. The credit plan and the use of selective and subsidized credits left the authorities with one instrument to counteract some of the polarization trends and to allocate capital in those areas that tended to be lagging.
These countervailing policies kept some of their effectiveness because of the existence of barriers in the financial markets: there was no national interbank market; and interest rates were administratively set, so that capital could not freely move according to expected returns. Nevertheless, it seems clear that the divergence induced by the unleashing of market forces in some regions has been greater than the convergence forces behind the Government’s policies.
The move toward a market-based monetary and financial system in China will be the next step in “marketizing” the economy. In a market-based financial system, the influence of the authorities on the sectoral and geographical allocation of funds will diminish compared with a situation in which the credit plan is effectively used. For instance, the People’s Bank of China (PBC) mopped up liquidity in some parts of the country in 1993 through the sale of PBC bills and made this liquidity available in other parts of the country. In an integrated financial system where indirect monetary instruments prevail, this type of intervention will become impossible or at least ineffective. These visible forces will be replaced by a more anonymous allocation process. The effects of the financial integration that will follow from financial liberalization will be similar to the effects of the integration of the real economy. Convergence will be supported by two factors. First, as noted above, funds will tend to flow to low-cost areas. Second, increased competition in the financial sector will enlarge the availability of credit for local borrowers in lagging areas.
Divergences could increase among regions, however, because funds will tend to flow to regions with the highest return rates or because local borrowers in lagging regions do not meet the eligibility standards of the banks.
The transition from a segmented to an integrated economy in China bears some resemblance to the gradual financial integration in the United States in the first decades of this century and in the European Union at present. In the United States, segmentation disappeared because of improved communications and transportation. In Europe, national markets are being united with the removal of national borders, which were obstacles to free trade in financial services.
Most countries worldwide have introduced policies or mechanisms to reduce internal welfare discrepancies among regions. The European Union, for one, has established from its inception in 1958 several mechanisms to reduce the social and economic discrepancies among its countries’ regions. However, both literature and country experience indicate that in Europe and elsewhere these mechanisms have had only a limited positive impact on regional developments and often have not achieved the intended goals or, even worse, have introduced other distortions. It seems, therefore, important to be very cautious when introducing mechanisms intended to eliminate regional distortions. As part of the strategy under the (current) Ninth Five-Year Plan, it was decided in 1995 that no more SEZs would be allowed. However, more cities in the underdeveloped interior would be opened to foreign investors. This plan recognized the need to narrow income disparities in China.
In light of these considerations, it has become relevant for China to revisit the current regional policies, which tend to favor the more prosperous regions. While such policies were justified in the initial stages of the reform process, they now seem to widen the gap between rich and poor regions, thereby adding to the problems involved in interest rate liberalization.
If needed, other mechanisms has become could also be selected that, based on the experiences of other countries, are not likely to introduce new discrepancies in financial markets or among the regions. Mechanisms and policies used in other countries can be divided into two broad categories: (i) specialized financial institutions, and (ii) automatic fiscal stabilizers. The use of specialized financial institutions to alleviate regional problems has a mixed record. Therefore, the second approach—the use of automatic stabilizers—deserves closer attention from the Chinese authorities. Some countries—particularly federal states, such as the United States and Germany—have introduced budgetary mechanisms that automatically channel funds from richer to less prosperous states or regions according to specific formulas. These automatic stabilizers usually prevent the regional discrepancies from increasing.
The PBC’s program for interest rate liberalization designed in 1995 in response to the decision of the Third Plenum calls for a gradual approach, based on the belief that China is not ready for an immediate, total liberalization of interest rates. According to this program, the liberalization of interest rates needs to be managed with flexibility, taking advantage of progress in the stabilization of the economy and in structural reforms. Cutting down inflation is seen as a prerequisite, as this would also facilitate the solving of structural problems. Lower inflation rates would allow a return to positive real interest rates, a narrowing of the gap between official and unofficial interest rates, more flexibility in setting administered interest rates, and a reduction of the magnitude of interest rate subsidies.
A first measure following the adoption of these principles in 1995 has been to increase flexibility in the conduct of interest rate policy. For instance, rates have been changed more frequently to signal to the markets the adoption of new strategies; the number of preferential rates has been decreased by eliminating some and merging others; the Government has switched to the use of direct subsidies in the agricultural sector; and international standards for calculating loan rates are gradually being adopted.
Liberalization is planned to be accomplished in three stages, with interbank market, lending, and deposit rates liberalized in turn. (The interest rates in the newly established interbank market were liberalized on June 1, 1996.) The rationale behind this sequencing is that the liberalization of the interbank rate is deemed to have the least political and social exposure, and that lending rates have already been partially liberalized. Deposit rates are scheduled to be liberalized last because it will take longer for the population to become accustomed to a different way of setting these rates, and also because savings mobilization has so far not been a problem in China. The timing of the liberalization of government securities rates (both short term and long term) as part of this plan has not yet been determined.
Different options are being contemplated for liberalizing bank lending rates. One option would be to follow and broaden the approach adopted since the end of the 1980s, that is, to allow institutions to mark up above the benchmark rates set by the PBC. Another option is to liberalize in order of the types of institutions, with NBFIs and urban credit cooperatives liberalized first, followed by other commercial banks and state commercial banks. Opponents argue that this approach would create unfair competition. A third option would be to liberalize the rates in some regions earlier than in others. However, it is argued that such an approach could provoke undesirable flows between regions and, in fact, reinforce current regional disparities. In order to ensure transparency in the market and to promote fair competition, consideration is also being given to establishing a mechanism to monitor banks’ interest rate spreads.70
The sequencing proposed by the authorities is in line with the approach adopted by several countries. The logic behind this sequencing is that the educational process that necessarily has to accompany nterest rate liberalization should be gradually spread from a core group of sophisticated market parties (bankers and the government) to a wider group of less sophisticated participants (enterprises and the general public).
Phases in the Formulation of Monetary Policy in Selected Countries
During the past three decades, countries have gone through three phases in their approach to monetary policy making. The discretionary approach dominated until the late 1960s in the first phase, the “postwar” phase. The second phase, in the 1970s and 1980s, saw an attempt to identify and follow rules. The most recent period has witnessed the third phase, a return to discretionary policy making.
Because the gold exchange standard prevailed during the postwar period (the first phase), the scope for discretionary monetary policy was limited but by no means absent. For the anchor country (the United States), the exchange rate was not much of a constraint on monetary policy, and the obligation to maintain convertibility of the dollar into gold was of notional significance only. Even the other countries in the system had considerable freedom to implement independent monetary policies, given the existence of exchange controls. During this period, most central banks operated their monetary policies through the adjustment of interest rates in response to perceived changes in demand conditions.
The collapse of the fixed exchange rate system triggered the search for a new anchor for monetary policy. This search was expedited by the surge in inflation that followed in the wake of the first oil shock. The finding in the United States and in a wide range of other countries of a stable relationship between changes in money aggregates and changes in nominal income intensified the interest in monetary rules and supported the formulation of new monetary policy arrangements. Thus, in the second phase of monetary policy, the majority of industrial countries began to use monetary targets. In general, targets were set in terms of broad money rather than base money because broad money was the aggregate theoretically related to income. However, for the three years from 1979, the United States targeted base money to reinforce the public perception of a determined anti-inflationary policy.
Monetary Targeting by the Group of Seven Industrial Countries
Monetary Targeting by the Group of Seven Industrial Countries
| Country | Target | Year Started |
|---|---|---|
| Germany | Central bank money | 1975 |
| Canada | M1 | 1975 |
| United States | M1 | 1976 |
| France | M2 | 1977 |
| Japan | M2 + CDs | 1978 |
| United Kingdom | M3 | 1979 |
| Italy | M2 | 1984 |
Monetary Targeting by the Group of Seven Industrial Countries
| Country | Target | Year Started |
|---|---|---|
| Germany | Central bank money | 1975 |
| Canada | M1 | 1975 |
| United States | M1 | 1976 |
| France | M2 | 1977 |
| Japan | M2 + CDs | 1978 |
| United Kingdom | M3 | 1979 |
| Italy | M2 | 1984 |
Countries experienced a fall in inflation following the peak of price increases in the early 1980s. However, it is not clear that the pursuit of intermediate policy targets was the only cause of this success. Indeed, most countries missed their monetary targets, and they did not always move quickly to come back down to the prescribed growth path.
Most recently, in the third phase, the Group of Seven industrial countries has downgraded monetary rules since the late 1980s. The United Kingdom dropped broad money targets in 1986 and continued to monitor only base money (MO). Japan reduced the emphasis on monetary aggregates in 1992. Since the end of the experiment with base money control in 1982, the United States has been gradually deemphasizing monetary aggregates. In 1993, Federal Reserve Chairman Greenspan stated that M2 had been downgraded as a reliable indicator of financial conditions in the economy, and that no single variable had been identified to take its place. France, which shifted from M2 to M3 in 1991, has set only a medium-term objective since 1994. Canada reduced the emphasis on monetary aggregates as early as 1982; from 1982 to 1991, monetary policy was carried out with price stability as the longer-term goal but without intermediate targets, and targets for reducing the rate of inflation were officially announced in early 1991.
Developments in Asian countries have followed along the same lines. Indonesia adopted interest rate targeting following the financial reforms in 1983 because of concerns that targeting monetary aggregates could result in undue increases or instability of interest rates, with possible adverse effects on output. By the end of the 1970s, Singapore approximated the textbook model of an open capital market that was fully integrated with global markets. The choice of targeting the exchange rate was determined by the openness of the trade account, which suggested that monetary policy would be most effective if the exchange rate were adopted as its intermediate target. In addition, exchange rate policy is used in Singapore to mitigate external inflationary pressures. In Korea, monetary targeting is still at the core of the monetary policy framework. However, the annual growth target for M2 has been applied and interpreted flexibly in recent years. Within an annual target range, the approach allows for significant deviations from quarterly targets. It is intended to preserve the advantages of monetary targeting—namely, its nominal anchor function and the maintenance of credibility—while capturing the benefits of some degree of discretion.
The historical record indicates that countries that maintained a fast pace of financial liberalization often experienced large disturbances in their demand-for-money relationships. Countries that went through less far-reaching reforms or were slower to implement reforms could place continued reliance on these relationships, although judgmental departures from monetary targets have also proved increasingly necessary. Most countries’ experiences indicate that monetary targeting should try to find a balance between rules and discretion. Approaches that were satisfactory need to be reviewed as the financial system becomes more sophisticated and the external sector becomes more open. More generally, the recent downgrading of monetary targeting in the third phase of monetary policy coincides with a better control of inflation and the globalization of the international financial markets. Both developments seem to indicate that monetary targeting is most appropriate to fight strong inflationary pressures in the fast-disappearing closed economy model.
The pace of liberalization (with the year 2000 as the target) should be monitored constantly. While it is true that other conditions need to be fulfilled for successful liberalization (such as SOE reform), too long a transition period may lead to new distortions in the financial system. One major distortion that emerged in several countries that went through long transitions is disintermediation, which often stemmed from an early liberalization of the interest rates in the NBFI sector.
The Shift to Indirect Monetary Policy
The Third Plenum mandated the PBC to adopt a framework of indirect monetary policy instruments by 2000. Given China’s present exchange regime, which is designed to stabilize the exchange rate, the effectiveness of such an indirect framework will depend on the degree of control that the PBC can exert over its claims on the banking sector, such that changes in that balance sheet item can offset the impact on banks’ reserves of fluctuations in net foreign assets. The establishment of reserve requirements in the early years of financial reform and the efforts made by the PBC to centralize its credit to the commercial banks support the development of liquidity management through indirect instruments.
The next steps in the process of reforming monetary policy consist of defining a framework of intermediate and operational targets, refining the existing indirect instruments (reserve requirements and PBC lending to the banks), introducing open market operations, and putting these instruments together in a consistent framework. In establishing this indirect instrument framework, building the appropriate infrastructure to use these instruments efficiently and effectively seems to require more effort than designing the instruments.
The Target-Instrument Framework
M2 as Intermediate Target
In 1994–95, the PBC made substantial progress in defining a monetary policy framework. While the authorities pursued an exchange rate objective (the stability of the renminbi against the U.S. dollar), they also defined an intermediate target in terms of broad money—M2. Empirical studies suggest that the demand for the three major aggregates in China—currency, narrow money, and broad money—underwent a structural change in 1988, owing to the introduction of a secondary market in government securities and of new financial assets at more market-determined interest rates (Tseng and others (1994)). However, because of the relatively stable long-run demand functions for the monetary aggregates in the post-1988 period, these studies also suggest that monetary targeting can be a feasible exercise. Demand for M2 seems to be more stable than demand for any other aggregate. Further research is still needed in this area, particularly because ongoing financial reform and innovation may alter the relationships between the respective monetary aggregates and their right-hand variables, such as real GDP, inflation, and interest rates. Box 10 provides an overview of recent approaches to monetary policymaking in industrialized and selected developing countries. The overview indicates that the role of intermediate monetary targets has been downplayed since the late 1980s.
Interest Rates as Operational Target
The selection of an operational target has not been debated much thus far in China, mainly because full reliance on an indirect instrument framework is not expected for some time yet. The choice for most countries is usually between a quantitative variable, such as the central bank’s net domestic assets or base money, or an interest rate. Preference for a quantitative target is often justified on the grounds that bringing high inflation under control is the central bank’s main objective, or that financial markets are not yet sufficiently developed to rely solely on interest rate signals. The main disadvantage of using a quantitative operational target is that its pursuance may induce some undesirable interest rate fluctuations.
Most industrialized countries—which have sophisticated financial markets—rely on short-term interest rates as their operational targets. As is explained in Box 11, two stylized models encompassing a broad spectrum of variants can be adopted. At one extreme, the central bank stays close to the market and intervenes frequently. At the other, the central bank tends to keep a distance from the market by letting it stabilize itself.
As interest rates are liberalized and financial markets develop, the PBC will have to design a framework following one of these two models—or any variant of them—and redesign its instrument framework accordingly. The design of the framework should be based on the PBC’s market philosophy (which emphasizes intense involvement versus maintaining a distance), but the choices will be limited in the initial years and determined more by the availability of timely and comprehensive statistics. A more distant approach might thus be necessary in the near future.
Monetary Policy Instruments
Most likely, the PBC’s future policy framework will consist of open market operations as the central instrument, supported by reserve requirements and central bank lending or standing facilities. Several technical issues will need to be discussed, such as the relative importance of these various instruments and the proper design of each of them, so that they together form a consistent framework allowing the PBC to absorb and inject liquidity in the financial system in a flexible way. Designing a consistent framework will also facilitate a break with the recent past, in which, as detailed in Section III, the PBC was forced to resort to a multitude of instruments (including PBC financing bills, the recall of loans from banks, and special deposits) to achieve its goals of containing inflation and restoring order in the markets.
The following discussion concentrates on reserve requirements and standing facilities (PBC lending to banks); the conduct of open market operations basically depends on the availability of an adequate micro structure for such operations and is therefore dealt with in the subsequent subsections.
Reform of reserve requirements could include the unification of the present two-tier system, once the payments system is working more efficiently, as well as the introduction of averaging procedures. A precondition for easy monitoring of reserve requirements is their aggregation at a bankwide level, instead of the current procedures, in which each bank branch holds its required reserves at the PBC branch at the same administrative level.
For two reasons, PBC lending to banks will remain an important monetary policy instrument, at least in the medium term. First, the banking system as a whole—largely because of the financial position of the state commercial banks—shows a structural dependence on PBC credit, a situation that needs time to be reversed.71 Second, among the range of monetary instruments readily available, PBC credit to banks is potentially the most flexible, particularly because open market operations will, at least in the near future, be too limited in scope to be relied upon solely for liquidity management. Thus, PBC lending facilities should be the main device to inject planned amounts of liquidity into the system.
To enhance the effectiveness of this instrument, it will be necessary in general to move from automatic lending to lending at the PBC’s discretion, in line with its monetary program. This shift entails moving from prefinancing arrangements toward refinancing mechanisms. Although the design of new mechanisms for PBC lending has not yet been completed, it appears that—in the context of the overall framework for monetary policy instruments—such a design could be along the following lines.72
The first instrument could be a refinance window, through which the PBC provides liquidity on a regular basis to fill the present structural gap of bank resources. The centralization in 1994 of the bulk of PBC credit at the level of the head office was a first step in this direction. Credit could be auctioned in a system in which the PBC sets either the volume (and lets the market decide on the interest rate) or the interest rate, depending on the objectives that it has in mind.
In using this refinance window, two principles should be followed. First, the volume of PBC lending should be determined on the basis of prevailing monetary conditions as derived from a monetary programming framework, with the aim of preventing the formation of excess reserves.73 Second, the duration of this facility should be short (one week, for instance) to enhance the flexibility of the PBC’s interventions. For this lending window to operate effectively, it has to be supported by a liquid and integrated interbank market, so that liquidity can flow effectively between banks and regions.
Monetary Policy Framework Models That Focus on Interest Rates as the Operational Target
Industrialized countries that fully rely on indirect instruments use basically two stylized models of monetary policy frameworks, with a broad spectrum of variants encompassing these two extremes. The choice of a model depends on the philosophy that the central bank wants to adhere to in its relations with the markets, the stage of development of the financial markets, the technological infrastructure in the markets, and the availability of a timely statistical base.
In one model, the central bank tries to peg the money market rate(s) very narrowly through its open market operations. To achieve this goal, the central bank has to intervene frequently in the market throughout the day. Other instruments, such as required reserves, may be used in this model, but they do not play an active role. The central bank may also have a discount facility at its disposal, but the monetary policy role of this instrument is limited. In this “interventionist” model, open market operations fulfill several goals: they provide and withdraw liquidity, and they are used to steer money market rates and signal changes in the monetary policy stance. This model of permanent presence in the market (which is very much like the U.K. and U.S. models) requires timely statistical information about the markets and highly developed financial markets.
The other extreme is a model wherein the central bank keeps a distance from the market and lets the market to a large extent stabilize itself within the boundaries set by the central bank. In this model, central banks set an interest rate corridor within which market rates can fluctuate, generally by introducing a Lombard facility (at the top of the corridor) and a deposit or discount facility (at the bottom of the corridor). Changes in the two interest rates related to these central bank facilities have a signaling function for the market (as they indicate a change in the stance of monetary policy). Within the corridor, the central bank resorts to open market operations to steer market rates, if deemed necessary.
This instrument could be supplemented by a type of Lombard facility that would help (branches of) financial institutions settle their end-of-day positions on the books of the PBC. As banks are not yet managing their liquidity on a centralized basis, there might be a need to decentralize this instrument temporarily. The rediscount facility currently operated by the PBC branches under the supervision of PBC headquarters could, with a few transformations, perform the functions of this instrument.
The Supporting Infrastructure
Since the Third Plenum decision in 1993, the PBC has been working steadily to develop supporting measures for open market operations, including a monetary forecasting framework, an integrated interbank market, and clearing and settlement arrangements in support of open market operations.
Liquidity Forecasting Framework
Success in achieving monetary and inflation objectives within a framework of indirect monetary policy depends in part on the PBC’s ability to forecast money demand in particular and liquidity developments in general. A reliable forecast for money demand will allow the PBC to set a domestic credit target consistent with the inflation objective. Because China is in the middle of a comprehensive financial sector reform, estimating money demand for forecasting purposes and the related design of a monetary program might be a difficult exercise.
The PBC has recently embarked upon a comprehensive program to identify a money demand function that can be used for policy purposes, as well as functions to forecast inflation, net foreign assets, and other net assets. These estimates will lay the foundation for a liquidity forecasting program that will enable the PBC to plan its monetary policy interventions in the emerging environment. Mainly because several of the required statistics were not available or needed under the planned economy, it will be necessary in this effort to overcome several deficiencies in the statistical apparatus.
An Integrated National Renminbi Interbank Market
In line with the mandate given by the Third Plenum, the PBC started preparing in 1995 for the establishment of an integrated national renminbi interbank market that would supersede the present infrastructure. This work reflects the growing recognition of the importance of an interbank market for the conduct of indirect monetary policy and for money market development in general (Box 12). In light of developments in 1988–89 and again in 1993, when the interbank market helped to fuel speculative financing, the authorities considered that the establishment of this market infrastructure and the liberalization of the interbank rate should be accompanied by measures to create order in and standardize the operations of the interbank market. The PBC’s intention is to restore orderly conditions, so that the inter-bank market does not function again as a channel for speculative financing but instead contributes to the development of a broader money market in China and to the transmission of monetary policy. Enhanced efficiency, transparency, and self-discipline are the main goals of the project.
Interbank Market and Financial Reforms
At the initial stage of financial reform, the establishment of a domestic interbank market is crucial. Such a market is required whether the central bank uses outright open market operations or refinance instruments. Indirect instruments of monetary management operate through changes in the volume of reserves of banks, with which they can settle transactions between themselves (interbank transactions) on the books of the central bank. The decision to change this volume must necessarily rest on the knowledge of the banking system’s needs for “settlement funds,” and changes in the price for such funds (the interbank market rate) will have an impact on other money market interest rates. Bank reserves can be affected through changes in central bank credit to the banks or through open market operations. Hence, the interbank market plays a major role in transmitting the central bank’s policy actions into changes in the behavior of commercial banks, lenders, and borrowers. These behavior changes, in turn, will affect the growth of the monetary aggregates and, more important, the pace of economic activity.
The central bank also has to play an active role in market development. The introduction of indirect instruments at an early stage—even if they cannot be fully effective—can be essential to developing financial markets in general and the interbank market in particular.
The importance of a nationally integrated interbank market for the efficiency and effectiveness of indirect monetary policy has recently been recognized in China. The reform of the interbank market raises four main issues concerning (i) the involvement of the central bank, (ii) the participants in the market, (iii) the degree of centralization of the market, and (iv) the role of the interbank market in the conduct of monetary policy.
With respect to the involvement of the central bank, a common feature in many countries embarking on financial reform is the development of the interbank market as a stage-by-stage process, which requires the central bank to take the initiative to promote interbank trading. In Turkey,1 owing to a variety of factors, some more political than economic, the banking system was highly segmented. Public sector banks were reluctant to lend to private banks not only because of an assessment of commercial risk but also, and perhaps more important, because of political considerations. Similarly, private banks tended to minimize their transactions with other commercial banks owing to competition. In particular, many of the private commercial banks in Turkey belong to different industrial groups. Competition and rivalry among these industrial groups often led to a reluctance on the part of their banks to deal with each other directly and, in particular, discouraged almost completely lending between banks. As a result, an interbank market did not exist in Turkey. However, banks were willing to lend to other banks if their counterpart was the central bank. This situation prompted the central bank to act as a blind broker (the counterpart of all transactions). In order to cover the credit risk, all transactions intermediated by the central bank had to be backed by acceptable collateral, such as government securities.
In Thailand, a repurchase market within the central bank was created in 1979 to further develop the fledgling money market and provide the central bank with a mechanism to monitor and, if necessary, intervene in the market. Participants are allowed to place buying and selling orders with the central bank, indicating the amount, interest rate, and maturity of the desired transactions. The central bank then tries to match the orders and determine a single “market” repurchase rate, that is, a fixing. If needed, the central bank intervenes to absorb or inject liquidity.
In Italy, although an over-the-counter interbank market had been operating for a long time, the central bank was prompted to take action because oligopolistic behavior led to segmentation of the market, and the related excessive volatility impeded the use of interest rates as a channel to transmit monetary policy. In 1990, the central bank promoted the establishment of a screen-based interbank market, accompanied by a thorough modernization of the payments system, enabling a real-time, direct movement of funds on banks’ centralized accounts with the central bank. Participation in the system is on a voluntary basis, and participants agree to abide by a set of clear and binding procedures. All interbank transactions among participants on contracts quoted in the system are carried out on the screen-based market and are cleared through the clearinghouse or by entries in the centralized accounts with the central bank. Transactions outside the system are allowed, and nonparticipant banks can freely trade among themselves in all types of deposits on the over-the-counter interbank market.
The involvement of the People’s Bank of China in the interbank market is seen in China as a means to restore orderly conditions so that the interbank market does not function as a channel for speculative financing, as occurred in 1988–89 and again in 1993, but instead contributes to the development of a broader money market and to the transmission of monetary policy.
Concerning the participants in the market, it should first be noted that a money market is a market that provides economic entities, such as financial institutions, business firms, the government, and individuals, with various kinds of instruments to intermediate their short-term demand for, and supply of, funds. The money market typically includes a repurchase market, secondary markets for securities (treasury bills, commercial paper, and negotiable certificates of deposit), and the interbank market (or call market). As such, the interbank market is the segment of the money market in which financial institutions can trade their deposits held at the central bank. As a consequence, participation in the interbank market is generally confined to financial institutions with current accounts at the central bank. Therefore, interbank markets may or may not include nonbank financial institutions (NBFIs), depending on whether they are authorized to maintain current accounts with the central bank. Only Korea (among the countries discussed here) offers the case of participation by NBFIs, although they are not allowed to maintain settlement accounts with the Bank of Korea.
With respect to the degree of centralization of the interbank market, direct transactions between participants in the interbank markets are allowed in all the countries under review. In Turkey, the establishment of an “official” interbank market intermediated by the central bank does not preclude direct transactions between banks. Moreover, the establishment of the official market was seen only as a temporary arrangement to educate participants and thus facilitate direct transactions. The centralized market structure in Italy is on a voluntary basis. Although it was established under the leadership of the central bank, it operates outside the central bank, which provides only settlement arrangements in support of market transactions. In Thailand, the repurchase market operated by the central bank does not preclude direct transactions between participants. In Korea, participants have the freedom to trade either through a broker system or directly. In Malaysia, the interbank market is an over-the-counter market in which participants are free to trade between themselves, with interbank brokers playing an active role.
With respect to the role of interbank markets in the conduct of monetary policy, central banks often deem it appropriate to be directly involved in the development of interbank markets because it is in that segment of the money market that monetary operations, such as credit auctions or repurchase agreements, are likely to take place. Moreover, the interbank market rate is often used as an operational target or a main indicator for the central bank (the federal funds rate in the United States, for instance). As such, the interbank market is the natural playground of central banks. The involvement of the central bank in interbank market development has increased with the shift to indirect instruments of monetary policy and, more particularly, to open market operations.
However, specific operating procedures differ among central banks, according to the stage of development of the various segments of the money market. In the United States, open market operations are conducted in the secondary market for government securities, while the federal funds rate is the operating target. In Thailand, the central bank operates a fixing mechanism for its repurchase window, whereas in other countries the central bank conducts direct bilateral transactions with market participants at the prevailing conditions. Except for the United States and Italy, where open market operations are conducted in the secondary market for government securities, such operations tend to be conducted primarily in the interbank market because that segment of the money market has the highest degree of liquidity.
The desire to develop liquidity management also induced changes in the way that the required reserve ratio operates. In Thailand, Turkey, and Italy, the central bank shifted to an averaging of daily balances in measuring the compliance, in order to limit the volatility of interest rates.
1 References to other countries are based on discussions held in a seminar on Interest Rate Liberalization and Money Market Development, jointly sponsored by the Monetary and Exchange Affairs Department of the International Monetary Fund and the People’s Bank of China (PBC), and held in Beijing during July 31-August 9, 1995. The experiences of Korea, Malaysia, Thailand, Turkey, Italy, and the United States were presented and discussed in light of the tentative plans prepared by the PBC. See also Mehran, Laurens, and Quintyn (1996).As implemented (on January 1, 1996), the interbank market consists of two levels. The first level—the National Interbank Trading Center—links the headquarters of the commercial banks and 35 Regional Financing Centers (RFCs). The National Interbank Trading Center is an electronic system that provides market information and a framework for trading. The second level is the 35 RFCs located in 35 provinces, autonomous regions, and cities with independent planning status, as well as the subcenters of the RFCs. These centers and subcenters link the branches of banks at the various administrative levels. Some of these centers have taken a shareholding form; others are organized according to a membership model; and, in limited cases, the PBC acts as an RFC.
Trading at the first level is done directly between the participants, which are allowed to select their counterparts independently and agree on interest rates for the transactions. Settlement is done directly between the parties through their accounts at the PBC. At the second level, the RFCs are parties to each transaction. However, they are not allowed to maintain open positions at the end of the day, that is, all borrowing from participants must be on-lent before the close of business. As a consequence, the RFCs may be exposed to liquidity and interest risks. Direct transactions between banks outside the financing centers are not permitted. However, the RFCs can operate as brokers between lenders and borrowers. Currently, most transactions at both levels of the market are unsecured.
Participation in the interbank market is open to those financial institutions that have accounts at the PBC—commercial banks and some NBFIs. Lending by NBFIs is not subject to specific limitations; however, such lending is still subject to the limits on volumes and maximum maturity imposed in 1993. Transactions by commercial banks or their branches are also subject to prudential limitations, expressed as a percentage of their deposit base. Institutions not in compliance with the reserve requirement ratio are not allowed to participate.
Daily information on the rates and amount of transactions at the first level is used to calculate the China interbank offered rate (CHIBOR), which is a weighted-average interest rate of all transactions at each maturity—7, 20, 30, 60, 90, and 120 days. The administrative ceiling on interest rates was lifted on June 1, 1996 for interbank transactions at the first level. The CHIBOR serves also as a basis for transactions at the second level.
The rather formal approach adopted by the PBC in creating an interbank market, as opposed to a more informal arrangement allowing for more initiative to be taken by the market participants, is motivated mainly by the PBC’s concern that the interbank market may become a permanent source of long-term finance for a number of market participants. While such regulations might be useful in the transitional years, monetary policy should be used to absorb excess liquidity in the system once indirect instruments become fully effective. These absorption operations should prevent funds from flowing out of banks into speculative purposes.
The inclusion of some NBFIs and provincial branches of state commercial banks in the interbank market reflects China’s realities today, but it can also be considered a transitional arrangement. Several NBFIs—the trust and investment companies, in particular—collect deposits and perform functions similar to banks. These institutions are also subject to reserve requirements and, by the same token, have accounts at the PBC. In order to monitor their operations more effectively, the authorities intend to impose limits on the maturities and volumes that these institutions can trade in the interbank market. In the same vein, the participation of commercial banks’ provincial branches is seen as a necessary transitional arrangement at a time when banks—and especially the state commercial banks—are still not in a position to conduct centralized liquidity management at the level of the head office.74
Nonfinancial institutions have been excluded from the interbank market. Some had been allowed to participate and were in fact often a source of speculative behavior in the market.
A Market Microstructure for Open Market Operations
A number of steps have been taken since 1993 to lay the foundation for the conduct of open market operations using negotiable government securities. In 1993, a system for designating primary dealers was established, and 19 financial institutions were selected. These companies have an obligation to purchase at least 1 percent of each new issue offered by the Ministry of Finance, and they have the privilege of participating in the PBC’s future open market operations. However, the initial plan to start some open market operations in 1994 and to rely more heavily on this instrument from 1995 onward (with the elimination of the credit plan) suffered some delay, mainly because of the limited amount of negotiable securities in circulation, the absence of a unified secondary market, and the lack of a proper clearing and settlement infrastructure.
After offering six-month treasury bills on January 25, 1994 and one-year bills on February 1, 1994, the Ministry of Finance did not issue any other bills in that year. It changed its initial intention to roll over treasury bills through frequent sales as the introduction of open market operations was delayed. Also, the resurgence of inflationary pressures in 1994 provoked a shift in the Government’s domestic debt-management strategy. The authorities’ primary objective became the dampening of inflationary pressures by selling government bonds to individuals to soak up consumer purchasing power. In the second half of 1995, the Ministry of Finance issued ¥ 11.8 billion one-year paperless bonds to primary dealers (¥ 3 billion were sold through an auction). In April 1996, the PBC conducted its first open market operations, using these government securities.
The secondary market in government securities is still small and fragmented (see Section V). Establishment of a nationwide book-entry system within the next few years should alleviate many inefficiencies. However, the enhanced efficiency of the secondary market in government securities will require the establishment of a nationwide market, with all participants in the country having access to the best bids and offers. This achievement, in turn, will require the enhancement of clearing and settlement arrangements.
Clearing and Settlement Arrangements in Support of Open Market Operations
It is expected that China’s National Automated Payments System will be up and running by about the turn of the century. Until such time, open market operations will have to rely on the present infrastructure (the Electronic Interbank System) or on interim arrangements. As current clearing and settlement facilities in China are not adequate to support open market operations, the PBC started in 1994 the development of an interim book-entry system for government securities, the Provisional Securities Settlement System, which is intended to be used in the early stages of open market operations. The system is designed to carry government securities, but small modifications would allow it to deal in other types of securities as well (such as financing bonds issued by the newly established policy lending banks). An interesting feature of the system is that it is designed for transactions between PBC headquarters and the headquarters of major banks. This in itself could give a significant impetus to centralized liquidity management, by state commercial banks in particular.
Next Steps in Foreign Exchange Reform
Foreign exchange reform has received a major boost since 1993–94. The following steps could be taken in the near future to establish a genuine foreign exchange interbank market governed by regulations that meet international standards.
Alternatives for Developing Exchange Markets
In developing an exchange market in China with the objective of eventually establishing a regular interbank market, the authorities face two basic alternative routes. Development could continue in the context of the CFETS, or direct dealing between financial institutions could be introduced. While the latter is the stated long-term goal, the CFETS could serve a useful function during the transitional period while institutions are developing needed skills and procedures.
An extension of trading hours would provide the banks with a current basis for setting buying and selling rates in their customer transactions throughout the day. Furthermore, it would increase the gross flows to the CFETS market. Because transactions would be conducted on a continuous basis with the market, there would be fewer possibilities for internal netting of transactions, and the exchange market would become deeper and more liquid. The adoption of modern risk-management techniques and prudential regulations will eventually force trading at each financial institution to be centralized at its head office or at only one branch.
The system should also eventually allow for direct bilateral settlement and for the possibility of rejecting a counterpart for credit risk reasons. It is important that member institutions assume all the credit risks in the system, although it will take some time for authorized dealers to get used to evaluating the creditworthiness of other market counterparts.
Supervising and Regulating Banks’ Foreign Exchange Operations
Issues to be addressed in this area range from reform of the accounting system and the banks’ internal structure to the institution of prudential regulations. Introduction of a new accounting system based on international standards is expected in 1997–98. The present separation between accounting in renminbi and accounting in foreign currency would disappear under this new system. The commercial bank law places branches under the authority of their headquarters. These stipulations should be enforced over time to clarify the relationships between branches and headquarters.
In an environment of fluctuating exchange rates and interest rates, responsible banking will have to be based on awareness of, and continuous control over, risks. It is, therefore, important that modern prudential regulations for banks’ foreign exchange operations and risks be introduced as soon as possible in China. These regulations and risk limits should replace the current (minimum) limits on banks’ liquid foreign assets. Each financial institution should be given only one global limit; if it wishes to, it could internally decide that part of the limit could be utilized by a branch or branches. Within the scope of the flexibility provided by the exposure limits, banks could be allowed to trade foreign exchange for their own accounts at any time.
Financial Institutions’ Operational and Managerial Capabilities
Despite the apparent depth and diversity of the financial system, the market is dominated by one bank, the Bank of China (BOC), which represents some 80 percent of exchange market transactions. The BOC is the only truly international institution, with 474 branches in 18 countries and territories. Most other banks have engaged in foreign exchange operations for only a few years, although some are very large institutions in the domestic market. However, the situation is changing rapidly, with all licensed banks rapidly establishing foreign relationships and, in many cases, representative offices, branches, or subsidiaries.
The fact that branches of banks in different provinces also have separate foreign exchange licenses, capital, and dealing functions complicates risk and position management. Although some branches have very limited rights, others are authorized to establish independent positions. Telecommunications and the exchange of information about transactions are apparently not problems for most banks. However, global risk monitoring and management often take place on only a monthly, quarterly, or annual basis. Many bank branches active in foreign exchange operations view themselves as separate banks with their own foreign-currency-denominated balance sheets; they measure their risks in U.S. dollars, not in renminbi. Many institutions may therefore have larger renminbi exposures than prudential banking would warrant.
It will not be long before Chinese banks link their major operations on-line to each other. This process will be expedited if there are competitive pressures on banks to move in this direction. This linkage will make it possible to quote and disseminate current rates throughout the country. When some banks start quoting current competitive exchange rates to major customers, other banks will follow. Transactions between banks and their customers will then typically be priced by banks on the basis of the prevailing market rate.
Market evolution and market making would also be easier if the settlement period for retail transactions were the same as (or longer than) the settlement period (currently one day) in the CFETS market. Otherwise, it will be difficult for banks to cover their retail transactions through purchases and sales in the wholesale market, and they will not be in full control of their foreign exchange positions.
Eventually, banks will also have to assume the credit risk of dealing. This assumption of risk could start through the introduction of direct bilateral settlement between transaction counterparts. Under such arrangements, dealers would have to establish credit limits for all their counterparts.
Forward Operations
There is no forward exchange market in China at this time, although the need for one is obvious. Banks should be in a position to quote forward rates and hedge forward transactions across a broad range of maturities. To do this, banks will need to have access to international foreign exchange and money markets. As discussed above, an embryonic domestic money market is beginning to emerge in China, although interest rates are not yet fully free. Hedging and the pricing of forward transactions should thus now be possible. Forward operations would speed up the integration of banks’ foreign exchange and domestic operations.
Leveling the Playing Field and Strengthening the Environment for Competition
Markets are most efficient in allocating and redistributing resources when all market participants are subject to the same rules and regulations. This is not yet the case in China. Foreign funded enterprises (FFEs) have the right to retain foreign exchange while domestic enterprises are subject to a surrender requirement. FFEs also can enter the CFETS directly while domestic enterprises have to deal through financial institutions. Moreover, foreign banks are restricted in their business activities essentially to handling sales of foreign exchange for FFEs. Addressing these issues constructively will help to strengthen the emerging exchange market mechanisms further.
