Zhou Zhengying

My presentation focuses on the way the central bank uses instruments of monetary policy to achieve the desired targets of monetary policy.

The choice of instruments of monetary policy is closely related to the economic management system, the financial system, and the sophistication of a market in a given economy. The difference in these areas underlines the difference in the choice of the instruments of monetary policy and the function they can play.

Generally speaking, the central bank has at its disposal three main policy instruments: the reserve-requirement ratio, the rediscount rate, and open market operations. The reserve-requirement ratio is one of the most powerful instruments that the central bank can use to control the monetary and credit aggregates. In China, such an instrument is geared toward readjusting the credit structure. The reserves lodged at the central bank are reallocated to the specialized banks in line with the industrial policy set by the state.

The rediscount rate or the central bank’s lending rate, a typical instrument for economic regulation and adjustment, is different from the reserve-requirement ratio in that it controls and adjusts the monetary and credit aggregates and their structure chiefly through affecting the cost of funding for borrowers. Therefore, on the one hand, it is a macroeconomic instrument for controlling and adjusting the monetary and credit aggregates; on the other, it facilitates the efficient allocation of financial resources in an economy.

Open market operations refer to the central bank’s purchases and sales of short-term government securities in the financial market to affect the monetary base and the money supply. They are very flexible compared with the reserve-requirement ratio and rediscount rate. Thus, they have become the day-to-day policy instruments, but they require the existence of fairly developed financial markets and a large amount of eligible securities for trading. That is the reason why many developing countries with underdeveloped financial markets are still unable to make use of open market operations.

Apart from these three traditional instruments, a large number of countries have some other approaches to control money and credit. These include ceilings, loan/capital ratios, interest rate ceilings, moral suasion, and window guidance. Experience in various countries has proved that through the implementation of a combination of the three major policy instruments and other supporting credit control mechanisms, the central bank is able to function effectively in strengthening the ability to exercise macroeconomic control and adjustment.

For a long time in the past, the execution of China’s monetary policy depended on the highly centralized plans for credit and cash. The restructuring and reform of the economic system has included in the financial sector the use of reserve requirements and the central bank’s refinancing facility and refinancing rate, for example. Today, China relies on the following four instruments for the implementation of monetary policy:

Guidance plans for credit and cash—Under the prevailing central bank system, these two plans still function as the effective instruments for controlling money and credit. Despite the fact that some of the targets are no longer in the category of guidance management, these two plans form the basis for macroeconomic regulation and adjustment of money and credit, since the targets under the plans are formulated under the state plans for production, investment, and commodity circulation.

The reserve-requirement ratio—The reserve-requirement system was adopted in 1984 when the People’s Bank of China began to perform exclusively the role of a central bank. As further efforts were made to separate the central bank’s accounts from those of other specialized banks, to separate the credit plan from the funding plan, and to introduce deposit-related lending in the area of credit management, the reserve-requirement ratio has become an important instrument for readjusting the credit structure in our economy.

The central bank’s refinancing rate—Given the fewer fund-raising operations of enterprises through bill discounts, the central bank mainly finances the specialized banks by providing credit loans. In this connection, the central bank’s refinancing rate is similar to the rediscount rate in terms of macroeconomic regulation and control. With the economic reform, the enterprises and specialized banks have come into a closer recognition of economic efficiency, thus enhancing the role of lending rate as a macro-regulating instrument affecting the funding cost.

The central bank’s lending quotas—Chinese financial markets are far from being fully developed. Since the conditions for direct open market operations are insufficient, the changes of the central bank’s monetary base are achieved mainly through the central bank’s lending operations. The provision or recall of loans can directly influence the availability of money and credit in the system. Thus the distribution of the central bank’s lending quotas has become an underlying instrument of monetary policy. Such distribution, flexible in terms of quantity, regional demand, and maturity, is the day-to-day instrument of monetary policy in China. In general, when using the foregoing policy instruments, one should take into consideration their different characteristics so that the instruments will function well together and obtain the desired targets in the process of effectively controlling money and credit aggregates.

Given the close relationship between the exchange rate, foreign debt, foreign exchange reserves, and the money supply in an economy, the central bank attaches great importance to the management of the exchange rate, foreign debt, and foreign exchange reserves in the implementation of monetary policy. A description of our management policies follows.

The central bank in China adjusts the renminbi exchange rate on the basis of the purchasing power of renminbi compared with foreign currencies, our balance of international payments developments, foreign exchange reserve position, and the exchange rate fluctuation in international financial markets. Because of the high inflation rate in recent years and the impact of an exchange rate realignment upon the domestic price level, and other factors concerned, we did not adjust the unreasonable exchange rate until recently. On December 16, 1989, in an attempt to address the overvalued renminbi exchange rate, we depreciated the renminbi by 21.2 percent; consequently, other foreign currencies rose by 26.9 percent. The adjusted exchange rate regime is conducive to the growth of production and increased economic and trade contracts with other countries. In the future, we will study further the issue of exchange rate readjustment and try to create favorable conditions for a reasonable exchange rate regime.

Our foreign indebtedness has been high since 1979—especially since 1985. The nation’s total external debt outstanding at the end of 1987 was nearly twice as much as that at the end of 1985. It reached $40 billion at the end of 1988, an increase of 32.4 percent compared with the end-of-year figure for 1987. A few points are worth mentioning in this regard. (1) We have borrowed from various sources and in various forms. In our external portfolio, long-term concessional loans from foreign governments and international financial institutions represent 27.2 percent, commercial lending and buyer’s credit from foreign commercial banks and financial institutions, 38.8 percent, and bond issues, 15.4 percent; the rest are overseas foreign exchange deposits and financial leasings. (2) The composition of our external debt is dominated by U.S. dollars and Japanese yen. (3) The maturity and allocation of external borrowing are arranged to the advantage of external financing. By the end of 1988, short-term borrowing accounted for 18.3 percent of the total debt outstanding. The medium-term and long-term borrowing chiefly finances the growth of transportation, energy supply, machinery industry, chemical industry, production of textiles and other light industrial goods, and the development of agriculture, animal husbandry, and fisheries. Experience has proved that external financing has facilitated the buildup of infrastructural sectors with large imports of advanced equipment and technology and has enhanced the growth of the nation’s key projects and the quality of products and their export competitiveness. In the management of foreign debt, the principle of a division of responsibility under unified leadership will be pursued further. Guided by enhanced management and stepped-up control, efforts will be made to keep a watchful eye on total indebtedness and its structure, to track closely the lending markets, and to strengthen control over total external borrowing. In addition, more work is needed to improve the existing system of collecting and monitoring debt data and to improve the analysis and forecasting of external debt so as to bring in, step by step, a scientific and standard system for debt management.

It is common practice for central banks the world over to manage foreign exchange reserves. The foreign reserves of China comprise treasury reserves and balances of the Bank of China. By the end of September 1989, our foreign exchange reserves were $14.2 billion. As the next step, the central bank will strengthen its management of reserves in terms of safety and rate of return and efforts will be made to readjust currency composition of reserves in a timely manner and to effectively reduce exchange rate exposure and at the same time ensure the international payments of the state.

China has already set up its financial system, which is composed of a central bank, four specialized banks, and a variety of nonbank financial institutions. Progress has been made to develop the financial market, and policy instruments, such as the reserve-requirement ratio and the central bank’s financing rate are playing an increasing role in macroeconomic control and adjustment. Insufficient conditions for the effective operation of those instruments has, however, to a certain degree, eroded their effectiveness. For instance, because the specialized banks are unable to balance their sources and uses of funding, an increase of required reserves is more often than not reallocated to the specialized banks in the form of short-term lending, thus, the desired result of the retrenchment policy is severely affected. Furthermore, because of the insensitivity toward interest rate change, the rise in the central bank’s lending rate can hardly, in most cases, effectively contain the excessive demand for credit.

Therefore, in order to bring the role of policy instruments into full play, there is a need to better pursue the facilitating reforms in the financial industry. These reforms would include (1) increasing the awareness of specialized banks of the need to balance their funding operations themselves and to reduce their overdependence on central bank financing when they face a funding shortage; (2) developing a financial market to promote funding activities through the use of securities, so as to gradually reduce the overdependence on credit lending and create conditions for open market operations; (3) strengthening the operational management of specialized banks and the gradual introduction of the risk-management mechanism to their lending operations, so as to increase the efficiency of their loans and augment the role of interest rates in controlling and adjusting the credit demand; and (4) strengthening the management of external debt and following closely the effect of changes in the balance of international payments on the domestic currency.

To sum up, efforts should be made to intensify economic reform, and, on our part, the reform in the financial sector, and to improve conditions for the implementation of monetary policy instruments and macromanagement of currency and credit.

Paul A. Volcker

I sense that we have begun moving from the abstract to the practical questions faced by a central bank. We are asked to get more specific: What is a central bank supposed to do? How does it go about doing it? My sense is that as the questions get more specific they get more difficult. Accordingly, my answers will get shorter.

I suppose that Governor Li has to go to the office every day and ask himself, and ask his colleagues in the People’s Bank, what to do. He then has to go to the State Council, or elsewhere, and convince other officials that he knows, and the People’s Bank knows, what is best for China and that his proposals make sense; he needs the tools necessary to carry out his intentions. I am not going to talk much about the tools because in that sense our approach in the United States is necessarily quite different from yours here. We carry out monetary policy essentially through open market operations, which is the most indirect way of approaching a problem. You are dealing essentially only with treasury securities in a very well-developed and personal market; it removes all those decisions of who gets affected and how.

Through open market operations, we affect the money supply and its growth and interest rates, but we do not interact with particular institutions. We interact with the market as a whole. With a quite differently developed market in China, you necessarily put more reliance upon discounting, rediscounting, and lending; that is not necessarily less efficient, although it does raise questions about—for better or for worse—credit allocation.

However one approaches the question of how precisely one implements policy, there is one point I feel quite certain about. It seems to me that in the conduct of monetary policy a special institution that we call the central bank needs to take the lead, and to take the lead it needs to be a strong institution. I do not necessarily say independent; practices vary quite a lot in terms of form and legal independence among developed countries. But I do emphasize that whatever the legal formalities, it needs to be strong and influential. It seems to me, strength and influence are nothing you can necessarily legislate or command. It depends upon performance; it depends upon performance that over time results in prestige and standing and respect. We are talking about somewhat intangible matters of competence and confidence, but central banks in the Western world are typically characterized by a high degree of professionalism and continuity in their operations, whatever their precise legal situations. In the West, we would typically say their management is nonpolitical. I am not sure that that particular description is exactly appropriate for China, where competition between political parties is not the same.

But let me emphasize, in that connection, that it is a fact of life that an influential central bank, a prestigious central bank, can be a great asset internationally. Mr. Mancera referred, I think, to the status of the Mexican central bank, and, if I understood him correctly, he said it was not independent. It is not independent in a formal, legal sense. But I think that I can report to you without fear of contradiction that the Bank of Mexico and Mr. Mancera have a great deal of influence, not just in monetary policy but in the economic policy of Mexico, generally. They are independent in a functional sense, and everybody knows it. That is a very considerable asset in my opinion to the Government of Mexico in dealing with the rest of the world, because there is a certain inherited confidence and trust in dealing with the central bank that frankly may not apply in the same degree to the rest of Mexico—and I am not making a particular point about Mexico. We see in country after country, particularly when one is dealing with foreign creditors, that a special degree of confidence often resides in the obligation of a central bank, because it is felt to be an institution with special continuity, a special nonpolitical character, a special ability to carry out its obligations. One should think about that dimension when considering the role of a central bank in any country, particularly a developing country that wants to rely upon external credit.

The second area is how to conduct policy in terms of what one actually looks at, when one comes to the office in the morning and decides what to do. It is fine to talk in vague abstractions about stability and growth and employment and balance of payments, but what does that tell you to do on Monday morning, January 15, in terms of operations. Is there a more or less fixed rule? Can we look in the book in the morning and look at the rule and look at the markets? Can we look at what is happening in some market or another or at some number or another and have it tell us what to do?

Let me suggest some of the indicators that have been talked about and used to some degree. The most popular one is some measure of the money supply. Unfortunately, most countries have several measures of the money supply, but one strong view in central banking says that what you do in the morning is determined by how the money supply looks and what your objective is for the money supply.

Another approach might be to look at interest rates and say that by and large interest rates ought to be positive in real terms in order to attract savings and provide stability; so let us look at interest rates and let us look at prices every day and see what are the policy implications. Another approach is to look at the exchange rate or, if the exchange rate is fixed, to look at what is happening to international reserves. If the exchange rate is appreciating, it is time to ease; if it is depreciating, it is time to tighten up; or, if reserves are rising, ease up; or, if reserves are falling, tighten up. That is not such a strange rule when one considers that that is what the gold standard amounted to—that was a very popular rule, fifty years ago, a hundred years ago. Or, one can look to the end objectives of policy and look at what is going on in prices or look at what is going on in production and make a policy conclusion, based upon whether prices are going up or down or how fast they are moving.

All those have certain attractions, but they all have certain difficulties. I can only speak from my own reaction in the United States and from the responsibilities I once had in the United States. Speaking from that experience, I can say that none of those single rules applied mechanically seemed very satisfactory. I felt at that time, at least, and I think it is quite clear this is the way the Federal Reserve is conducting policy today, that they are relying upon a fixed rule in none of those respects to conduct policy and that indeed policy is conducted on the basis of an evaluation of all those factors and some practical pragmatic judgment, reached from day to day or week to week or month to month, about what the implication is for easing or tightening policy. That statement does not get you very far because it sounds very sensible; it is also a good way to make mistakes. Given the lags and uncertainties that I spoke about this morning, you cannot tell from looking at the market today, or looking at prices today, or looking at production today what the implications are for policy, because today’s policy may affect prices a year from now, or production six months from now.

In this situation, and depending upon a particular country or a particular time, it has often been useful to give perhaps a little more weight to one or another of the indicators that I spoke of, indicators that react more quickly. The favorite ones have typically been the money supply or the exchange rate or some combination of the two. They are measures that more sensitively reflect what is going on, first of all in the markets today, and second, if maintained in some kind of steady and predictable way, tend to keep the economy reasonably on course over a longer period. We were quite insistent for a time, ten years ago in the United States, upon guiding the money supply in accordance with some predetermined levels. But the relationship between the money supply and economic activity and the money supply and prices demonstratively became a lot more uncertain, a lot more volatile.

I do not know enough about China, but it may be that in a developing country of this sort, with less developed markets, and less alternatives in the form in which money is held and liquid assets are held, the relationship between the money supply and the real economy and the money supply and prices may be a lot closer than in the United States. If so, that would certainly be an argument for putting, among all the factors, a certain amount of weight on money growth over a period of time in determining policy. One word of warning in that respect: a stable relationship does not necessarily mean a constant relationship. In a sense, particularly in a developing country, you may find that the growth of the money supply is rising quite normally, more rapidly than the economy, as the economy becomes more and more financially oriented as it grows. As the banking system grows, there may be room for monetization of the economy, which leads to more rapid growth in the money supply, as we measure it, than in economic activity. But that is a judgment that can only be reached by very close and careful study of the experience in any one country.

For three or four decades, we had the opposite situation in the United States; as the markets developed more and more outside the banking system, the growth in the money supply was slower than the GNP; so it depends very much on the particular circumstances in a particular country.

Miguel Mancera

If there is a central bank in a country, it would seem obvious that it is the institution that should implement monetary policy; however, this is not always the case. There may be situations where another authority—for example, the ministry of finance—issues the relevant regulations and instructs the central bank as to how to conduct specific transactions in the financial markets.

Turning to the question of who should formulate monetary policy, arrangements vary from country to country. Usually the drafting of the monetary program is a function of the central bank. Then, if the central bank is not autonomous, the ministry of finance or the authorities may modify or entirely change the draft.

In my view, no institution is better placed than the central bank to draft the monetary program. Nor is one better equipped to implement monetary policy. This is because no other authority has closer contact with the money market than the central bank. Other authorities are more distant. In some cases, they may be out of touch as far as monetary affairs are concerned, no matter how firmly they keep their feet on the ground with regard to other matters.

There is another reason for entrusting the formulation and implementation of monetary policy to the central bank. In many countries this institution—fairly or unfairly—is held responsible, at least partially, for the stability of the currency either in terms of its domestic purchasing power or in terms of its rate of exchange. It has a legitimate interest in the adoption and execution of a monetary policy conducive to stability.

In formulating monetary policy, the authorities must remember that that policy does not operate in a vacuum but within the realities of a given country at a particular time. Monetary policy must therefore be consistent with the expected or intended rates of growth of the economy, of prices, and of the international monetary reserves of the country. Moreover, it must take into account the likely behavior of public finances, as well as of private saving and investment. In formulating monetary policy, due consideration must be given to its consistency with a number of important exogenous elements, such as the prospective international environment, including the possible evolution of prices of imports and exports, of capital flows, and of other balance of payments items. Monetary policy should not, however, be simply made to fit in a given context; it can be used to influence and modify that context. Specifically, it can be used to fight inflation and to determine balance of payments results; however, it is not always successful in achieving these goals.

One of the main reasons why monetary policy may not succeed is that in many cases fiscal policy may limit central bank action. Let us assume a country—not difficult to find—where the domestic public debt is large, fiscal deficits enormous, and inflation high. It is conceivable, at least theoretically, that inflation could be stopped within a rather short time should the central bank bring the growth of its domestic credit to a halt (assuming, for the sake of simplicity, that the external sector behaves naturally). Why then are central banks unable to stop inflation in many instances?

The most likely answer is that the government of the country in question is not able to borrow from the market the amount needed to fund its deficit. In principle, as the government becomes unable to finance the entirety of its expenditures, some of them should be curtailed. Everyone knows, however, that in reality this can be done only to a limited extent in the short run. Large-scale cuts imply, for instance, laying off an enormous number of employees or interrupting the service of the public debt. Both courses of action may inflict more damage on the economy and on the population than inflation itself. Yet it is also true that if inflation is not fought, albeit gradually, it is very likely to go out of control, to the point where the economy collapses.

From what I have said, it becomes clear that if monetary policy is to succeed in stabilizing prices, the public deficit cannot be larger than the amount fundable with real savings plus the amount of primary credit, that is, the credit of the central bank that may be created without producing inflationary pressure. Indeed, some primary credit can be created in this fashion, provided there is also an increase in the demand for monetary assets. Usually this increase comes naturally as the economy grows and as it passes from self-sufficient units to a wider division of labor and as it evolves from barter to the general use of money.

In the presence of a large fiscal deficit that cannot be financed without resorting to excessive primary credit, stopping inflation is, as far I know, impossible. This is why stabilization programs must include or be preceded by the correction of public finances. Correction of public finances, however, even their full equilibrium, cannot by itself guarantee that inflation will be stopped. This is because other sources of expansion of the monetary base might still be present, notably excessive central bank financing to the private sector.

To achieve and maintain price stability, not only the monetary base but also the domestic credit of the central bank must not expand in a measure inconsistent with the real increase in the demand for the notes and deposits constituting such base. If domestic credit increases excessively and continuously, international reserves will diminish until devaluation becomes unavoidable.

In the background paper prepared by Mr. Baliñ of the IMF, for this conference, there is an excellent discussion on the roles, merits, and demerits of the various instruments available to a central bank in implementing monetary policy. It would be pointless for me to say in different words what has already been well explained in that paper. I should simply state that I entirely agree with the views there expressed.

Nevertheless, it might be useful to share with you some experiences that we have had in Mexico with some of these instruments. Before telling you about them, I would like to point out, however, that the effectiveness of a particular instrument depends very much on the breadth, depth, and degree of sophistication of the financial system. Some instruments are very effective in little developed financial systems and less so in more developed ones; whereas the opposite applies to other instruments.

When banks or similar institutions are the only significant component of the financial system, some measures, for instance, changing reserve requirements or setting credit ceilings, may be very effective, albeit harsh. However, if, for example, very high nonremunerated reserve requirements are in force over a long time, parallel credit markets will tend to develop, rendering the regulation on bank reserves ineffectual. The same development occurs when credit ceilings last too long and even more so if deposit rates are also held “by decree” at artificially low levels.

Reserve requirements, and to a lesser extent credit ceilings, were used extensively in Mexico for decades. However, as the financial system, both formal and informal, grew to include an increasing number of nonbank participants, the effectiveness of these instruments diminished. This was particularly true when the bank deposit rates were regulated and the central bank did not wish, or was not allowed, to let them reach a level consistent with what market conditions demanded.

The loss of effectiveness of reserve requirements and of credit ceilings as monetary policy tools became very noticeable in Mexico during the third quarter of 1988, a time when bank deposit rates were held below market levels. As nonbank participants in the money market had increased in number and sophistication over the previous years, massive bank disintermediation took place posing an immediate threat. Fortunately, at that stage the central bank was able to convince the other authorities involved that liberalizing bank intermediation was indispensable. Thus, deposit rates were freed (lending rates had already been freed well before), credit ceilings were removed, and compulsory lending to the government and to other privileged borrowers was eliminated.

Reserve requirements were replaced by a so-called liquidity coefficient according to which 30 percent of the total amount of deposits must be invested by banks in government paper (to be bought and sold by them in the market), or held in deposits with the Bank of Mexico, or held in cash.

This far-reaching liberalization has had remarkable results. Banks have become far more competitive as the differential between deposit and lending rates is narrowing. This has not impaired the soundness of banks, as the narrower spreads are being applied to larger volumes of credit and as banks are now charging for a number of services that they were previously providing free of charge or at prices below cost. By pricing these services in a more rational way, banks cease to be the vehicles for the transfer of subsidies from depositors and borrowers to the users of such services.

The liberalization of bank intermediation has not hindered the implementation of monetary policy. In fact, it is now carried out with more effectiveness by means of open market operations. But let me point out that there are at least two important prerequisites for using open market operations as an effective instrument of monetary policy. One is the recognition that interest rates must be flexible. This is an intellectual prerequisite, but one that is essential, a sine qua non. The second prerequisite is more material, It is the existence of a reasonably deep and efficient money market where treasury bills or other paper can be traded extensively.

Our experience suggests that open market operations have three distinct advantages over other instruments. First, their effect is not limited only to the banking system but is felt more broadly in the financial market in general, including the informal credit markets. Second, they directly affect the monetary aggregate, which is, in my view, the most important one for purposes of monetary policy, namely, the monetary base. And third, they can be decided and carried out with extreme speed and flexibility.

Monetary policy has a tremendous influence on the exchange rate. I would say that, in the long run, the most important factor in determining the exchange rate’s average level is the behavior of the domestic credit of the central bank, or primary credit. If this is excessive, the population’s purchasing power will tend to increase. As spending increases, imports grow and exports diminish. This situation tends to deplete the country’s international reserves, so that, at a certain point, devaluation or foreign exchange rationing becomes unavoidable. After this outcome, the inflationary pressure that might have already existed is exacerbated.

Let me reiterate that primary credit should be managed in a manner consistent with price stability. If this principle is observed, we can expect the rate of exchange of the national currency to other major and stable currencies to not vary abruptly, except when international reserves are so low that the daily or seasonal imbalances of demand for and supply of foreign exchange cannot be compensated.

What should the central bank do with regard to exchange policy if for one reason or the other it cannot manage primary credit in a manner consistent with stability? In this circumstance, it seems to me, the lesser evil is to adopt a crawling peg, that is, a scheme of daily small devaluations. This scheme is preferable to abrupt devaluations from time to time, because the behavior of the exchange rate is more predictable from day to day. Thus, a consistent relationship between domestic and foreign interest rates can be established.

Abrupt devaluations of the currency are very harmful. They create an environment where consistency between domestic and foreign interest rates is difficult to achieve. As a consequence, speculation increases and short-term international capital flows may have a destabilizing effect on the domestic economy. Ex ante interest rates diminish even if ex post rates go up. Thus, saving is discouraged by the low ex ante rates, while servicing debts becomes more costly owing to the high ex post rates. These problems clearly appear in countries where there are no controls on international capital movements. Yet even where these controls exist, similar problems may arise, for instance, through “leads and lags” in import payments and export receipts.

International capital flows, fortunately, are not only of a speculative nature, a good part of them also responds to direct foreign investment decisions or to borrowing by domestic entities to finance the expansion of production facilities. The central bank’s action in respect of these flows depends on many variables. Generally speaking, however, it could be said that if a sudden large inflow of capital appears, which is not largely destined to the importation of equipment or other goods, the central bank would be well advised to sterilize a part of the monetary expansion caused by the inflow. Otherwise, inflationary pressure is to be expected as a consequence of excessive expenditure. Over time, the central bank could gradually reverse its sterilizing action so that the economy uses the added purchasing power that the inflow of foreign savings can provide.

International capital movements can be managed not only through indirect measures, such as market transactions carried out by the central bank, but also by means of direct regulations or controls.

Since international capital movements may have a strong impact on monetary aggregates, the central bank should have at the very least an advisory role to the authority empowered to regulate such movements.

It is logical that foreign borrowing by public sector entities should be approved by the financial authorities, since the government is normally held responsible, de jure or de facto, for the service of the respective debts. If foreign borrowing by private firms is free, it should be made absolutely clear to the lenders that the government will not bail out the debtors should they be unable to pay.

The role of the central bank in managing external reserves is twofold. First, the central bank must seek the best possible combination of security, yield, and liquidity of the assets constituting such reserves. Second, and more important, the central bank, through monetary policy measures, should determine the total amount of external reserves most appropriate in each circumstance. These are difficult tasks as they often clash with other economic policy objectives.

Jean Godeaux

I stated this morning that the formulation of monetary policy and the selection of an intermediate target by implementing monetary policy varied according to the size of the economy, the degree of openness of the economy, and the state of development of the economy, but that, whatever these variations, the essential goal remained that of price stability. When it comes to discussing, as we are now, the problems of formulation, implementation, and monitoring of monetary policy, the two factors, openness of the economy and stage of development, in particular, the development of financial markets, play a decisive role.

For the purpose of exposition, some professors of economics would describe an appropriate economic policy as one encompassing a magic square, one side of which is the level of output, another side is the evolution of prices, the third side is employment—or unemployment—and the fourth is the external balance. Geometrical analogies are always imperfect, as are all comparisons. I would be tempted to say that we really ought to consider a magic pentagon, because there is a fifth element, which, as we said this morning, is of paramount importance: the state of public finance. The possible influence of the central bank on these four or five elements is quite unequal. We are in the habit in our country of thinking that an adequate financial and monetary policy should be achieved by a good working relationship between the central bank, the ministry of finance, and the banking commission (in our country the supervision of banks is entrusted to a separate body, in which the central bank is importantly represented). The influence that the central bank may have within this troika depends on its autonomy, which in turn depends on its professionalism, on the prestige which it enjoys. All these determine the leadership that the central bank can in fact exercise.

For the implementation of monetary policy in our country and, more and more, in practically all European countries that are members of the European Monetary System (EMS), the most important intermediate target is the exchange rate. Therefore, the thing we look at every morning, when we arrive in our office, is the exchange rate and the situation of the foreign exchange market. Immediately after that, interest rates, and in particular, interest rate differentials are the most important factor. To the extent that the foreign exchange risk is perceived to be decreasing, interest rate differentials exert a greater influence on movements of funds across borders.

This adherence to the stability of the exchange rate as an intermediate objective of monetary policy and the confidence that it can inspire in the minds of the market operators can have a very important effect on the economy. In 1982, we had to face a situation in which, to keep an acceptable position in the EMS, Belgium had to have short-term interest rates 5½ percent higher than the Federal Republic of Germany, When I left my office, this differential had been reduced to 1¾ percent. This was made possible because of the improvement in the general economic situation, thanks to the policies pursued by the Government, and as a result of the central bank’s policy aimed at building confidence in the stability of the currency.

Much of what I have said is of limited applicability to China because conditions are different in many respects. But the core of my testimony is, I believe, valid.

Summary of Discussion