VII Instruments of Monetary Policy and Monetary Developments
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Abstract

Prior to the reforms, monetary policy was implemented through the credit plan and the cash plan. As the credit plan was the financial counterpart of the physical or investment plan, it specified the amount of credit needed by enterprises to implement their output targets. Monetary policy was thus a passive instrument in the execution of the Government’s objectives. As described in the preceding section, the cash plan covered the various factors that influenced the amount of cash in the economy and, as such, complemented the credit plan.

Prior to the reforms, monetary policy was implemented through the credit plan and the cash plan. As the credit plan was the financial counterpart of the physical or investment plan, it specified the amount of credit needed by enterprises to implement their output targets. Monetary policy was thus a passive instrument in the execution of the Government’s objectives. As described in the preceding section, the cash plan covered the various factors that influenced the amount of cash in the economy and, as such, complemented the credit plan.

The Operating Framework

Reflecting the coexistence since 1979 in the economy of planning devices and market mechanisms, the operating procedures for monetary policy underwent gradual changes. In the process, monetary policy acquired a more independent role as a tool for macroeconomic management. In this new environment, however, the operating procedures had to meet several requirements that were often contradictory.

First, the priorities of the Government had to be met through the credit plan while the emerging non-state-owned industrial sector had to be given access to bank financing. Second, to be effective as a macroeconomic tool, the operating procedures of monetary policy had to remain in line with the changing institutional structure of the financial system and the gradually increasing openness of China’s economy. Third, in this changing environment, the People’s Bank of China (PBC) had to pursue two objectives that were often conflicting: the credit plan, with its inherent expansionary and inflationary bias, remained the primary objective of the Government’s policy, but at the same time the PBC was supposed to use monetary policy actions to control inflation.

The potential for conflicts can perhaps be best conveyed by the fact that, in its transformation to a genuine central bank, the PBC’s mandate was never explicitly changed from de facto lender of first resort in the command economy to that of lender of last resort in a market environment. The dilemma posed by these two objectives was never really addressed in the period before 1992–93 (when work on a new law started) and was at the origin of shortcomings in the PBC’s ability in responding to monetary developments.

The operating procedures for monetary policy evolved into a dual-control system as indirect control methods gradually supplemented direct controls; however, the dilemmas inherent in such a dual-control system were also present. The credit plan remained the core policy instrument, but its formulation underwent changes as macroeconomic considerations were increasingly taken into account. In addition, the credit plan’s implementation was at times relaxed as banks were given more freedom to set their lending rates. Particularly since the second half of the 1980s, however, the credit quotas (derived from the plan) lost part of their effectiveness because of changes in the financial sector.40

Indirect instruments—reserve requirements, PBC lending to banks, and more frequent interest rate changes—were introduced as soon as the PBC started operating in 1984–85. These instruments were meant to supplement the credit quotas to enable the PBC to respond more flexibly to changing conditions. “Window guidance,” or moral suasion, has also been used to some extent as an instrument of monetary policy.

However, the continuing demands placed on the financial system by policy loans constrained the flexibility and effectiveness of these alternative control methods throughout most of the period. These limitations are clearly seen in the role played by interest rates. They were used increasingly to control monetary aggregates, but their effectiveness remained limited, in part because the “soft” budget constraints of state-owned enterprises (SOEs) made those enterprises unresponsive to the cost of borrowing. In fact, the impact of interest rate changes was felt much more on household savings than on bank lending.

Moreover, the so-called indirect methods were not necessarily used to influence the markets (as they are intended to) but as substitutes for money markets. Since the mid-1980s, two instruments—PBC lending to specialized banks and reserve requirements—have been used throughout the country to adjust shortages or excesses of liquidity that would otherwise be leveled out by an integrated interbank market.

The decision in 1993 of the Third Plenum to move to a market economy included the adoption of indirect instruments to guide macroeconomic development. As a result, the PBC started preparations in 1993 for the introduction of open market operations as its main monetary policy instrument, with reserve requirements and PBC lending to banks as its supporting instruments. The credit plan was to be phased out gradually by replacing it with asset-liability management ratios to manage assets and liabilities and an increasing reliance on indirect instruments until such time as this reliance could be total. As part of the transition, direct PBC credit to the Government was discontinued in early 1994—more than a year before the new PBC law enshrined this decision—and the authorities contemplated using the interest rate instrument more actively (by changing the administratively set rates more frequently).

The reforms in the foreign exchange system of early 1994 had important consequences for monetary management. The liberalization of foreign exchange transactions is a potential source of inflows and outflows of liquidity, given the authorities’ objective to stabilize the exchange rate. Thus, these reforms have increased the need for active liquidity management based on the use of indirect monetary policy instruments.

Because it takes time to develop the appropriate infrastructure to conduct indirect monetary policy effectively, the PBC, in its fight against inflation, has been forced to rely on several ad hoc instruments since 1992. As will be discussed in a subsequent subsection, the PBC issued finance bills (a type of central bank bill) in 1993, and the PBC attracted excess liquidity by offering special deposits at the central bank in 1994 and 1995.

The Credit Plan

In the past, the credit plan served simply as the financial counterpart to the Government’s investment plan. As a result, it was formulated as a “bottom-up” exercise focusing on the credit needs of borrowers for planned output targets (see Box 6). The first change took place in the early 1980s when banks were given more discretion to lend working capital, thereby allowing them to depart somewhat from the credit quotas. This change concerned only the process of implementing—not formulating—the credit plan.

Second, changing economic conditions in the mid-1980s influenced the monitoring and implementation of the credit plan and the related quota framework. In the period 1986–88, credit quotas became merely indicative targets, and overshooting was not penalized. On other occasions, particularly during the 1989 austerity period, the quotas were more strictly enforced, and the proportion of directed credit increased.

Third, in line with the diversification of the financial system, the scope of the credit plan was broadened in 1988 to include credit to nonbank financial institutions (NBFIs) and direct financing of enterprises, in addition to credit to specialized and universal banks. However, the narrow credit plan, which set credit quotas for specialized and universal banks, remained the core plan; it was monitored more closely by the PBC and was the only plan that needed approval by the State Council.41

Finally, a significant departure from the traditional formulation took place in the latter part of the 1980s when the PBC began to evaluate the consistency of the credit plan with the broader macroeconomic objectives of price stability, the balance of payments, and economic growth. The target for aggregate domestic credit was formulated in line with money supply targets and no longer as a purely bottom-up process; it thus signaled the authorities’ recognition of the increasing role of market mechanisms in China’s economy.

However, this change in procedures also brought to the surface the potential conflicts involved in implementing such a plan in an economy that is adopting market mechanisms. The credit plan is a compromise among three agencies: the State Planning Commission (whose interest lies in assuring that the plan provides sufficient funds for investments under the five-year plans); the Ministry of Finance (which tries to minimize the budgetary costs of financing loss-making SOEs and, therefore, aims to include as much as possible of this funding in the credit plan); and the PBC (which tries to ensure macroeconomic stability).

The above changes follow from a combination of, on the one hand, the PBC’s willingness to downplay the role of the credit plan as a monetary policy tool in a changing environment and, on the other hand, the reluctance of the political authorities to give up the credit plan, as well as the PBC’s inability to rely on other instruments when monetary policy needs to be tightened.

The accelerated move since 1992 toward indirect instruments of monetary policy led the PBC to develop a strategy for phasing out the credit plan after 1994. In 1995, only the four state commercial banks and the four universal (or nationwide commercial) banks were subject to formal credit quotas. All other banks’ lending activities were guided by the loan-to-deposit ratio. The phasing out of credit quotas for the state commercial banks is planned to take place within the next two years, but this action will depend on these banks’ ability to match loans and deposits (and thus reduce their reliance on borrowing from the PBC).

The Credit Plan

Prior to the economic reforms in China, the credit plan, together with the cash plan (see Box 5), the central government budget, and the foreign exchange plan, represented the (subordinate) financing side of the physical plan. Even though the emphasis has shifted during the reform years, these plans must still be drafted.

Several basic principles underlie the credit plan. Some of the methods and principles have undergone modifications during the reform period. The credit plan is developed annually by three agencies—the People’s Bank of China (PBC), the Ministry of Finance, and the State Planning Commission—and is subject to approval by the State Council. The need for credit at the macroeconomic level is determined by the State Council’s targets for output growth, investment, and inflation. At the microeconomic level, a bottom-up aggregation of sectoral and local funding needs is passed on by the local authorities to the provincial authorities and finally to the national authorities. Whereas the credit plan during most of the 1980s was basically a bottom-up process with an inherent expansionary bias, the PBC has tried since the end of the 1980s to make the plan consistent with macroeconomic targets, such as real growth and inflation.

The credit plan is implemented through a set of credit quotas for each specialized and universal bank. In addition, ceilings are set on access to PBC lending for the banks and on direct financing of enterprises (through enterprise bonds and shares). The PBC head-quarters also sets aside a portion of the aggregate credit ceiling for PBC branches to use at their own discretion in their regions.

The PBC allocates annual credit quotas to the head office of each specialized and universal bank, which, in turn, allocates quotas to its subordinate branches. The credit plan also sets subceilings for specific types of loans, and, since 1990, nonbinding quarterly credit ceilings—in addition to the annual ceilings—have been in place. The PBC headquarters also allocates separate credit quotas for the PBC branches in Shanghai and Shenzhen, which, in turn, allocate quotas to the specialized and universal banks in their respective regions. The PBC thus derives quotas for credit by region, as well as by bank branch, in order to control credit aggregates.

The allocation of credit quotas among specialized and universal banks is based on each bank’s loan share during the previous year, as well as on the importance of the sectoral credit that the bank provides under the overall investment plan. The monitoring of credit quotas of individual bank branches is done both vertically, by the headquarters of specialized and universal banks, and horizontally, by the local branches of the PBC, which control credit quotas within their regions. PBC branches, in turn, make quarterly reports to the PBC headquarters, which adjusts credit quotas among regions as required by changing credit needs.

Starting in 1988, the authorities made a distinction between the central credit plan as described above and the broader credit plan. The latter includes lending by rural credit cooperatives (RCCs) and all other nonbank financial institutions (NBFIs), with the exception of financial leasing companies. The broader credit plan has a more indicative character than the central credit plan. The PBC headquarters, in consultation with its branches and the Agricultural Bank of China, determines ceilings for the overall credit expansion of RCCs, while other NBFIs are governed by the PBC alone. The PBC assigns credit quotas to the local PBC branches for the NBFIs in their regions. These quotas apply only to the total credit of NBFIs and are monitored on an annual basis. Direct financing of enterprises, in the form of enterprise bonds, has also been subject to credit quotas. By bringing credit to NBFIs and direct financing of enterprises under the credit plan, the PBC hoped to be better able to manage and control the aggregate credit needs of the economy.

As part of the reforms contemplated in the wake of the 1993 decision to expedite financial sector reform, the authorities have adopted a plan to gradually phase out the credit plan. The 1995 credit plan applied only to the four state commercial banks and the four universal banks (the Bank of Communications, the China International Trust and Investment Corporation’s Industrial Bank, Hua Xia Bank, and China Everbright Bank). The lending activities of all other banks and NBFIs are to be guided by the loan-to-deposit ratio. As soon as the eight aforementioned banks are deemed ready to comply with the loan-to-deposit ratio and other specified ratios, the credit plan will be phased out altogether.

PBC Lending Facilities

In 1984, PBC lending to specialized banks was introduced to manage overall bank liquidity and to enable banks to meet their credit plan targets by filling the resource gap between bank deposits and lending. PBC lending comprises four different types of lending:

  • Annual lending, which carries maturities of one to two years, is primarily the directed credit required to meet planned output targets;

  • Seasonal lending, with maturities of two to four months, mainly covers the seasonal withdrawal of deposits;

  • Daily lending carries maturities of up to ten days; and

  • A rediscount facility, mainly for commercial paper, has maturities of six months to provide additional resources to specialized banks during the year.

At the end of the 1980s, an average of 60 percent of total PBC lending to specialized banks was annual lending, with seasonal and daily lending accounting for 35 percent and 5 percent of the total, respectively. With annual lending as the dominant component, the PBC lending facility was thus closely linked to the credit plan.

In principle, PBC credit is extended to specialized banks only, but a number of NBFIs have been approved by the PBC to access its credit facilities.42 In order to borrow under their annual and quarterly quotas from the PBC, specialized banks and approved NBFIs are required to submit applications to PBC headquarters stating the loan amount and maturity, as well as the intended use of borrowed funds and the capacity to repay.43 In the first years of the PBC lending facilities, PBC branches had significant autonomy in providing credit to financial institutions in their jurisdictions on the basis of “own resources,” which consisted of excess reserves and loan recoveries from financial institutions, as well as of deposits of government bodies and the post office. In this way, PBC branches were encouraged to increase their loan recoveries and mobilization of funds. Pressure from regional and local governments, however, contributed to an increase in lending by the branches of the PBC, which, in turn, contributed to inflationary pressures.

As a result, the PBC increased its control over credit creation in 1989 as part of the austerity program by requiring its branches to transfer to a head-quarters account all deposits from financial institutions (including excess reserves), as well as deposits of government bodies and the post office. So, while PBC branches still had some funds to use at their own discretion, their lending capacity was limited to resources that they received from headquarters. The Shanghai and Shenzhen branches retained their autonomy in decisions on lending to financial institutions in their respective regions.

In recent years, PBC lending facilities were further reformed to dissociate the instrument from the credit plan and to transform it into an instrument for liquidity management. As part of the 16-Point Program, the PBC started calling back loans to state-owned specialized banks and other financial institutions as a mechanism to control liquidity. In 1994, the decision was taken to centralize most PBC lending at the headquarters level, thereby forcing the banks to improve their internal liquidity management. The rediscount window is still operated at the branch level under a ceiling allocated by the PBC headquarters.

Reserve Requirements

Reserve requirements were introduced in 1984 to influence liquidity and liquidity distribution in the financial system. For the first year, the redeposit rates were differentiated according to the type of deposit: 40 percent on urban household deposits, 20 percent on enterprise deposits, and 25 percent on rural deposits (De Wulf and Goldsbrough (1986)), p. 228). In 1985, the requirement was reduced and made uniform at 10 percent for all domestic currency deposits of specialized and universal banks, rural credit cooperatives (RCCs), urban credit cooperatives (UCCs), and trust and investment companies (TICs).44 In response to the need to tighten monetary policy, the ratio was increased to 12 percent in 1987 and to 13 percent in 1988.

In an effort to tighten its monetary policy stance further, the PBC supplemented the required reserves in 1989 by effecting guidelines on “excess reserve requirements” in the range of 5–7 percent of domestic currency deposits. The rationale for introducing these guidelines was partly to sterilize the lending capacity of specialized banks, given the high level of excess reserves at the time, but also to serve as a cushion in light of the shallowness of the interbank market and the inefficiencies of the payments, clearing, and settlement system.

To meet the requirements, banks are required to keep reserve accounts at the PBC. Required and excess reserves are remunerated at the same interest rate. Compliance is based on outstanding deposits at the end of each month. In practice, however, banks adjust the accounts every ten days. Shortfalls in the required reserves are subject to a penalty interest rate of 4 basis points of the shortage a day. The excess reserve requirement can be seen as a second tier of reserves that has to be held on an average basis, as banks can use these reserves for settlements of payments, interbank lending, or cash withdrawals.

So, technically speaking, the two-tier reserve requirement system amounts de facto to one single requirement of 18–20 percent of banks’ deposits, to be met on an average basis. In fact, there can never be a shortfall in the legal reserve requirement because of the cushion provided by the excess reserve requirement.

Mainly because of the administrative organization of the PBC and the specialized banks, required and excess reserves are held by each branch of each bank at the PBC branch at the same administrative level. Consequently, monitoring is also done at the branch level. This arrangement has several implications. Monitoring by the PBC of required and excess (or free) reserves on a systemwide basis is complicated and time-consuming, and thus takes place with considerable delays. In addition, to adjust their reserve positions with the PBC, bank branches have to go to the interbank market because smoothly working intrabank communications are lacking.

A first measure to link reserve requirements better to liquidity monitoring and management was the decision taken in 1995 to have banks meet their excess reserve guidelines on a consolidated (bankwide) basis. In a system in which bank branches mostly operate autonomously, this measure was a significant step in the direction of centralized liquidity management. This change gives the commercial banks more responsibility in internally managing their reserves, while giving the PBC a better overview of liquidity developments in the system and improving its ability to assess those developments and to decide on the amount and timing of the market interventions needed to mop up or inject liquidity.

Interest Rates

Because the financial system has been seen as a discretionary allocative tool, China’s interest rate structure has always been very complex, with more than 50 rates administered by the PBC.45 On the lending side, besides the basic distinction made between working capital loans (of different maturities) and fixed-assets loans, industrial and commercial loans, agricultural loans, and household loans are treated differently. On the deposit side, a distinction is made between individual and institutional depositors, and the PBC sets rates for sight deposits, three-and six-month deposits, and deposits of one, two, three, five, and eight years.

Starting in 1985, and particularly since 1988, interest rates have been adjusted more frequently, primarily in response to inflationary pressures, but also because of the profitability considerations of enterprises and specialized banks (Chart 7 and Tables 5 and 6). Banks were also allowed to adjust loan rates within a 10 percent margin above the administered rate.46 There was no such flexibility, however, for deposit rates.47 The austerity program of 1989 reversed this partial interest rate liberalization, which was not resumed until the early 1990s when the austerity period had ended and banks were again allowed to set their lending rates within prespecified margins. This margin has been 60 percent for RCCs, 30 percent for UCCs, and 20 percent for the other banking institutions.48 Until the reform of the interbank market in early 1996, interest rate regulations applied also to interbank transactions. The ceiling on the interbank rate was equal to the interest rate on working capital loans plus 20 percent.

Table 5.

Selected Interest Rates on Loans

(In percent)

article image
Source: People’s Bank of China.
Table 6.

Interest on Deposits, PBC Operations, and Interbank Market

(In percent)

article image
Source: People's Bank of China.

Regulated by the PBC from April 1990 to July 1993. From January 1995, not more than 13.176 percent (20 percent above working capital loans).

Chart 7.
Chart 7.

Interest Rate Developments

(In percent)

Source: People’s Bank of China.1 Calculated as the year-on-year percent change of consumer prices.

The introduction of more flexibility in interest rates seems to have been constrained by at least three factors. First, the need for prior State Council approval for each rate change made the process cumbersome and lengthy. Second, during most of the period, the authorities’ interest rate policy was directed toward two often-conflicting goals: to encourage long-term savings mobilization and to facilitate borrowing by SOEs—particularly those with financial problems. Pursuing these objectives often led to inconsistencies, such as higher interest rates for deposits than loans over the same period, which resulted in negative interest rate margins for banks (Table 7). In general, the margins between most lending and deposit rates of equivalent duration remained very narrow. To resolve these inconsistencies, the authorities resorted to using an indexation scheme for long-term deposit rates in times of high inflation. This scheme allowed them to keep lending rates low while maintaining attractive deposit rates. The scheme was used for the first time in 1988, when inflation started building up.49 Third, the heavy reliance by the specialized banks on borrowing from the PBC—up to one third of their resources—proved to be another constraining factor, as changes in the PBC’s lending rates affected the average cost of the banks’ resources directly and dramatically.

Table 7.

Margins on Selected Maturities

(In percent)

article image
Source: People’s Bank of China.

Open Market Operations

The PBC began using open-market-type operations in 1993 to influence the level of liquidity in the financial system.50 In that year, the central bank issued central bank bills in the amount of ¥ 20 billion to absorb excess liquidity in some parts of the country (and to redistribute it to areas with shortages). In 1994 and 1995, the PBC offered the banks special deposits at attractive interest rates to further absorb the excess liquidity in the system.51 These instruments were introduced because the PBC had to find some means of coping with the excess liquidity until the infrastructure for open market operations was ready.

At the end of 1993, the PBC contemplated the introduction of genuine open market operations as its main instrument of monetary policy. Soon, however, the PBC realized that the absence of an integrated interbank market and interest liberalization were major obstacles to the effective conduct of open market operations. Nevertheless, it was considered that open market operations could be used to pursue purely quantitative adjustments in banks’ reserves, rather than the more common combination of price and quantity adjustments used in a liberalized environment.

However, the authorities quickly realized that changing the volumes of reserves of the banking system (by injecting or absorbing liquidity) without affecting the interest rates could, in fact, induce additional instability in the system. For instance, through the action of the credit multiplier, an injection of liquidity could stimulate additional bank lending, leading to the creation of additional deposits, which could, in turn, further increase bank lending. Even though this process would eventually extinguish, it might lead to an overshooting of the central bank’s initial targets, depending on the behavior of the multiplier, and could thus require additional interventions (in the opposite direction) by the central bank.

The authorities thus put on hold their plans to rely on open market operations. At the same time, they made additional efforts to develop an environment wherein the open market instrument could be used effectively, including through the gradual liberalization of interest rates (see Section IX). The preparations for open market operations included the issuance by the Ministry of Finance of six-month and one-year treasury bills in early 1994 (a project that was subsequently shelved because it proved premature) and again in late 1995, and the development of a provisional book-entry system (the Provisional Securities Settlement System) by the PBC.

Monetary Developments

Monetary developments since the start of the economic reforms have been characterized by wide fluctuations in the growth rates of money and credit aggregates, which is in line with the characteristic cycles through which the Chinese economy has been going. The nature of these cycles has been well documented in the literature on China.52 This subsection concentrates on the monetary aspects of those cycles, analyzing the relationship and interactions between the instrument framework and monetary developments during the successive cycles.

Since 1979, China has gone through four macroeconomic cycles, the most recent of which has not yet been completed. A review of monetary developments in these four cycles brings to the surface inconsistencies between the monetary policy control framework and the developments in the financial sector, in addition to highlighting the handicaps that the PBC had to overcome in institution building during the first decade of its existence.

The First Cycle (1979–82)

The main engine of economic growth during the first cycle was agricultural reform—leading to a significant increase in rural incomes—and increases in domestic investment. Broad money grew by nearly 25 percent in the latter part of 1979 and most of 1980, and the annual inflation rate reached 20 percent during that same period. In 1981, price controls, direct credit controls, and trade policies were tightened in an effort to restore orderly conditions.

The Second Cycle (1984-Early 1986)

The second cycle was initiated with the introduction of a two-tier pricing system, the granting of greater autonomy to enterprises in setting wages, the liberalization of foreign trade, and the establishment of a two-tier banking system. However, increased investment spending and the large wage increases granted by many enterprises not confronted with hard budget constraints led to the overheating of the economy. Credit expanded from a 9 percent annualized growth rate at the beginning of 1984 to 76 percent in the fourth quarter of that year. Inflation went up to 17 percent in early 1985.

The second cycle was the first one in which the PBC operated as a “proper” central bank in a two-tier financial system. The problems encountered in controlling monetary developments may to a large extent be attributable to the central bank’s—and, more generally, the authorities’—unfamiliarity with using monetary policy instruments other than credit quotas in the newly decentralized financial system. Even though reserve requirements had been introduced and the PBC was in a position to regulate its credit to the banking system, the main reply to the monetary overheating came through a stricter enforcement of the credit quotas in 1985. Additional measures consisted of raising the interest rates and devaluing the renminbi.

The Third Cycle (Mid-1986-Late 1989)

The third cycle originated in concerns about the slowdown in economic growth that resulted from the tightening of policies in 1985. Credit policy was eased in 1986; as described above, credit quotas for individual banks had become merely indicative, and banks had more freedom in setting their interest rates. In addition, regional interbank markets emerged. The combination of these measures and innovations fueled broad money and domestic credit growth to annual rates of over 30 percent (Chart 8).

Chart 8.
Chart 8.

Money, Credit, and Price Developments, 1985:IV–1994:III

Source: People’s Bank of China.1 Includes government bond holdings of banks.

The growth in these aggregates was largely brought about by a significant drawdown of the banks’ reserves. As shown in Chart 9, at the end of 1985, total reserves were at 27 percent of bank deposits—compared with the required levels of 10 percent—and the more liberal application of credit quotas and the establishment of interbank markets instigated banks to use the reserves for additional lending. By the second quarter of 1988, total reserves had come down to 17 percent of total deposits—still several percentage points above the required minimum, which, in the process, had been raised to 13 percent.

Chart 9.
Chart 9.

Indicators of PBC Control on Banks’ Reserves, 1985:IV–1994:IV

(In percent of deposits)

Sources: People’s Bank of China; and International Monetary Fund, International Financial Statistics.

These developments revealed some of the growing inconsistencies between the PBC’s control framework and financial sector developments in the latter part of the 1980s. The relaxation of credit quotas could not be compensated for by a more active use of the PBC’s other instruments: reserve requirements were increased on two occasions, but further increases would probably have hit banks that were suffering from liquidity shortages—liquidity was spread unevenly across the country—and would have met with resistance from the political authorities, because such increases would have prevented the banks from fulfilling the credit plan objectives. Thus, even though the growth of PBC credit to the banks was drastically reduced in 1987 (Chart 10), the PBC had in general not enough freedom to use this instrument and effectively absorb the banks’ excess reserves.

Chart 10.
Chart 10.

Factors Contributing to Changes in Banks’ Reserves1

(Annual percent change)

Source: People’s Bank of China.1 Factors with a positive sign have an expansive impact on bank’s reserves, while factors with a negative sign have a restrictive impact.

The PBC’s control problems were further exacerbated by its institutional structure, a legacy of the past. Political decentralization had drastically altered the relationships between the PBC’s branches and headquarters, on the one hand, and the local political authorities, specialized banks, and enterprises, on the other (Huang (1994)). Before the reforms, PBC branches were simply the executors of the credit plan in their political region.53 Since the start of the reform process, however, they have been used as effective instruments in the promotion of local interests and economic growth. In fact, local political authorities considered PBC branches as merely departments of local governments that had to meet their objectives. The web of common interests among local authorities, SOEs, and specialized banks put local PBC branches under great pressure and pulled them away from the supervision and influence of the PBC headquarters. These factors made proper monetary and credit control very difficult.

After inflation had sharply climbed to an annual rate of more than 25 percent in 1988 (bottom panel, Chart 8), drastic measures to tighten credit policies, along with other economic policy measures, were taken. Credit quotas became mandatory again, the reserve ratio was increased to 13 percent, PBC credit was tightened, interest rate liberalization measures were reversed, interest rates were raised, interbank market activities were controlled more tightly, and the renminbi was devalued by 21 percent. The 1989 guidelines on excess reserve requirements (as discussed above) had the effect of absorbing the larger part of the banks’ excess or free reserves (Chart 9).54 Additional measures enacted in 1988 strengthened the PBC headquarters’ control over the lending activities of its branches, imposed the requirement that appointments of branch presidents be approved by PBC headquarters, and ensured that PBC short-term lending to financial institutions would be reimbursed when it fell due.

As illustrated in the bottom panel of Chart 8, the growth of broad money fell from 27 percent in the second quarter of 1988 to 13 percent in the third quarter of 1989. Inflation started going down in the first quarter of 1989 and reached its lowest point (3 percent) in the third quarter of 1990, causing interest rates to become positive again in real terms.

The Fourth Cycle (1992-Present)

The fourth cycle has not yet come to an end. In late 1991, the domestic reform process, as well as the opening of the economy, resumed, including price reforms, the beginning of the reform of the SOEs, and the extension of Special Economic Zones to inland regions. Just as in earlier cycles, these reforms fueled an investment boom, accommodated by expansionary domestic financial policies. The sequencing of events in the fourth cycle is similar to the previous cycle, as growth in money and credit since late 1991 has for the greater part been financed through a drawdown of the banks’ free reserves.

The growth of broad money oscillated around the 30 percent level in 1992. Inflation started picking up in the third quarter of 1992 and reached 20 percent at the end of 1993 (Chart 8, bottom panel). Measures to tighten credit were taken in the summer of 1993 as part of the 16-Point Program. These measures included increasing interest rates and tightening PBC credit to the banks (including through the centralization of PBC credit at the headquarters level), as well as recalling overdue PBC loans, recalling “illegal” loans made through the interbank market by banks and TICs, and taking measures to improve the authorities’ control over the interbank market.

The credit crunch that followed the implementation of the program mainly hit the SOEs, which led the authorities to take accommodating actions toward the end of 1993. PBC credit to the banks had already picked up during the third quarter but grew even faster in the fourth quarter of 1993.

While monetary factors combined with a real estate boom were major factors behind the acceleration of inflation in 1993, the further acceleration in 1994 primarily stemmed from increases in food prices, adjustments in agricultural and other administered prices, and the reform of the exchange and tax system. In fact, monetary and credit policies were considerably tightened during 1994.

Despite this tightening, broad money grew rapidly (with 34 percent annual growth rate at the end of September 1994, compared with an annual growth of 24 percent in 1993). Growth in domestic credit also accelerated in 1994 from an annual rate of about 20 percent in 1993 to about 27 percent at the end of September (Chart 8). These higher growth rates reflect the large increase in PBC lending to the public sector at the end of 1993 and the increase in net foreign assets of the PBC in 1994 (Charts 10 and 11).

During most of 1994, the PBC tried to offset the expansionary effects of the movements in broad money and domestic credit by restricting its lending to the banking system, recalling loans from specialized banks, and attracting special deposits from selected financial institutions. The PBC’s net foreign assets grew from ¥ 148.7 billion at the end of 1993 to ¥ 416.5 billion at the end of September 1994 (Chart 11), while its claims on financial institutions slightly decreased to ¥ 981.2 billion at the end of 1993, whereupon they started growing again, but at a more modest pace than in 1993.

Chart 11.
Chart 11.

Sources of Banks’ Reserves1, 1985:IV–1994:IV

(In billions of yuan)

Source: People’s Bank of China.1 Factors with a positive sign have an expansive impact on bank’s reserves, while factors with a negative sign have a restrictive impact.

Charts 10 and 11 draw a distinction between those items on the PBC’s balance sheet that are under its control (discretionary factors) and those that are not (nondiscretionary factors). The charts show that in 1994 the PBC was able to offset the larger part of the increase in the nondiscretionary factors with two instruments, its lending and reserve requirements. As a result, as seen in the bottom panel of Chart 11, the banks’ excess reserves increased only slightly (from ¥ 266 billion to ¥ 291 billion).55 Although the banks’ excess reserves remained above the PBC guidelines (5–7 percent of total deposits), the ratio of total reserves to deposits dropped from 25 percent at the end of 1993 to 22 percent at the end of September 1994 (Chart 9).

The parallel increase in banks’ free reserves and in PBC refinancing during the second half of 1993 (as depicted in Chart 11) reveals in part some of the inefficiencies of the interbank market. Banks with shortages of reserves received additional PBC credit, while banks with surplus funds built up excess reserves. However, these developments also reveal differences in the ability of individual banks to manage their reserves. At the branch level, for instance, the quota of PBC credit obtained during the year from the head office is crucial, as it will set the basis for the next year’s quota. In such a framework, excess reserves, which, in addition, are remunerated by the PBC, do not have much importance.

This latest cycle brings to the forefront another inconsistency between the control framework and the financial system. Several NBFIs have become increasingly active in banking operations. This activity helps explain why, particularly since 1990–91, total credit growth exceeded the targeted volumes. Since the early 1990s, growth in domestic credit—the concept covered by the credit plan—has increasingly deviated from growth in (net) domestic assets—the concept that includes credit to the economy granted by NBFIs. The PBC has tried to correct part of this problem by including several categories of NBFIs under the credit plan.

Overview: Monetary Developments Versus the Instrument Framework

This section has demonstrated that since 1985–86—the time of the introduction of new monetary policy instruments—monetary policy has been confronted with the dilemma that neither direct nor indirect instruments can operate fully effectively. Financial sector reform has gone far enough in terms of decentralization and diversification to make the “old-style” direct controls increasingly ineffective. At the same time, however, resort to indirect instruments has remained impaired because of three factors.

  • The financial sector is not yet sufficiently developed to transmit the impulses given through these instruments to the rest of the economy. The large banks have a structural need for funds to fulfill the credit plan targets, the incentive structure for the banks to manage their funds more profitably remains poorly developed, and the organization of the banks is not conducive to liquidity management and monitoring at the aggregate level.

  • Because the interbank market is not yet nationally integrated, it cannot efficiently redistribute liquidity among the banks. Those with shortages must therefore seek accommodation at the PBC. This shortcoming also prevents the interbank market from efficiently transmitting monetary policy signals.

  • The (political) requirements that steer the credit plan limit the PBC’s control over its own balance sheet and, thus, its operational autonomy in using indirect levers to influence macroeconomic monetary conditions. More particularly, PBC lending to the banks remains dominated by the need to fill the banks’ resource gap in order to meet the credit plan targets.

As a result of these transitional circumstances, indirect instruments have often been used as substitutes for the missing redistribution mechanisms needed to channel funds from banks (or regions) with surplus liquidity to those with shortages. In addition, during each episode of economic overheating in the 1980s, the central bank had to resort to direct administrative controls and—to a considerable extent—moral suasion to bring back orderly conditions.

Cited By

  • View in gallery

    Interest Rate Developments

    (In percent)

  • View in gallery

    Money, Credit, and Price Developments, 1985:IV–1994:III

  • View in gallery

    Indicators of PBC Control on Banks’ Reserves, 1985:IV–1994:IV

    (In percent of deposits)

  • View in gallery

    Factors Contributing to Changes in Banks’ Reserves1

    (Annual percent change)

  • View in gallery

    Sources of Banks’ Reserves1, 1985:IV–1994:IV

    (In billions of yuan)

  • Alexander, William, and others, The Adoption of Indirect Instruments of Monetary Policy, IMF Occasional Paper 126 (Washington: International Monetary Fund, June 1995).

    • Search Google Scholar
    • Export Citation
  • Bell, Michael, Hoe Ee Khor, and Kalpana Kochhar, China at the Threshold of a Market Economy, IMF Occasional Paper 107 (Washington: International Monetary Fund, September 1993).

    • Search Google Scholar
    • Export Citation
  • Blejer, Mario, and others, China: Economic Reform and Macroeconomic Management, IMF Occasional Paper 76 (Washington: International Monetary Fund, January 1991).

    • Search Google Scholar
    • Export Citation
  • Dalla, Ismail, The Emerging Asian Bond Market (Washington: World Bank, 1995).

  • De Wulf, Luc, and David Goldsbrough,The Evolving Role of Monetary Policy in China,Staff Papers, International Monetary Fund (Washington), Vol. 33 (June 1986), pp. 20942.

    • Search Google Scholar
    • Export Citation
  • Fan, Qimiao, and Peter Nolan, eds., China’s Economic Reforms: The Costs and Benefits of Incrementalism (New York: St. Martin’s Press, 1994).

    • Search Google Scholar
    • Export Citation
  • Girardin, Eric,Difficulties with Credit Control and Financial Sector Reform in China,OECD Development Center Studies (Paris: Organization for Economic Cooperation and Development, June 1995).

    • Search Google Scholar
    • Export Citation
  • Goldstein, Morris, David Folkerts-Landau, and others, International Capital Markets: Developments, Prospects, and Policy Issues (Washington: International Monetary Fund, September 1994).

    • Search Google Scholar
    • Export Citation
  • Huang, Guabo,Problems of Monetary Control in China: Targets, Behavior and Mechanism,China’s Economic Reforms: The Costs and Benefits of Incrementalism, ed. by Qimiao Fan and Peter Nolan (New York: St. Martin’s Press, 1994).

    • Search Google Scholar
    • Export Citation
  • Khor, Hoe Ee,China—Macroeconomic Cycles in the 1980s,IMF Working Paper 91/85 (Washington: International Monetary Fund, September 1991).

    • Search Google Scholar
    • Export Citation
  • Khor, Hoe Ee, China’s Foreign Currency Swap Market,IMF Paper on Policy Analysis and Assessment 94/1 (Washington: International Monetary Fund, December 1993).

    • Search Google Scholar
    • Export Citation
  • McKinnon, Ronald I., Financial Growth and Macroeconomic Stability in China, 1978—92: Implications for Russia and Eastern Europe (Washington: International Monetary Fund, 1993).

    • Search Google Scholar
    • Export Citation
  • Mehran, Hassanali, Bernard Laurens, and Marc, Quintyn,Interest Rate Liberalization and Money Market Development in a Selected Number of Countries” (Washington: International Monetary Fund, forthcoming, 1996).

    • Search Google Scholar
    • Export Citation
  • People’s Bank of China (1994a), Annual Report 1994 (Beijing: People’s Bank of China, 1994).

  • People’s Bank of China (1994b), China’s Financial Outlook 1994 (Beijing: People’s Bank of China, 1994).

  • People’s Bank of China, Annual Report 1995 (Beijing: People’s Bank of China, 1995).

  • People’s Bank of China, Almanac of China’s Finance and Banking, various years.

  • Perkins, Dwight H.,Reforming China’s Economic System,Journal of Economic Literature, Vol. 26 (June 1988), pp. 60145.

  • Sachs, Jeffrey, and Wing Thye Woo,Structural Factors in the Economic Reforms of China, Eastern Europe, and the Former Soviet Union,Economic Policy, No. 18 (April 1994), pp. 10243.

    • Search Google Scholar
    • Export Citation
  • Santorum, Anita,The Control of Money Supply in Developing Countries: China 1949–1988,ODI Working Paper 29 (London: Overseas Development Institute, April 1989).

    • Search Google Scholar
    • Export Citation
  • Tseng, Wanda, and others, Economic Reform in China: A New Phase, IMF Occasional Paper 114 (Washington: International Monetary Fund, November 1994).

    • Search Google Scholar
    • Export Citation
  • World Bank, “China—Financial Sector Review: Financial Policies and Institutional Development” (unpublished; Washington: World Bank, 1990).

    • Search Google Scholar
    • Export Citation
  • World Bank, The East Asian Miracle: Economic Growth and Public Policy (New York: Oxford University Press for the World Bank, 1993).

  • World Bank, The Emerging Asian Bond Market—China (Washington: World Bank, 1995).

  • Yi, Gang, Money, Banking, and Financial Markets in China (Boulder, Colorado: Westview Press, 1994).