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Tepper School of Business, Carnegie Mellon University; and Research Department, IMF, respectively. We thank Ray Brooks, Steven Dunaway, John Fernald, Jiming Ha, Robert Hetzel, Bernard Laurens, Lamin Leigh, Allan Meltzer, Ronald McKinnon, Mark Stone, Sun Tao, Tao Zhang, Yanchun Zhang and seminar participants at the Federal Reserve Banks of Cleveland and San Francisco for useful comments. We are also grateful to numerous other colleagues at the IMF, including participants in various internal seminars, for helpful discussions and comments. Wellian Wiranto provided excellent research assistance.
Excessive outflows can force a depreciation of the exchange rate unless domestic interest rates are raised to deter them. Excessive inflows create inflationary money growth unless they are sterilized or interest rates are cut to deter them.
Of course, a central bank must support its interest rate policy actions with open market operations to accommodate the quantity of base money demanded along the chosen interest rate path. But the resulting path for base money need not play a causal role in the transmission of monetary policy.
Goodfriend (1993) and Goodfriend and King (2005) document how inflation scares have destabilized the U.S. economy in the past. On the flip side, credibility for low inflation achieved by the Greenspan Fed played an important role in holding down actual and expected inflation on three occasions since the mid-1990s—when the unemployment rate dropped to 4 percent during the late 1990s, when the Fed cut interest rates from 6 ½ percent to 1 ¾ percent to fight the recession in 2001, and when energy prices rose sharply in 2004-5.
Although inflation in China has been reasonably stable of late, China’s earlier experiences suggest that it is potentially susceptible to both inflation and deflation scares. For instance, the Chinese economy endured a burst of high inflation in 1994-5, when inflation exceeded 20 percent (Figure A1). The economy experienced deflationary episodes in 1998-99 and 2002.
Since the mid-1980s, the federal funds rate policy instrument ranged from a high of nearly 10 percent, to resist rising inflation in early 1989, to a low of 1 percent to preempt deflation in 2003. Moreover, the Fed has had to move interest rates aggressively on a number of occasions. For instance, in order to preempt rising inflation during 1994, the Fed raised short rates by 3 percentage points. The Fed lowered short rates in 2001 by 4 ¾ percentage points to cushion the recession. On two occasions in particular, after the October 1987 stock market crash and the 2001 terrorist attacks, the Fed had to cut the federal funds rate aggressively on very short notice to stabilize financial markets.
We follow the usual presumption—that the demand for currency is unaffected by capital flows—so that unsterilized purchases or sales of foreign exchange by a central bank show up as changes in bank reserves.
Allen, Qian and Qian (2005) argue that there is also a large unregulated informal financial sector that plays an important role in financial intermediation in China.
The PBC’s Monetary Policy Report for the fourth quarter of 2005 notes that, of the funds raised in the domestic financial market in that quarter, bank loans account for 78 percent, corporate bonds and stocks account for about 6 percent each, and the rest are government securities. This represents a significant change relative to even the first quarter of 2005, when bank loans accounted for as much as 89 percent and corporate bonds and stocks for only about 1 percent. The government has initiated efforts to reduce the number of nontraded shares and improve the functioning of equity markets.
Under WTO accession commitments, foreign banks will be allowed to enter China at the end of 2006. Although the degree of penetration by foreign banks is likely to be limited in the foreseeable future, the Chinese authorities are using this date as a deadline for all banks to meet a number of objectives, including benchmark capital adequacy ratios and improvements in governance indicators.
A telling (and probably slightly unfair!) indication of the importance accorded to such non-market based and non-prudential measures to control credit growth is a sub-heading in the chapter on Monetary Policy Conduct in the PBC’s 2004Q2 Monetary Policy Report (page 44). It reads: “Moral suasion intensified to guide credit structure optimization.”
Bad loans to SOEs are more readily forgiven than bad loans to the private sector.
There has been some recent improvement in this dimension, even among the SCBs. In the fourth quarter of 2005, the share of loans priced at or below the base rate was down to three-fifths, while the share of loans priced above 1.3 times the base rate rose marginally to 6 percent.
Podpiera (2006) examines lending growth, credit pricing, and regional patterns in lending to look for evidence of changes in the behavior of SCBs following recent reforms and strengthening of their balance sheets. He concludes that the pricing of credit risk remains rather undifferentiated and that SCBs do not appear to take enterprise profitability into account when making lending decisions.
This is higher than the official figure of $819 billion at end-2005, as it includes the reserves used for recapitalization of the SCBs—$45 billion in December 2003 (Bank of China and China Construction Bank; $22.5 billion each) and $15 billion in April 2005 (Industrial and Commercial Bank of China). It also includes $5 billion transferred to the Export-Import Bank in September 2005 and $6 billion worth of foreign exchange swaps that the PBC conducted with domestic banks in November 2005.
Stephen Green estimates that, in 2004, the PBC sterilized about 48 percent of total net foreign exchange inflows ($98.3 billion of base money withdrawal relative to inflows of about $206 billion). This includes about $74.5 billion in net issuance of PBC bills. The overall sterilization estimate includes an amount of $23.8 billion in PBC bills that Green believes were issued in secret to the four SCBs. Repo transactions were used to sterilize base money in the middle of the year but their net effect on the monetary base during the year was about zero. Green estimates that, during July-August 2005, the sterilization ratio may have dropped below 20 percent, as the PBC shifted monetary policy to a more neutral mode to offset any adverse effects of the currency revaluation.
The flexible strategy for monetary policy anchored by a long-run inflation objective that we suggest for China is closely related to that recommended for the United States by Bernanke (2004) and Goodfriend (2005). It is also related to the “inflation targeting lite” approach (Stone, 2003), although we believe that the subordination of the inflation target to other macroeconomic objectives considered there would hamper the effectiveness of monetary policy in anchoring inflation expectations.
Food prices are quite volatile in China and, to a lesser extent, so are energy prices. Food still accounts for about forty percent of the consumption basket of Chinese households, giving it a large weight in the CPI, and retail prices of energy are administered.
The optimal speed of financial sector reforms in a second-best world with multiple distortions, and how it is tied in with other reforms, is a complicated issue (see Prasad and Rajan, 2006). Indeed, instruments such as “window guidance” may continue to play a limited role during the transition to a more efficient banking system. However, such instruments must be utilized with care since they may not work as expected and may have perverse side-effects.
The notions that the current exchange rate regime is sustainable indefinitely and that capital controls will continue to provide room for independent monetary policy are, in our view, either fallacious or ignore many of the attendant costs and risks. This issue is discussed at length in Appendix I.
This would not preclude the PBC from engaging in limited foreign exchange intervention at the margin. See Broaddus and Goodfriend (1996) for an analysis of the Federal Reserve’s foreign exchange operations.
Broaddus and Goodfriend (2001) make this point with reference to the Federal Reserve. They argue that, to formulate and carry out monetary policy effectively, the Federal Reserve must maintain a high level of independence within the government, and its asset practices must support and reinforce that independence. With this in mind, they propose two related principles to guide Federal Reserve asset selection: (i) acquisitions should respect the integrity of fiscal policy by precluding the use of the Federal Reserve’s “off-budget” status to allocate credit across various sectors of the economy, and (ii) acquisitions should insulate the Federal Reserve from political entanglements that could undermine its independence. Broaddus and Goodfriend argue that the Federal Reserve should conform to these principles by restricting its asset purchases to Treasury securities. By extending its credit to the Treasury, the Federal Reserve minimizes its participation in private credit markets and transfers directly to the government all the revenue (net of operating expenses) from money creation. Finally, they argue that the Treasury should maintain and replenish a floating debt sufficient to satisfy the Federal Reserve’s asset acquisition needs, even if the Treasury has no fiscal reason to issue debt.
The ceiling on deposit rates and the floor on loan rates together have kept cash flows in the banking system positive, in spite of the large share of NPLs on bank balance sheets.
As long as inflation remains low, open market operations sufficient to implement monetary policy have relatively minor fiscal implications.
For instance, interest rate ceilings in the United States did not prevent the Federal Reserve from achieving its macroeconomic objectives with monetary policy in the period before interest rates were deregulated fully by the Depository Institutions Deregulation and Monetary Control Act of 1980. The Fed managed the growth of bank reserves to achieve whatever degree of restraint on the growth of money and credit was deemed necessary. When regulatory restraints on explicit interest rates were binding, a combination of disintermediation, implicit payment of interest and non-price rationing cleared the credit markets. Nevertheless, interest rate regulations inhibited the flexibility of the economy to respond to monetary policy actions.
The PBC issues quarterly monetary policy reports. In addition, the PBC recently released its first Financial Stability Report; this is expected to be an [annual] report.
Also see the discussion in Eichengreen (2004) and Prasad, Rumbaugh and Wang (2005). Prasad and Wei (2005) document that a surge in non-FDI capital inflows—mostly reflecting a sharp reversal of net errors and omissions (unrecorded flows), which had been negative for most of the latter half of the 1990s—accounts for much of the surge in the pace of reserve accumulation during the period 2001-04. They also show that short-term external debt has risen sharply in recent years, perhaps in part reflecting anticipation of an appreciation of the renminbi. This could increase external vulnerability if circumstances were to change.
In this second case, the PBC would drain reserves from the banking system to maintain the desired degree of pressure on reserve positions.
Note that the banking system has some limited capacity to accommodate a given flow of central bank bills indefinitely on a balanced growth path. The balanced issuance of PBC bills would keep the relative extent of crowding out constant.