Appendix I. Why the PBC Should Rely on Market-Based Monetary Policy
Appendix II. Monetary Policy with Open Capital Account and Large Capital Inflows
Appendix III. Modeling Money Demand in China
Appendix IV. Monitoring Financial and Monetary Indicators as Intermediate Targets
Appendix V. The Role of Money and Asset Prices in the ECB Monetary Strategy
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A preliminary version of the paper was prepared for a course at the Joint IMF-China Training Center on “Determining the Intermediate Target for Monetary Policy: Practical Issues,” Dalian (China), June 19–22, 2006. The authors are grateful, without implication, to Steven Barnett, Ulrich Bindseil, Alexandre Chailloux, Dong Dibin, Stephen Green, Sun Guofeng, Turgut Kisinbay, Lamin Leigh, Klaus Masuch, Anna Nordstrom, Richard Popdiera, Eswar Prasad, Mark Stone and Barry Topf for their comments, as well as participants in a seminar held at the People’s Bank of China on December 15, 2006 to discuss a draft version of the paper.
The Third Plenary Session of the 14th Central Committee of the Communist Party of China Third Plenum laid down, for the first time, the goals of establishing a socialist market economy by the end of the century, thereby allowing the market to play a decisive role in resource allocation (see Mehran, Laurens and Quintyn, 1996). However, commercial banks are subject to a device to protect their intermediation margins (deposit rates are subject to a ceiling and lending rates to a floor).\, and rural credit cooperatives are still subject to an interest rate ceiling on loans.
In April and August 2006 the PBC raised the benchmark rates for banks’ loans, and in August 2006 it also raised the benchmark deposit rate.
The PBC reversed its policy of lowering the reserve requirement ratio from a peak of 13 percent to 8 percent in November 1999. Starting in 2003 the PBC increased the ratio to the current level of 9.5 percent for large state-owned banks and joint-stock banks and 10 percent for smaller institutions.
Moral suasion may have also helped contain the cost of sterilization.
Source: Oxford Analyitica and National Bureau of Statistics. The authorities modified the housing loan policy in an effort to promote risk awareness of borrowers. In March 2005, the PBC eliminated the preferential interest rate on housing loans and imposed a lower limit of 0.9 times the benchmark lending rate with the same maturity, and it raised the down payment on consumer housing loans from 20 percent to 30 percent in cities and areas where real estate prices are considered to be rising too fast. In June 2006 the China Banking Regulatory Commission ruled that banks may lend only 70 percent of house value to individual buyers, down from 80 percent (Green, 2006). These adjustments are expected to stabilize housing prices.
Appendix II describes some policy responses by a group of countries that faced capital inflows. Most countries have responded with a combination of steps including, in all cases, greater exchange rate flexibility.
As of end 2002, the ratio of domestic credit to GDP was above 160 percent in China, compared to 140 percent in Japan, and less than 100 percent in the United States and Asian emerging markets (Prasad, 2004). Bank credit to nongovernment entities represents more than 100 percent of GDP.
Bank restructuring involved China Construction Bank, Bank of China, and the Industrial and Commercial Bank of China. All three banks are also raising capital through IPO issuance. Reforms at the Agricultural Bank of China, the fourth state-owned bank, are still pending. See Karacadag (2003) and Podpiera (2006).
The ratio of NPLs to total loans reported by the authorities declined to 13 percent in 2004 and reached 7.5 percent at end-September 2006. Some financial analysts place the NPLs ratio at a much higher level.
One may also infer that the PBC did not attempt to achieve the targets at all costs.
Lardy (2005) argues that against the stability of the nominal exchange rate over the past nine years, much of the overshooting of the monetary targets aimed, explicitly, at supporting job growth. He also warns that the over-expansion in 2002–03 was an over-reaction to the potential adverse effects of SARs on economic growth.
The liberalization of lending rates was not always smooth. In 1987 banks were allowed to charge higher rates on working capital loans up to 20 percent above the respective ceilings. In May 1996 the margin was reduced to 10 percent to alleviate financial costs to enterprises. In April 1999, the margin was expanded to 30 percent for loans to SMEs but remained at 10 percent for large enterprises (see People’s Bank of China, 2005).
See Zhou (2005) indicating that removing the limits may result in improper market competition. Therefore, they could be maintained for a relatively long period of time before they can be removed.
See People’s Bank of China, 2006 Q1 Monetary Policy Report.
See People’s Bank of China, 2006 Q1 Monetary Policy Report.
At times, the widening spread between NDF implied and domestic rates (because of appreciation pressures on the off-shore market) have allowed corporates operating onshore to raise RMB funding at negative rates.
See Laurens (2005) for a review of the use of instruments at different stages of market development.
The PBC recognizes that the remuneration of excess reserves undermines the effectiveness of monetary policy management. See PBC 2005 Q1 Monetary Policy Report.
In the first quarter of 2006, securities and fund management companies’ borrowing in the repo and interbank market amounted respectively to about 20 percent and 40 percent of market turnover.
Foreign banks can only borrow 1.5 times their branch capital in the RMB interbank market.
At the end of March 2006 trading in the OTC market stood around 30 times trading in CFETS.
The primiary dealer system is expected to help strengthen the transmission of the central bank’s policy intentions in its foreign exchange operations as well as the effectiveness of those operations.
A level of excess reserves of more than 1/3 of required reserves stands particularly high compared, for instance, to the Euro area, where excess reserves amount to less than 1 percent of required reserves.
Obviously, the relationship between inflation and changes in M2 involves a lag. We have estimated a money-price equation by using a distributed lag model in the form of
A nominal anchor is a nominal variable that policymakers use to tie down the price level. Its role is two-fold, (i) help promote price stability; and (ii) limit the time-inconsistency problem of discretionary monetary policy. A credible nominal anchor is important to control inflationary expectations and provide confidence in monetary policy whereby agents can distinguish between movements in relative prices (necessary for consumption and investment decision making) and those associated with the price level.
Data corresponds to the International Financial Statistics, various issues. A smooth estimate of the long-term trend component of inflation is obtained by means of a Hodrick-Prescott filter.
It was found that the ordering of the variables for the impulse response functions has little effect and the Choleski responses are very similar to unrestricted responses. To double check this result we note that the correlation matrix of the VAR residuals is close to diagonal.
In Figures 6 and 7, the dotted lines represent 90 percent confidence intervals. The vertical axis shows the deviation from the baseline level of the target variable in response to a one standard deviation (SD) change to the shock variable, while the horizontal axis presents the number of months elapsed after the shock.
See Arnone, Laurens and Segalotto (2006a) and (2006b) for a survey of central bank autonomy indicators and progress made on central bank autonomy in OECD, developing and emerging market economies.
Reserve requirements can and should probably be retained (most central banks in advanced economies have retained them). However, but their function, when averaging provisions are in place, is to serve as a mecahims to absorb short-term liquidity shocks. Hence, they facilitate short-term liquidity management and the steering of short-term momey market rate to the central bank’s policy rate.
See Appendix IV for an overview of an anchoring strategy based on the monitoring of financial and monetary indicators as intermediate targets.
While some advocate greater reliance on interest rates signals in view of its benefits for financial market development and the allocation of funds, others emphasize the risks, in particular its implications for the provision of bank credit to the financially weak fraction of the corporate sector (i.e., state-owned enterprises).
Based on the level of confidence that empirical evidence provides, the role of money can range from being used to define quantitative targets, to being used to supplement the short-term risks to price stability with medium-term risks, as is the practice at the ECB (see Appendix V for a review of the ECB approach and Mishkin (2000) for a review of the experience of selected industrialized countries with monetary targeting).
Within such a strategic framework, the PBC may announce a long run inflation goal (making it clear that this is not a move to an IT framework) as a priority for monetary policy to help tie down inflation expectations (see also Goodfriend and Prasad, 2006).
We use the benchmark rate for RMB denominated deposit rate.
The level has been normalized to equal 1. Hence the log of the price level is zero (p=0).
Another challenge, outside of the scope of this paper, has to do with the lack of a an operational framework with regard to the official policy of keeping the RMB exchange rate stable at an adaptive and equilibrium level.
There is anecdotal evidence that the 2005 reduction of the ERR resulted in high credit growth.
Another option would be to increase the level of remuneration of excess reserves to a market level if the instrument is to be used to mop up excess liquidity on a permanent basis.
The ADF tests (not shown here) cannot reject the null hypothesis of the presence of a unit root in all series suggesting the existence of a stochastic trend thus implying that they are stationary in first differences.
If the variables involved are not cointegrated, then the differences among them could become larger as time goes by, without a tendency to return to a stable path together.
Based on ECB (2003), and (2004); Issing (2003), and Masuch, Nicoletti-Altimari, Pill and Rostagno (2003).