Monetary policy transmission and the choice of instruments

The previous blog post in this series looked at the institutional reforms in China’s monetary policy set-up in the 1990s. It found that the increased levels of operational independence of the People’s Bank of China (PBC), the abolishment of the credit plan, and the establishment of the nominal exchange rate as a nominal anchor were key factors for the success of China’s monetary policy approach at that time, with lasting effects. This blog post looks at some of the additional operational reforms within the central bank that contributed to a successful monetary transition.

A simple set of operational targets provided guidance during the transition

One of the most important reforms in the mid-1990s was the change in the operational target of Chinese monetary policy. From 1994–95, the PBC targeted money supply growth (M1 or M2). Money growth targets moved closely with what would be implied by output, velocity, and inflation targets (correlation 0.85). However, the level of the money growth targets was typically 4-5 percentage points higher, with a maximum deviation of around 8 percentage points in 2003. Geiger (2008) finds that interest rates tended to move in the direction of the desired monetary policy action but were not a key component of monetary policy. The lack of a competitive financial market meant that interest rates were not allocative (and interest rates were only partly liberalized). China often missed its money growth target—especially when it was trying to bring down inflation. Nonetheless, the overall performance was quite good in terms of bias—average M1 growth was almost exactly the average of targeted growth, with average M2 growth 1.3% above target. Still, the PBC succeeded in achieving low and relatively stable inflation over 1998–2006. In part, this might be because specific money growth targets helped the PBC to avoid the excessive money supply growth of the mid-1980s/early 1990s.

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A broad mix of instruments was necessary to steer the transition toward market-based monetary policy

In addition to changes to the operational framework, the PBC started relying on new instruments. Laurens (2005) and Laurens and Maino (2007) divide monetary policy operations into three basic types. (1) Direct instruments involve direct administrative control over interest rates/quantities in the financial sector and are a carryover from a planned economy. These include (in the Chinese context) window guidance and wage/price controls. (2) Rule-based instruments work indirectly but still rely on the regulatory power of the central bank. These include reserve requirements, standing facilities, and statutory liquidity requirements. (3) Market-based instruments (open market operations (OMOs)) involve the central bank trading in the money market and are the primary instrument used by central banks in developed countries. China’s approach involved using all three types (for more details, see World Bank 2016, 11-20).

In practice, there were many challenges. It was expected that the PBC would be more able to implement these changes given its greater independence and clarity of objectives, and these measures would be more effective due to the separation of policy and commercial lending. In practice, the transition was challenging and incomplete. In the late 1990s, faced with deflation and falling credit growth, the PBC tried to stimulate the economy using indirect instruments. Over 1998–99, the PBC slashed official interest rates, increased the supply of base money through OMOs, reduced the required reserve ratio from 13% to 6%, and reduced the interest rates paid on reserves (Green 2005). However, credit growth continued to slow over 2000–01.

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In late 2001, the PBC resorted to window guidance and asked banks to increase lending. The government also introduced expansionary fiscal policy. As outlined in Green (2005), credit growth shot up from below 10% to around 35%. China now faced the opposite problem: credit growth was too fast. Around 2003, the PBC raised interest rates, reduced the money supply through OMOs, and increased reserve requirements. Again, the policies seemed to be working slowly and so in the middle of 2003, the PBC began to introduce window guidance to reduce lending (Green 2005; Geiger 2008). Combined with the other initiatives discussed above (such as price controls), credit growth dropped back to below 16% by June 2004.

Without complementary reforms to advance financial sector development, the transition could not work

The experience over 1998–2004 suggests that market-based instruments may have been less effective than the PBC had hoped due to incomplete development of the financial sector.  However, the same lack of institutional structure inhibiting indirect instruments meant that window guidance was available and effective. An alternative interpretation is that market-based polices were new and hence more difficult to implement properly (for example, harder to signal future actions), whereas window guidance was essentially a continuation of the credit plan that had been used for many years. The mixed strategy allowed the central bank to control credit and monetary growth even in the face of limited financial market development and a concentrated and uncompetitive banking sector. Still, the overshooting of credit growth in the early 2000s suggests that it is very difficult to use direct controls to fine-tune the macroeconomy. The ability to use window guidance also depends on the overall state footprint in the economy, which varies greatly among developing and transition economies.

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Fully effective, market-based implementation of monetary policy is not possible without complementary reforms.  Such reforms need to make the banking sector more competitive and separate policy and non-policy lending. Knowing this, the Chinese authorities separated policy banks from commercial banks in 1994. However, in line with the gradualist approach, the reforms were incomplete—state-owned commercial banks were still not fully commercial—which may have reduced the effectiveness of market-based instruments over the following decade.

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