Journal Issue

Forum: China Explores Options for Improving Monetary Policy

International Monetary Fund. External Relations Dept.
Published Date:
July 2006
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Considerable attention has been devoted to China’s monetary policy and the benefits that greater exchange rate flexibility would bring—in particular by allowing a truly independent monetary policy. But the debate should not overshadow the significant modernization that has already taken place in how the People’s Bank of China (PBC) conducts monetary policy. A recent workshop, organized at the invitation of the PBC, discussed options for the central bank to formalize its monetary policy framework and improve its monetary operations, drawing on central bank expertise from around the world.

Since it began performing the functions of a central bank in 1984, the PBC has moved gradually to a monetary strategy anchored on intermediate monetary targets. The PBC aims to keep inflation low and growth high, and it announces targets for the growth of narrow and broad monetary aggregates—M1 and M2—in line with these objectives. The PBC has also developed an array of monetary policy instruments similar to those used by the most advanced central banks. In particular, it uses reserve requirements and open market operations, including to sterilize foreign exchange inflows. The use of open market operations has been made possible, in turn, by the development of nationwide foreign exchange and money markets.

China’s monetary policy framework appears broadly appropriate at this stage of its economic and financial market development but, over time, its effectiveness may diminish as the economy’s sophistication increases. With this in mind, the PBC asked the IMF to organize a workshop in the context of the Joint China-IMF Training Program. The workshop, Determining the Intermediate Target for Monetary Policy: Practical Issues, sought to distill best practices and discuss their relevance for China. Experts from the central banks of Israel and Chile and from the European Central Bank (ECB) reviewed the building blocks needed for a robust monetary policy decision-making process in an economy moving toward a market-based monetary framework, while IMF and PBC experts discussed China’s monetary policymaking and the challenges ahead.

An international perspective

In addressing how monetary management is handled in a country with an open capital account and large capital inflows, Barry Topf (Bank of Israel) observed that efforts to pursue an independent monetary policy while simultaneously maintaining a fixed exchange rate and unrestricted capital flows are unlikely to be successful. When capital inflows become substantial, they can pose a serious challenge to monetary policy or the pegged exchange rate. If the exchange rate peg is given priority, price stability can be endangered; and if the exchange rate is allowed to appreciate, there are implications for competitiveness and economic activity. Most countries have responded to the dilemma with a combination of steps that generally include greater exchange rate flexibility.

Does official intervention in the foreign exchange market have a role in the transition toward greater exchange rate flexibility? Intervention, Topf noted, can have a number of goals, including adjusting the level of reserves, trying to change the exchange rate’s level or volatility, or responding to disorderly markets. The last two are important to the monetary regime and the central bank’s role in monetary policy. In advanced and some emerging market economies, the trend has been to intervene less. Intervention, however, has remained an important instrument for many developing countries that still use the exchange rate as an intermediate target, and exchange controls make its use more effective. In Israel, intervention gradually became less effective and more costly. Eventually, exchange rate flexibility, and a credible monetary policy with a different nominal anchor (an inflation target) obviated the need for intervention. Avoiding moral hazard and ensuring the efficient assignment of risk were crucial features of the shift from a pegged exchange rate, but these could be established only after the markets tested the authorities’ commitment.

Igal Magendzo (Central Bank of Chile) stressed that communication and transparency are needed to bolster the accountability and perceived legitimacy of independent central banks and strengthen their operational effectiveness by clarifying agents’ understanding and expectations of monetary policy, especially when the policy relies on open market operations. Effective communication allows the central bank to make its objectives clear, inform outsiders about how policy decisions are made, and disseminate information.

Klaus Masuch (ECB), describing the importance the ECB gives to monetary analysis, underscored that monetary growth and inflation are closely related in the medium to long run. This relationship means that monetary policy needs a nominal anchor separate from the variables used to construct short-term inflation forecasts. Thus, monetary analysis underpins the medium-term orientation of the ECB’s monetary policy as the “second pillar” of its framework, although no quantitative targets are assigned to monetary aggregates. Other indicators considered within economic analysis (including projections) are a broad range of price and cost indicators, aggregate demand and its components, labor market conditions, fiscal developments, financial market conditions, and private sector expectations based on financial market prices and surveys.

Asset prices also need to be considered because they are relevant to the objective of price stability over the medium term, Masuch said. Thus an overly expansionary monetary policy may initially show up in high money and credit growth and asset price inflation—not in higher inflation of goods and services prices. This is another reason why thorough monetary analysis is vital. Ultimately, a medium-term orientation and a focus on money and credit aggregates allow the central bank to respond to asset price developments in a way that best contributes to price stability over longer horizons.

The options

In China’s experience, PBC experts said, the correlation of M1 and M2 growth with economic growth and inflation has not been stable over time, and the objectives for growth of the monetary aggregates have frequently been missed (see table). According to the IMF experts, international experience has also shown that anchoring monetary policy on money targets often lost its effectiveness as a result of domestic and external financial liberalization.

It is difficult, the PBC experts emphasized, to assess how fast China should move to make interest rates an intermediate or operating target for monetary policy. The discussions highlighted the adverse effect of excess liquidity and the segmentation of the money market on the development of a robust benchmark yield curve. This, together with the limited scope that banks have to carry out operations on a purely commercial basis, has hindered the effectiveness of the interest rate as an instrument of monetary policy. As a result, the PBC’s market-based monetary policy actions currently have limited effects on the cost of funds, and the PBC has had to rely on reserve requirements to a greater extent than other major central banks. It has also resorted to moral suasion to provide guidance for credit growth and its sectoral allocation—a practice no longer used by major central banks.

Missing the targets

The objectives for growth of monetary aggregates have frequently been missed.

M1 growth1

M2 growth1


Measures of the money supply: M1 includes currency and checking accounts; M2 includes M1 plus savings deposits, certificates of deposit, and money market funds.

Data: Michael Geiger, 2006, “Monetary Policy in China (1994–2004), Targets, Instruments and Their Effectiveness,” Wurzbug Economic Papers No. 68.

Measures of the money supply: M1 includes currency and checking accounts; M2 includes M1 plus savings deposits, certificates of deposit, and money market funds.

Data: Michael Geiger, 2006, “Monetary Policy in China (1994–2004), Targets, Instruments and Their Effectiveness,” Wurzbug Economic Papers No. 68.

IMF experts pointed out that in a low-inflation environment, many central banks have abandoned monetary targeting. As inflationary pressures diminish, the informative role played by monetary aggregates also declines, even when they have a clear long-run relationship with inflation. This experience argues for a monetary targeting strategy that is not overly rigid and that monitors macroeconomic indicators to gauge the appropriateness of correcting a deviation from initial assumptions. At the same time, there are good reasons to monitor money and credit aggregates, without giving these indicators the status of intermediate targets.

Finally, in implementing monetary policy, the IMF experts agreed that if a policy interest rate is to be set as an intermediate or operating target, China will need to decrease the level of excess reserves in the banking system. The aim would be to provide banks with incentives to borrow from each other in the interbank market and then use a short-term PBC rate as a policy signal. Greater reliance on interest rates would not only strengthen the effectiveness of China’s monetary policy but also ensure a more efficient allocation of financial resources and savings and help prevent the buildup of risks in the financial sector.

Bernard Laurens and Rodolfo Maino

IMF Monetary and Financial Systems Department

This article is partially based on a forthcoming IMF Working Paper, “China: Developing Effective Strategic and Operational Monetary Frameworks.”

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