The debate about China’s monetary policy has long swirled around one topic—China’s exchange rate regime. Many observers have been calling for a revaluation to correct what they see as an unfair competitive advantage that China maintains by keeping its exchange rate undervalued. Whether or not there is merit to calls for a currency appreciation, what China needs is a truly independent monetary policy, which is not possible with a de facto fixed exchange rate, argue Marvin Goodfriend and Eswar Prasad in a new IMF Working Paper. Indeed, that is an important reason the IMF has been calling for greater exchange rate flexibility in China.
As China’s economy develops and becomes more market-oriented, and as its integration with the world economy continues, monetary policy will need to shoulder an increasingly large burden in ensuring stable, noninflationary growth. Rising integration, for instance, implies greater vulnerability to external shocks, and monetary policy is typically the first line of defense against many such shocks. Although deeper structural reforms may be the key determinants of long-term growth, monetary policy has an important role to play in creating the stable macroeconomic environment that is essential for those reforms to take root.
In recent years, China’s monetary policy has operated under difficult constraints, including a fixed exchange rate regime, an underdeveloped financial system, and numerous institutional weaknesses. While capital controls provide some room for monetary policy to maneuver even in such a regime, this room tends to be quite limited in practice and could result in inadequate control of investment growth and inflationary (or deflationary) pressures. Furthermore, the effectiveness of capital controls inevitably erodes over time as domestic and international investors find channels, including expanding trade, to evade them. Indeed, China’s rapid accumulation of foreign reserves in recent years (see chart) is symptomatic of the difficult balancing act that its monetary policymakers face on the domestic and external fronts.
These considerations have led the authorities to move toward a more flexible exchange rate regime. On July 21, 2005, China revalued the renminbi by 2.1 percent relative to the U.S. dollar and announced that the renminbi’s value would henceforth be set with reference to a basket of currencies rather than pegged to the dollar. Although the renminbi’s value relative to the U.S. dollar has fluctuated only moderately since then, the Chinese authorities have clearly stated their intention to allow for greater flexibility over time.
Managing inflation expectations
An important consequence of the move toward a flexible exchange rate is the need to adopt a new nominal anchor and strategy for monetary policy. Prominent economists, such as Robert Mundell and Ronald McKinnon, have forcefully argued that the fixed exchange rate has provided a stable nominal anchor and that a flexible exchange rate would deprive the economy of this anchor. They have a valid point: a stable nominal anchor is essential to manage inflation expectations. But McKinnon and Mundell have, the authors argue, the wrong idea about which anchor would work best.
Goodfriend and Prasad make the case that China should adopt a low inflation objective—an explicit or implicit long-run range for the inflation rate and an acknowledgement that low inflation is a priority for monetary policy—as the new nominal anchor. Theory and experience—from both advanced industrial economies and emerging market economies—suggest that adopting such a framework is the most reliable way to enable the People’s Bank of China (PBC) to stabilize domestic inflation and protect employment against macroeconomic shocks.
Inflation objectives have emerged in recent years as the leading nominal anchor for monetary policy around the world. An inflation objective can accommodate fluctuations in productivity growth and changing relationships between monetary or credit aggregates and inflation, all of which are relevant considerations for a developing economy. It also has the virtue of easy communicability.
Stocks and flows
China’s foreign exchange reserves have been rising rapidly.
Notes: The flow and stock numbers for foreign exchange reserves include the amounts used for bank recapitalizations: $45 billion in December 2003, $15 billion in April 2005, and $5 billion in September 2005—as well as a $6 billion foreign exchange swap that the People’s Bank of China conducted with domestic banks in November 2005.
Data: CEIC Data Company Ltd. and authors’ calculations.
Can this framework be reconciled with the PBC’s broader mandate? The law governing the PBC states that, “under the guidance of the State Council, the PBC formulates and implements monetary policy, prevents and resolves financial risks, and safeguards financial stability.” Furthermore, how would a low inflation objective be consistent with promoting sustained high employment growth—a key consideration for Chinese policymakers? In the authors’ view, it is precisely by providing a firm and credible nominal anchor through a low inflation objective that the PBC can best contribute to overall macroeconomic stability and best provide for sustained employment growth and financial stability.
The authors stop short of advocating a full-fledged inflation targeting regime. For an economy such as China’s that is undergoing marked transitions, there would be numerous impediments to operating such a regime effectively. A low inflation objective is more practical for the foreseeable future and should deliver most of the benefits of formal inflation targeting. In light of the economy’s changing structure and weaknesses in the monetary transmission mechanism, the framework could accommodate a continued role for the PBC to monitor and manage monetary (and credit) aggregates. But money may not constitute a good stand-alone nominal anchor because the changes in China’s economic and financial structure imply that the rate of money growth consistent with a stable rate of inflation is likely to be highly variable.
Operational independence for the central bank
Some of the basic requirements of an inflation targeting regime are also important for a low inflation objective. Principal among these is operational independence for the central bank. This means that the PBC should have the authority and the capability to use its monetary policy instruments—bank reserves or an interest rate—to credibly anchor inflation and stabilize the macroeconomy. But it would be important for the Chinese government to explicitly acknowledge its support for a low inflation objective as the nominal anchor for monetary policy.
What would it take to put in place a low inflation objective? Exchange rate flexibility is, of course, a prerequisite for an independent monetary policy. But a move toward greater exchange rate flexibility is hardly the solution by itself. Indeed, enhancing the effectiveness of the monetary transmission mechanism poses difficult challenges independent of the constraints related to the exchange rate regime. The primary one is the reform of the financial system, through which monetary policy must influence economic activity. In China, the state-owned banking system still dominates the financial landscape. For instance, deposits in the banking system now amount to about 160 percent of GDP, with a correspondingly high level of credit to GDP.
Banking sector reform
Despite recent improvements in the commercial orientation of the banking sector and enhanced banking supervision and regulation, Chinese banks are still far from being robust, commercially driven financial entities. Given the dominance of the banking sector in China’s financial landscape, this has important implications for monetary policy transmission.
Thus, China must transform the banking system into one that can direct credit prudently to its most valued uses, given correct interest rate signals. Even in the best of circumstances, it will take years for China to put in place all of the components of a modern, efficient banking system. This is especially so when one recognizes that the transition process must be supervised and regulated with great care to preserve the public’s confidence in the banks and guard against the moral hazard problems associated with explicit or implicit deposit insurance provided by the government.
Nevertheless, the authors argue, it is feasible and desirable for China to put in place the financial sector reforms and regulations that would enable it to adopt an independent monetary policy with low inflation as the nominal anchor. The main point would be to ensure that banks could withstand the financial stress that may result from fluctuations in interest rates necessary to stabilize the macroeconomy and maintain stable low inflation. Indeed, significant progress has already been made in strengthening bank balance sheets.
Goodfriend and Prasad’s proposal has three additional attributes. First, it would allow for continuity in the operational approach to monetary policy. The PBC could gradually adapt its procedures to the pursuit of an independent monetary policy as supporting reforms are put in place. The proposal would entail mainly a shift in strategic focus to a well-defined inflation anchor. Second, under current circumstances, the shift to an inflation anchor would be seamless because it would involve merely locking in the current low rate of inflation. Third, the adoption of an effective independent monetary policy would facilitate various reforms with intrinsic benefits of their own. For instance, the resulting macroeco-nomic stability would facilitate the modernization of the financial system. In addition, the new policy regime would necessitate improvements in the statistical base that would enhance public sector transparency and encourage better communication about policy intentions.
This article is based on IMF Working Paper No. 06/111, “A Framework for Independent Monetary Policy in China,” by Marvin Goodfriend and Eswar Prasad. Copies are available for $15.00 each from IMF Publication Services. Please see page 208 for ordering details. The full text is also available on the IMF’s website (www.imf.org).