The Evolving Role of Central Banks

17 The Evolving Role of the Central Bank in China

Patrick Downes, and Reza Vaez-Zadeh
Published Date:
June 1991
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The role of the central bank in China has undergone major changes since 1979. These changes were part of the reform process that introduced a significant number of market elements in the functioning of China’s economy. The reform has been gradual and has involved a lot of experimentation. In the financial sector, including the People’s Bank of China (PBC), the process of reform has had similar characteristics.

This paper presents a brief review of the broad economic reforms that have taken place in China and then focuses on the evolution of the financial sector and the role of the PBC. In this context, it discusses key issues that had to be addressed, such as the importance of financial reform in the economic reform process, the degree of independence of the central bank, the choice of monetary targets and instruments, and the need to reform bank supervision.

Broad Economic Reforms

In 1979, China started an economic reform process that endeavored to increase economic efficiency by allowing market forces to become a major determinant of resource allocation and consequently reduce the role of the central plan. Various forms of property ownership, including private ownership, were allowed, but public ownership remained dominant; the role of economic incentives was stressed, thus transferring a much greater degree of influence to the price mechanism. The economy was opened to the rest of the world.

Reform covered enterprise management, rural and industrial development, financial intermediation, and public finance. Starting in agriculture, and spreading to urban industry, production units have been granted more autonomy, including in price setting. A “two-track” system of price determination has evolved, under which one set of prices is negotiated with the state and another, for production in excess of quota, is market determined. For the past four years, a dual exchange market has been in place. It includes an official segment at a fixed exchange rate and a segment with somewhat freer access in which the rate is allowed to vary.

Greater decentralization of government functions has accompanied the reform process; local and provincial authorities have been allowed to play a larger role in economic decision making than before the reform.

Financial Institutions and Monetary Policy Before the Reform

Before the reform, the main task of financial institutions and monetary policy was to ensure the fulfillment of the production targets embodied in the central plan. The banking system was centralized in the PBC, a monobank that combined the functions of the central and commercial banks. All specialized banks were part of the PBC, except for the Bank of China, which was responsible for foreign exchange operations.

As in other prereform centrally planned economies, monetary policy was entirely passive or accommodative and relied on two planning frameworks: the credit plan and the cash plan. The credit plan was the financial counterpart of the production plan, determining the amount of credit to be allocated to each enterprise. Enterprises were obliged to remit all surplus funds to the central government. All investment was financed through the budget. Thus, bank credit to enterprises financed working capital requirements only. The PBC also provided credit to the budget on several occasions. Credit to enterprises was viewed as noninflationary (because it was backed by commodity flows), while credit to the budget was viewed as inflationary. This distinction was reflected in the fact that only the former was included in the credit plan.

The cash plan was determined by the planning authorities and was designed to supply the amount of currency needed for wages and for agricultural procurement by the state. The plan reflected the separate circuits that existed for enterprises, on the one hand, and for households and agricultural producers, on the other. Enterprises had to carry out most of their transactions through bank transfers. They could use their bank deposits to settle only transactions authorized by the production plan. Moreover, their use of currency was strictly regulated. Households could hold cash and savings deposits only; they could not have checking accounts and had no access to credit. Therefore, currency was the only asset that provided freely usable purchasing power, which made its control through the cash plan so important.

The arrangements outlined above provided for a very limited role for monetary policy—and hence for an independent central bank—in economic management. The PBC thus participated in the formulation of the credit plan and was responsible for its implementation but did not set its own monetary targets. Moreover, with regard to the cash plan, it could only monitor its execution and provide warnings when deviations occurred, since it had no control over the transactions that led to the creation and absorption of currency.

Financial Reform in the 1980s

China carried out substantial financial reform over the past decade. Commercial banking functions were gradually separated from the PBC, which became a full-fledged central bank in 1984. Four specialized banks—Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), People’s Construction Bank of China (PCBC), and the Bank of China (BOC), for handling foreign exchange transactions—were established to deal with different economic sectors, although some degree of competition among them was increasingly permitted. Over time, additional financial institutions came into operation: two universal banks at the national level, local commercial banks, nonbank financial institutions, development banks, urban credit cooperatives (a network of rural credit cooperatives has existed since the prereform period), and finance companies.

The PBC After the Reform

The functions and responsibilities of the PBC have come to resemble more closely those of a central bank in market economies. It formulates financial policy, determines interest rates, issues currency, and formulates and implements credit policy. It supervises bank and nonbank financial institutions. It acts as banker to the government by managing the state treasury. It is the custodian of the official foreign currency reserves. And last but not least, it acts as banker to banks by extending advances, rediscounting and refinancing to the specialized banks, and providing banking services such as clearance.

The degree of development of these functions varies: some, like currency issue, are fully developed; others, such as prudential bank supervision, have not began as yet. In addition to the foregoing functions, the PBC has occasionally been called on to perform others that would not normally be associated with a central bank, such as direct lending to selected projects.

While China has not passed yet a central bank law,1 the PBC’s position within the state institutions is defined in the “Provisional Regulations of the People’s Republic of China on the Control of Banks,” promulgated in 1986, whose Article 5 reads: “The People’s Bank of China is the State organ through which the State Council leads and controls the fiscal affairs of the nation, and is the central bank of the State…” Thus, final authority on major financial decisions rests with the State Council rather than the PBC.

The PBC has a large number of branches, which have been subject to “dual leadership”: the head office of the PBC and the provincial authorities. The shift of commercial banking responsibilities from the PBC to other banks has resulted in a reduction in the number of its branches and staff: in 1979 it had 15,000 branches and subbranches and a staff of over a quarter of a million; by the late 1980s it had reduced its branches to about 2,500 and reduced its staff by about two thirds. Despite this reduction, the number of branches and, more important, their powers to act independently from head office have exceeded what is typical in market economies.

Issues Faced by the PBC

The reform process transformed the responsibilities of the PBC from providing passive financing for plan transactions to playing a key role in macroeconomic management. This posed several major issues for the PBC: On what monetary targets should it focus? What techniques and instruments should it use to attain those targets? What should be the relationships between the PBC’s head office and its branches, and between them and the rest of the financial system? What should be the roles of the market and of the PBC (or the Plan) in allocating credit across sectors? And how should the PBC supervise the banking system?

Monetary Policy and Instruments

The economic reform process, by decentralizing decision making among economic agents, has made the economy more responsive to changes in the monetary policy stance. Therefore, the variability in growth of monetary aggregates that was observed in the postreform period had significant effects on growth, inflation, and the balance of payments. Some of that variability reflected periodic changes in the priority that the State Council assigned to various economic objectives, which limited the PBC’s ability to focus on macroeconomic stability, and some reflected the challenge of reforming monetary policy instruments. The reform, by increasing the financial autonomy of enterprises, made currency targeting increasingly less relevant and targeting broader aggregates (such as broad money and domestic credit) more important.

The annual credit plan and the cash plan have nevertheless remained the central elements in the formulation of monetary policy. But whereas formerly the credit plan was driven almost exclusively by the financial needs of the physical plan, now the PBC incorporates macroeconomic criteria (objectives for growth, inflation, and balance of payments overall position) in determining the permissible credit expansion. Moreover, while the cash plan still exists, the PBC no longer focuses its attention exclusively on currency but also on broader monetary aggregates. To supplement the credit plan, a general financial program was introduced in 1989. It consolidates the lending carried out by all financial institutions and also covers credits for budget financing.

The PBC relied on both direct and indirect monetary instruments to carry out monetary policy after the reform. Credit ceilings have been the main direct monetary instrument. The credit plan establishes such ceilings for each specialized bank, which in turn sets a ceiling for each of its branches. The intensity with which these ceilings have been enforced has varied, depending largely on the overall monetary policy stance. While these ceilings have been effective in targeting credit aggregates, they introduce distortions in the financial system. As of March 1989, the credit plan was extended to all financial institutions, except financial leasing companies. The PBC has also created some indirect monetary instrument, which have gained in importance over time. Three of them are discussed below.

Reserve requirements. Banks must redeposit with the PBC a certain fraction of their deposits. Until 1985, the ratios were relatively high and differed substantially according to the type of bank. They were then unified and lowered substantially: set at 10 percent in 1985, they have been gradually raised to stand at 14 percent in 1990. While rural and urban credit cooperatives must observe the same reserve requirement as banks, their reserve balances must be maintained with the ABC and ICBC and other banks, respectively. In addition, in 1989 the PBC required financial institutions to keep excess reserves at a minimum of 5 to 7 percent of deposits.

Interest rates. Until 1988, adjustments were infrequent despite changing economic circumstances (especially inflation rates). Recently, interest rates have been moved relatively frequently and the yield on long-term savings deposits is now guaranteed to be at least equal to inflation. Institutions have been given somewhat greater latitude in determining their own rates.

PBC lending to specialized banks. This lending finances about one third of specialized banks’ loans. While potentially a most important tool of monetary targeting, the existence of credit ceilings has limited its usefulness.

Relationship Between the Head Office and Branches of the PBC

The relationship between the PBC head office and its branches has been a major issue in the adaptation of the PBC’s structure to the postreform situation. The “dual leadership” concept and the powers vested in the branches created some difficulties. In particular, the fact that PBC branches could extend credit on their own to the corresponding branches of specialized banks weakened the PBC’s grasp on the supply of credit. In 1988, two important steps were taken to increase the control of the PBC’s head office over its branches. First, the power of the branches to extend credit on their own was sharply curtailed. Second, the PBC’s head office was empowered to appoint the managers of its branches.

Sectoral Credit Allocation

The Chinese authorities have been balancing two objectives in credit allocation: ensuring that “priority” sectors and projects get financing, and allowing financial institutions greater freedom in credit allocation. These objectives have conflicted in many instances, which has resulted in changes in regulations and practices. The PBC has been involved in the sectoral credit allocation, including at times through direct lending to specific projects.

Bank Supervision

The “Provisional Regulations of the People’s Republic of China on the Control of Banks,” mentioned above, vest in the PBC the power to supervise, regulate, and inspect financial institutions. The PBC has delegated some supervisory powers with regard to rural and urban credit cooperatives on the ABC and ICBC, respectively. The focus of regulations so far has been on compliance with financial regulations, rather than on prudential supervision.

Some Lessons from the PBC Experience

While financial reform in China has not been completed yet, the experience accumulated so far makes it possible to show some important lessons: (1) Market-oriented reform entails decentralization of decision making in the economy. At the same time, preserving macro-economic stability in this context requires strong central institutions and instruments of macroeconomic management. (2) The central bank should have full powers, at the head-office level, to adopt the monetary policy decisions that are required to attain the broader economic goals of the government. (3) Monetary targets and instruments may need to be changed or reformulated in order to be effective under the new circumstances. For instance in China’s case, targeting a broad monetary aggregate became much more important after the reform than before the reform. (4) In order to reap the benefits of the economic reform, the central bank should replace direct controls with indirect monetary instruments that increase the efficiency of the financial system while allowing the attainment of the monetary targets. (5) There is likely to be a conflict between credit allocation according to plan priorities and credit allocation according to market criteria. Resolving the conflict in an efficient way may require adopting decisions in areas (such as pricing) that go beyond financial sector policies. (6) Bank supervision needs to be broadened to include prudential supervision, in addition to checking compliance with financial regulations. This becomes more urgent to preserve the soundness of a two-tier banking system as enterprise reform makes progress and enterprises are allowed to fail.

*The author is Division Chief in the Central Banking Department of the International Monetary Fund. This paper was prepared while he was a member of the Asian Department. The author wishes to thank Ms. Linda M. Koenig and Messrs. Martin J. Fetherston and Michael W. Bell for their comments and assistance.
1This reflects the authorities’ desire to gain experience in the workings of the financial system after the reform before drafting final legislation.

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