Evolution of the People’s Bank and Its Monetary Policy Tools

Although the People’s Bank of China was founded in December 1948, it did not function as a true central bank until after September 1983. It was previously a “monobank,” responsible for commercial banking as well as central banking functions, and essentially serving as the instrument for carrying out the government’s credit plan for the economy (see Chap­ter 7).

Passage of the Law of the People’s Bank of China on March 18, 1995 helped make clear the People’s Bank’s responsibility for monetary pol­icy and financial regulation, and provided for the setup of a monetary policy committee. Importantly, this 1995 law was preceded by the 1994 Budget Law, which, as discussed in Chapter 3, prohibited the government from borrowing from the People’s Bank. This 1994 law helped weaken the link between fiscal and monetary policy and was followed by increased government reliance on debt finance rather than money finance. Market­based monetary policymaking remained handicapped by limited interest rate liberalization, however, and only since 2004 have commercial banks been able to set their lending rates free of any upper limit above the People’s Bank’s benchmark rate (Geiger, 2006, p.

Experimentation with open market operations began as early as 1993 but were handicapped by the lack of a proper interbank market, prompting their temporary suspension in 1997 (see Geiger, 2006, p. 13). The reintroduction of open market operations in May 1998 proved to be much more success­ful, though, with the range of the operations extending from short-term government securities to a wider set of government instruments, policy financial bonds, and central bank bills (Xie, 2004, p. 4). Central bank bills are short-term debt instruments issued by the People’s Bank itself. Their issuance was significantly expanded on September 24, 2002, when the Peo­ple’s Bank converted all repurchase contracts signed since June 25,2002 into equivalent central bank bills (Xie, 2004, pp. 4-5). The People’s Bank had begun making increasing foreign exchange purchases on the open market to offset upward pressure on the renminbi exchange rate with the dollar. In 2002, these repurchase agreements assumed an increasingly important role in offsetting the tendency for rising reserve inflows to boost overall monetary base growth in China. The problem was that the scale of these activities was threatening to produce a shortage of bonds in the market, hence the need to develop and expand central bank bills as an alternative liquid instrument.

Most central bank bills have carried maturity dates of one year or less. Central bank bills became the People’s Bank’s major weapon in offsetting the liquidity effects of China’s huge reserve buildup in the 2000s. The bills began to be tradable on the interbank bond market in April 2003, and have since achieved a dominant position in this market.

Table 4.1. The Growing Importance of Central Bank Bills, 20022006

Source: Li and Du (2007, p. 131).

(Kwan, 2006b; People’s Bank of China, 2007, p. 15).^[58] Issuance has been by continuous rolling competitive bidding and the active secondary market for these bills gave rise to a market-determined benchmark interest rate. A United States-style tender offering system was introduced in March 2006 and central bank bills have become significant not only as a monetary policy tool but also in furthering the ongoing movement toward interest rate liberalization.

The People’s Bank has not only used open market operations but also increased reserve requirements in the attempt to contain the extra liquidity generated by inflows of funds from abroad in recent years. In this way, the People’s Bank has endeavored to keep money growth rates from rising too rapidly. Money supply targets were first introduced in 1986 and the elimination of credit ceilings in 1998 left money supply, principally M2, as the sole intermediate target officially directed toward achieving the ultimate goal of price stability (Laurens and Maino, 2007, p. 10)- with People’s Bank Monetary Policy Director Dai Genyou (Dai, 2002), for example, stressing the steady growth achieved in M2, in the 14% to 15% range, over the 1998-2001 period. M2 growth in turn relies upon monetary base growth, or high powered money, produced via the People’s Bank’s open market operations. The People’s Bank’s targets for Ml and M2 growth have at times been breached to the upside, as in 2002-2003, for example, but deviations from targeted growth rates havebeen reduced since the late 1990s - especially for M2 (see Geiger, 2006, p. 29). Whereas Geiger (2006) suggests that the central bank relied upon wage and price controls and window guidance to contain inflation despite missing the announced money growth targets, the fact remains that the lowered money growth targets after 1996 were accompanied by both sharply declining rates of money growth and declining inflation (see Chapter 3). Indeed, actual M2 growth rates tended to be lower than the targets over the 1997-2001 deflationary period - when an overly tight monetary policy appeared to facilitate the outright declines in prices that emerged over this interval.

The government and the central bank seem, for the most part, to have shared a similar concern with limiting the inflationary consequences of the reserve buildup in the early 2000s - although Lardy (2005a, pp. 44-46) does point to the hiking of money supply targets in 2003 being prompted by the government’s concerns about growth prospects in the midst of the SARS epidemic.^[59] Certainly, even though the December 27, 2003 amendment of the Law of the People’s Bank of China offered some enhancements to central bank autonomy, the government retains significant scope for influencing the course of monetary policy.^[60] The People’s Bank’s focus on purely monetary policy issues was admittedly enhanced by the March 2003 establishment of the China Banking Regulatory Commission, which was charged with the financial industry supervision that had previously fallen under the purview of the People’s Bank. Nevertheless, the formal independence of the People’s Bank remains quite limited. The central bank’s monetary policy committee is still technically no more than an advisory committee and, as it stands, incorporates several government officials, including the deputy Minister of Finance (see Zhou and Li, 2007, pp. 80-84). Goodfriend and Prasad (2006) stress the need for proper operational independence of the People’s Bank and advocate a move away from money supply targeting in favor of inflation targeting, with an explicit inflation objective to help anchor inflation expectations.

Upward pressure on money supply growth has been fueled by rapidly growing inflows of foreign exchange reserves in the 2000s (Chapters 1 and 2). This reserve buildup directly adds to monetary base, which comprises the sum of foreign and domestic assets, requiring the central bank to bring about an offsetting reduction in domestic assets if overall money growth rates are not to expand. The contractionary policies aimed at achieving such offsetting reductions in the domestic component of the monetary base are also known as “sterilization” measures.

In response to overheating, the PBC mainly resorted to economic management efforts to contain the particularly large increase in the credit and monetary supply. This included open market operations to drain liquidity, higher reserve require­ments, window guidance and structural adjustments (for instance, intensified reg­ulation of lending to the real estate sector and a clampdown on illicit real estate loans).

The People’s Bank carried out 110 open market operations in 2004 alone, selling securities, chiefly central bank bills, to withdraw liquidity from the economy. He et al. (2005) calculate that these interventions brought the monetary base growth rate down from 30% to 11.4% in 2004. Overall, He et al. (2005) find that the effects of increases in foreign assets were essentially fully offset by an equal reduction in domestic assets over the 1998-2004 period, implying complete sterilization. Ouyang, Rajan, and Willett (2007) find near-complete sterilization over the 1999-2005 period, with typically 90% of the reserve inflows being sterilized.^[61] Meanwhile, less than full offset of increases in foreign assets over the 1997-2006 period is suggested by Bouvatier (2007) - while Burdekin and Siklos (2008) find negative effects of foreign reserve growth on total monetary base growth combined with positive effects on M2 growth during 1990-2003. Although all of these studies indicate that the buildup of foreign reserves had a major impact on People’s Bank policy, the available empirical estimates suggest that the People’s Bank remained largely successful in insulating overall money growth from the effects of these reserve inflows. Further analysis of this relationship is provided in the econometric work presented later in the chapter.

Table 4.2. Successive Hikes in the Required Reserve Ratio, September 2003-June 2007

Source: Great ChinaDatabase (http://www.finasia.biz/tejonline/tejonline.htm).

In addition to open market operations, the People’s Bank launched a succession of hikes in the minimum reserve requirement ratio, forcing banks to hold onto more funds to back the loans that they issue. An initial full percentage point increase in the ratio was imposed in September 2003, followed by a half percentage point increase in April 2004 and then eight more half percentage point increases in just eleven months, starting from July 2006. These increases took the reserve requirement ratio up from 6% in August 2003 to 11.5% in June 2007 (see Table 4.2).^[62] Other measures included hikes in the People’s Bank’s benchmark lending and deposit rates in both 2004 and 2007 and more administrative measures like the directive to state banks to refrain from lending to targeted sectors, such as real estate, ahead of the May 2004 holidays (McGregor, 2006a). The People’s Bank of China (2007, p. 16) has also not hesitated to issue “special” central bank bills to commercial banks with relatively rapid credit growth and sufficient liquidity. This measure not only withdrew liquidity but also served as a warning to banks with high credit growth.