China’s Monetary Policy Essay Example

  • Category: Economics, Money,
  • Pages: 8
  • Words: 2066
  • Published: 13 August 2020
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China’s economy is not one to neglect. In recent years, China’s economy has been evolving. China’s money-market funds have doubled, making it the second largest market behind the United States (McCurry and Kollewee, 2011). However, it is essential to look at China’s monetary policy, as despite the economy’s successes, it holds some flaws. Monetary policy is a crucial part of a country’s economics because it concerns the stability and money supply of the economy. There are many ways to conduct monetary policy. The United States uses price measures, while the tools to conduct monetary policy in the China are quantitative based. The issues with China’s monetary policy are conflicting goals and the ineffectiveness of direct credit policies and interest rates. However, the best way to remedy this issue is to follow the monetary policy instruments that the United States uses. 

Conflicting Goals of the Central Bank

Monetary policy is a recent development in China since the People’s Bank of China (PBC) only became the central bank in 1984 (Fan et al., 2011),  responsible for implementing monetary policy. Without a central bank, many commercial banks have the freedom to implement monetary policy as they please, bringing national economic division. Following this declaration, the PBC aimed to maintain the stability and promote economic growth (Conway et al., 2010). In other words, the PBC was responsible for conducting monetary policy, specifically through changing the money supply. 

As money supply changes, demand and interest rates change. The central bank grows the economy by changing the price level or interest rate to be lower. This is because the cost of borrowing is lower, so there would be more investment activity. On the other hand, it would maintain stability by ensuring the money supply and interest rate is constant. Thus, these goals contradict one another, which can be attributed as a cause for the problems with China’s monetary policy. 

Even though the PBC has multiple goals, one study finds that in 1995, China has indeed tried to confine its goals and “set inflation fighting as its priority” (Fan et al., 2011). The fact that it took China around ten years shows that China realizes problems relatively quickly. Prioritizing one goal, inflation fighting, could be seen as a successful monetary policy strategy because China has recently experienced drastic economic growth. At the same time, inflation fighting is a strategy that targets stability of the money supply. However, that is not to say the issues with Chinese monetary policy are resolved.

 A more recent study finds that the governor of the PBC stated “China’s monetary policy should be made to meet multiple objectives rather than focus on only fighting inflation” (Ma and Li, 2015). This suggests that the individual with the most power at the PBC disregards China’s economic growth, and prefers a implementing more liberated monetary policy strategies that targets various economic matters. Another argument can be made that the head of the PBC does not want to solely focus on inflation fighting because he does not believe it is the best monetary policy strategy in China. 

More recently, “the main focus of the Chinese monetary policy has been more toward stabilizing output” (Qin et al., 2018), contradicting Fan’s (2011) statement. This proves that the PBC does acknowledge the two goals it has created, and its monetary policy has addressed both issues. Because of that, it can be inferred that China has changed its monetary policy approach. Therefore, the underlying issue with China’s monetary policy remains ambiguity and changes regarding how to approach the economy. Not only is China’s monetary policy flawed as a result of unclear goals, but the tools used to implement monetary policy demonstrate issues.  

Monetary Policy Tools In China

China’s shift away from a centrally planned economy is evident in its current use of direct credit plans as an instrument to conduct monetary policy. In 1998, the PBC declared that it had “abandoned the traditional central-planning system” (Fan et al., 2011).This suggests China began attempting to shift towards centralizing the economy by giving the PBC sole control for monetary policy, which could be seen as an indication of hope. 

However, looking at monetary policy tools currently used by China, there is overwhelming evidence that its actions do not support their statement. In abandoning direct credit policies, China began adopting window guidance (Geiger, 2012), a policy remnant of direct credit policies. Window guidance is when policymakers tell banks “when to lend and not to lend” (Fernald et al., 2014). That is to say, the PBC plans out all economic activity. On the surface, window guidance may seem like an effective monetary policy because the PBC is informed on all bank activity. However, this enslaves banks to the dictations of the PBC, while in other economies, commercial banks’ decision to lend is independent of the central bank. Allowing banks to lend at their own pleasure is a strategy that would allow the PBC to meet its two main goals. 

Different banks will have the freedom to differentially respond to differences in interest rates. Lending is related to interest rates because banks’ demand for lending money depends on how much interest they must pay for pursuing such action. If a bank decides to lend, they are taking action to change the economy, suggesting efforts to grow the economy. If a bank decides not to lend, they are keeping the economy the same, suggesting that the economy is remaining stable. Therefore, China’s continued use of window guidance as a monetary policy tool, despite claiming an abandonment of direct tools demonstrate a cause of China’s monetary policy issue. 

Since there are multiple goals, the PBC must apply “multiple policy instruments” (Sun, 2015). This is concerning because such tools could contradict one another or be more effective than one another. In fact, the structure of China’s economy has proven that “the interest rate rule alone [is] inadequate” (Liu and Zhang, 2010) for conducting monetary policy. This creates the argument that interest rate policies can be an effective monetary policy tool, but only in certain economies and. 

However, if China uses the interest rate, it must use other tools in conjunction. Further studies of China’s economy in the 1990s, the beginning period of China’s reform expand on Liu and Zhang’s (2010) research, examining the real side of the economy. The research states that “interest-rate policies [...] had little, if any, impact on the real side of the Chinese economy” (Fernald et al., 2014). The real side of the economy deals with goods in the market. A change in prices is a sign that they money supply has changed. Since the real side of the economy was not impacted, it can be concluded that interest rate policies are used to maintain stability. 

However, the PBC’s goals additionally include growing the economy. Therefore, interest rate policies are not an effective monetary policy tool, because the PBC is unable to meet both of its goals. This further justifies the argument that the problem with China’s monetary policy is that with contrasting goals, it cannot implement an effective monetary policy. This furthermore contributes to issues with China’s monetary policy because there is uncertainty as to how the PBC should focus its monetary policy.

Monetary Policy Tools In Other Countries

Despite the issues with China’s monetary policy, China can use the United States as a precedent. Like China, the central bank of the United States has several goals. And, like China, the United States utilizes a variety of tools to implement their monetary policy. Even though some studies claim that developed countries use one tool for monetary policy (Sun, 2015), there is stronger evidence that developed countries use “standard tools such as open market operations and the discount rate” (Fungacova et al., 2016).

The three main tools that the United States central bank uses are open market operations, the discount rate, and the reserve requirement ratio (St. Louis Fed). The authors imply that these monetary policy tools are ideal, and should be used as a guideline for developing countries in their growth. They emphasize open market operations and the discount rate, suggesting that they are of utmost importance. Open market operations are when the government buys government bonds commercial banks, or sells them. 

This impacts the money supply because buying government bonds increases the liquidity of the money held at the commercial bank. The increased liquidity in turn creates more money and the government will pay for the money created at a future date. The reserve requirement ratio is when the central bank mandates the amount of money commercial banks must keep. In other words, the reserve requirement is a percent of all money that is held by banks and kept out of circulation.

The Reserve Requirement Ratio

Even though the United States uses three monetary policy tools, the reserve requirement ratio is not used often. Analysis of monetary policy tools in other central banks, such as the Federal Bank of the United States assert that the reserve ratio is “no longer used” (Berkelmans et al., 2016), indicating that central banks certainly have used reserve requirements as a monetary policy tool in the past. However, the practice is almost presently nonexistent. Since developed economies have decreased their reliance of the reserve requirement ratio as a monetary policy tool, they must use a different tool. In fact, studies indicate that the primary monetary policy tool of developed economies is open market operations (Sun, 2013). 

Even though the United States acknowledges having many options of monetary policy tools to use, it will only use one. This contrasts China, as it similarly has many options of monetary policy to use, but does not have a dominant one. Open market operations are used most frequently because they are best for fine-tuning movements in short-term interest rates (Sun, 2013). Since open market operations are purchases or sales of short-term government bonds, it is evident that they are used most often because it is easiest to transmit. The fact that it is for minor adjustments show that the economies of more advanced economies are generally stable. 

Since China does not use open market operations, it can be concluded that China’s economy is not stable, even though stability is one of the PBC’s monetary policy goals. Therefore, an additional cause of China’s monetary policy issues is a lack of stability like that in the United States and other developed countries. 

Despite claims that China relies heavily on direct monetary policy tools such as window guidance, some studies show China is adapting modern methods, such as frequent adjustments of the “deposit reserve ratio” (Fu and Liu, 2015). Even though China has multiple monetary policy tools, the changing reserve requirement ratio signals its increased use by the PBC. Changing the required amount of money banks are allowed to change or hold consequently changes the money supply. 

A study on China’s reliance on the reserve requirement for monetary policy concludes reserve requirements are “an effective monetary policy instrument that can be used as a substitute to other monetary policy instruments in China” (Fugacova et al., 2016). Not only does this show that the reserve requirement is an effective monetary policy tool, it also shows that China should abandon other tools in use and place a greater reliance on their reserve requirement ratio. This is further justified because it is also a tool used by the United States. 

Additional studies of reserve requirement changes found that they are “not necessarily indicative of monetary easing or tightening, but are more related to the management of foreign exchange reserves” (Sun, 2013). This demonstrates that even though China is using the reserve requirement as a monetary policy tool, it is not using it properly. Since monetary policy concerns the money supply, it should focus on the central bank and the private sector rather than the international sector. Foreign exchange reserves deal with the international sector, indicating that the reserve requirement is not precisely used for monetary policy. Contracting or expanding money supply demonstrates monetary policy in action. 

However, changing the reserve requirement in China is not a monetary policy tool, because it does not signal changes in money supply. This appears to contradict previous research on China’s use of the reserve requirement, as Fungacova et al. (2016) state that “reserve requirements are an effective monetary policy instrument”. However, monetary policy effectiveness can be measured in many ways. The research claims that reserve requirements are effective, but only in the sense that it impacts the loan growth rate. Therefore, even though the reserve requirement is a tool used by both China and advanced economies as the United States, it is not necessarily used for effective monetary policy in China. 

Conclusion

As China’s economy emerges as a major power, it is critical to examine the economy. Particularly, the resulting issues of its monetary policy. The central bank of China, the People’s Bank of China aims to simultaneously maintain stable yet grow. There are many monetary policy tools available to the country to use, which can be categorized as quantitative or price based. Window guidance is a quantitative tool that restricts banks, which is an issue concerning monetary policy. Another failed policy is the interest rate rule, because results have not been apparent. Instead, China can follow the example of the United States and use price based measures, specifically the reserve requirement ratio, which, when used effectively, is an efficient monetary policy for the country. The success of monetary policy in China depends on following the successes of others, concluding that success is best achieved by following existing examples.