A brief description of China’s monetary policy framework

Hui Yuan
Associate Professor Department of Economics, National Academy of Governance

Monetary Policy Institute Blog #103

“Compared to the dramatic changes in interest rates in major advanced economies, China’s interest rates are moderate and relatively stable, which provide the conditions for implementing a normal monetary policy for a long period.”

On June 24, 2016, the governor of the People’s Bank of China (PBC), Zhou said at an IMF Central Banking Lecture, “as China has the features of both a large transition economy and an emerging market economy, China’s central bank and its monetary policy are yet to be well understood by the outside world”. This situation remains relatively unchanged even today.

When the reform and opening up started in 1978, China didn’t have a monetary authority in the modern sense, not to mention a proper monetary policy framework. Nowadays, China has not only built a central bank with its Monetary Policy Committee, but also greatly improved the framework for modern monetary policy with Chinese characteristics including multi-objectives, several intermediate targets, its transmission mechanisms, and the sound or prudent operational philosophy.

Multi-objectives

The ultimate goals of China’s monetary policy are to maintain the stability of the value of the currency so as to promote economic growth according to the Law on the People’s Bank of China, in 1995. Beside that, employment levels, equilibrium of the balance of payments, and financial stability are also included with different weights (Zhou, 2013; Yi, 2023). These multiple goals are consistent with post-Keynesian theory, which argues that the goals of monetary policy should go beyond strict price stability and include financial stability and macroeconomic stabilization, with regard to both economic sustainability and employment levels (Rochon and Rossi). However, they are derived from characteristic specific to China as the largest developing country and the monetary policy practices.

Intermediate targets

To achieve these goals, the PBC claims to use M2 and aggregate financing as the anchoring of the intermediary objective, which means keeping the growth of the money supply and aggregate financing generally in line with nominal economic growth according to the 14th Five-Year Plan for Economic and Social Development and Long-Range Objectives through the Year 2035.

However, with the transformation of China’s economy and the development of financial markets and products, the seemingly stable relationship between the quantitative intermediate target and the ultimate goal of monetary policy tends to weaken. Furthermore, the deepening of market-oriented interest rate reform has provided a solid foundation for the gradual shift of monetary policy framework from quantitative to price-based regulations.

Table 1 presents the main interest rates in China and their levels, at the end of 2022. The PBC believes that the equilibrium interest rate is determined by market supply and demand, but its level in the long run should equal the natural interest rate. Since the natural interest rate is an abstract concept in theory, the PBC adopts the golden rule to evaluate the effect of monetary policy implementation, which requires the real interest rate to roughly approach the potential economic growth rate (Yi; MPAG).

Transmission mechanisms

Nowadays, the core of the PBC’s monetary policy is to control interest rates, that is, to control interest rates at levels conducive to price stability and economic growth (Yi, 2023). Two channels for monetary policy transmission are proposed (Figure 1). For short-term interest rates, with the assistance of interest rate corridors — the ceiling and floor of which are the 7-day SLF interest rate and interest rate on excess reserves respectively — the PBC guides the market rates represented by the DR007 (7-day repo rate between depository institutions with rate securities as collateral) to move around the short-term policy rate (the 7-day reverse repo rate). For medium-term interest rates, the PBC developed a transmission mechanism featuring “MLF rate →LPR →loan rates”. Although government bond yields and bond market rates are mainly determined by market forces, they can be affected by the PBC’s operations trying to control short and medium rates.

Operational philosophy

As Hawtrey indicated in his famous book, now more than 90 years ago, central banking is an art concerning the relation of cause to effect and means to end. China’s monetary policy framework advocated by the PBC generally adheres to a sound or prudent adjustments philosophy, which requires monetary policy to be appropriate in intensity and handled in a more forward-looking, flexible, and targeted manner (MPAG). Firstly, the “soundness” reflects the concept of dynamic regulation and counter-cyclical adjustments in light of changes in economic and financial conditions. Monetary policy should prevent overheating and inflation in the economic upturn, and deal with economic recessions and deflation in the downturn (MPAG).

Secondly, a sound policy should be cross-cycle and cross-regional. While monetary policy may have long-term complex aggregate and structural impacts, and the policy effect may be uncertain, it’s necessary to hold the cross-cycle and cross-regional view in counter-cyclical adjustments (Yi, 2023).

Thirdly, the “soundness” also means to put domestic goals first, instead of just following monetary policy operations in developed countries (Yi, 2023). China is a major economy that can rely on domestic demand, priority should be placed on internal equilibrium when there is any contradiction between the internal and external equilibrium.

Since the Great Recession caused by the global financial crisis in 2008, monetary authorities around the world have been forced to implement new unconventional policy tools to stimulate the economy, some of them even adopted a negative interest rate policy. This said, since 2022, major advanced economies have experienced severe inflation, forcing central banks to raise interest rates quickly and shrink the balance sheet. Compared to the dramatic changes in interest rates in major advanced economies, China’s interest rates are moderate and relatively stable, which provide the conditions for implementing a normal monetary policy for a long period. In particular, China didn’t follow the interest rate hike, but cut interest rates in a timely and appropriate manner to promote economic growth. The 7-day reverse repo rate fell by 30 basis points, the 1-year and 5-year LPR fell by 25 basis points and 45 basis points respectively, and the CPI in 2022 was 2%. It is possible that China’s monetary policy framework will retain certain features different from those of major advanced economies for quite a long time as the reforms go further.

References

Yi, G. (2023), “Independent and effective monetary policy and its impact on economic and financial stability” (in Chinese), Economic Research Journal, 6: 19–29.

Zhou, X. C. 2013. The main characteristics of China’s monetary policy since the new century (in Chinese), China Finance, 2: 9–14.