Monetary Policy Junhui Qian 2018 Content Basics Monetary

Monetary Policy Junhui Qian, 2018

Content • Basics • Monetary policy instruments • • Reserve requirement Central bank loans Rediscounting Interest rate policy Exchange rate policy Open market operations Credit policy and window guidance • Recent trends • Macroprudential regulation

Functions of A Modern Central B • Banking for the government • Control availability of money and credit • Operate payment and settlement system • Lender of last resort • Surveillance and regulation of commercial banks ank

Objectives of Monetary Policy • For most countries: • Low and stable inflation • Low employment (high economic growth) • For some countries: • Stable foreign exchange rates

Intermediate Objectives of Monetary Policy • Interest rates • Money supply • Base money: currency in circulation + reserve • Money multiplier: Money supply (M 2 or M 1) / Base money • Total credit and loans

Usual Instruments of Monetary Policy • Interbank overnight lending rate (e. g. , US federal funds rate) • Reserve requirement • Central bank loans (Lending to financial institutions) and rediscounting • Open market operations • Trading treasury bonds • Issuance of central bank bills/papers • Repo and reverse repo

Central Banking Before The Reform • Credit and cash plans were part of the central economic planning. • The planner controlled how much credit and cash should be issued and who should receive them. • With virtually no financial market, the planner easily controlled money supply.

The Birth of The Chinese Central Bank • Before the reform, PBC was a bureau under the Ministry of Finance in charge of monetary matters for economic planning. • The Agricultural Bank of China (ABC) was formed in Jan 1979 and was in charge of banking for the rural sector. • Bank of China was spun off in March 1979 and specialized in foreign currency management. • On Sep 17 of 1983, the State Council decided to transform PBC into a central bank in charge of monetary policy. Mechanism for reserve requirements and lending to commercial (special) banks was established. • The Industrial and Commercial Bank of China was formed in Jan 1984 and took away the industrial and commercial banking business of PBC. • By 1984, PBC became a de facto sole-purpose central bank. • In 1995, the Law of People’s Bank of China was passed, PBC became the central bank of China formally.

General Trends of Chinese Central Banking • More and more independent, from the Ministry of Finance, from the local governments, and in the future, from the State Council. • In 1995, overdraft by MF was forbidden. • In 1998, nine big branches replaced the old 31 provincial branches. • Rely less and less on command, and more on indirect control through market-based instruments.

The Case for Targeting Money Growth (M 2) • Necessity: • Financial system in transition • Soft budget constraints of the state sector and the local governments • Feasibility: • Bank dominance in the financial system

Content • Basics • Monetary policy instruments • • Reserve requirement Central bank loans Rediscounting Interest rate policy Exchange rate policy Open market operations Credit policy and window guidance • Macroprudential regulation • Recent trends

Reserve Requirement • Reserve requirement was established in 1984. • Two accounts: deposit reserve and settlement reserve • The deposit reserve ratio (DRR) was 20% for enterprise deposits, 40% for savings deposits, 25% for rural deposits. • In 1985, the DRR was unified as 10%. • The DRR was raised to 12% in 1987 and 13% in 1988 to combat inflation. • In 1989, the settlement reserve was required to keep 5%-7% of all deposits. • In 1998, two accounts were unified. • The DRR was lowered from 13% to 8%. • Banks may keep excess reserve in PBC. • Deposit reserves are interest-bearing.

Required Reserve Ratio (1985 -2018) Required Reserve Ratio 25, 00 20, 00 15, 00 10, 00 5, 00 0, 00 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Small Banks Big Banks

Central Bank Loans • The central bank loan (再贷款) is the central bank’s lending to commercial banks and other financial institutions. • CBL was a major source of base money expansion. • Since 1994, position for purchasing foreign exchange became the major source of base money expansion. • Since 1998, central bank loans was used in adjusting lending structure in the economy or injecting liquidity to financial institutions in distress.

Rediscounting • Rediscounting (再贴现) refers to the practice of discounting commercial papers by the central bank, which is to inject liquidity into the banking sector. • Rediscounting often happens when banks are in distress. • Rediscounting was one of the major instruments in the 1990 s, and was used both in adjusting structural composition of liquidity provision and in signaling policy orientation. • The role of rediscounting has declined since 2000.

Interest Rate Policy • Before 1995, almost all interest rates were determined by PBC. • Since 1995, PBC has been persistently liberalizing interest rates. • In June 1996, interbank lending rate was liberalized. • In June 1997, interbank bond market was opened. Repo rate and interest rate on bonds were liberalized. • In Sep 1998, interest rates on the issuance of policy bonds and treasury bonds were liberalized. • In Sep 1999, treasury bonds started to be auctioned in the interbank bond market. • In Jan 2007, SHIBOR (Shang. Hai Inter. Bank Offer Rates) was started.

Liberalization of Interest Rates on Deposits and Loans • The ordering the interest rate liberalization: first foreign, then domestic; first money market, then loans, then deposits; first longterm big-denomination, then short-term small denomination. • By Nov 2013, only the domestic deposit rate has a upper-limit. Other interest rates, including those on loans, are all determined by the market. • In Oct 2015, the upper-limit on the domestic deposit rate is also removed. • The central bank maintains the control over the benchmark interest rate, which is important for the setting of various loan interest rate (e. g. , the mortgage interest rate).

1 -year deposite 1 -year loan Inflation 2 -0 18 20 2 2 -0 17 20 16 20 2 -0 15 20 2 -0 -0 14 20 2 2 -0 13 20 12 20 2 -0 11 20 -0 2 2 -0 10 20 09 20 2 -0 08 20 2 -0 -0 07 20 2 2 -0 06 20 05 20 2 -0 04 20 -0 2 2 -0 03 20 2 2 -0 02 20 01 20 -0 00 20 -0 2 2 2 -0 99 19 98 19 -0 97 19 2 -0 -0 96 19 2 2 2 -0 95 19 94 19 -0 93 19 -0 2 -0 92 19 2 2 -0 91 19 90 19 -0 89 19 Benchmark Interest Rates and Inflation Rate (%) 30 25 20 15 10 5 0 (5)

Exchange Rate Policy • In 1994, RMB official exchange rate was merged with the market rate. • The interbank foreign exchange market was established. The exchange rate was formally determined by the market. But PBC intervened heavily. • From 1995 to 2005, the RMB/USD was de facto pegged at 8. 3, with a daily fluctuation capped in [-0. 3%, 0. 3%]. • From July 2005, RMB no longer pegs USD. RMB started to appreciate gradually. From 2005 to early 2014, RMB appreciated around 37%. • In August 2010, China established the RMB offshore market (CNH market).

The Reform of the RMB Exchange Rate (since 2005) Milestones Date Main changes “ 7. 21” Reform 2005. 7. 21 Introduce the managed floating mechanism, with a [-0. 3%, 0. 3%] fluctuation band around the central parity rate. 2006. 1. 4 Introduce market makers and a new mechanism for the setting of the central parity rate. 2007. 5. 21 Widen the fluctuation band to [-0. 5%, 0. 5%]. 2008. 10. 6 Restrict volatility with the onset of the global financial crisis. 2010. 22 End of crisis mode. “ 4. 21” Reform 2012. 4. 21 Widen the fluctuation band to [-1%, 1%]; Deregulate banks’ foreign exchange dealings. “ 3. 17” Reform 2014. 3. 17 Widen the fluctuation band to [-2%, 2%]. “ 8. 11” Reform 2015. 8. 11 Let the central parity rate reflect market demand supply (previous closing rate). 2016. 2. 15 Introduce the mechanism of “closing rate plus exchange-rate movements of a basket of currencies” for setting the central parity. 2017. 5. 26 Introduce a “counter-cyclical factor” into the central parity pricing mechanism.

2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 RMB/USD Exchange Rate (Annual) USDCNY 10 9 8 7 6 5 4 3 2 1 0

Sterilized Intervention • To prevent RMB from appreciating (before 2005), or from appreciating too fast (2005 -2014), the central bank has to intervene the foreign exchange market by purchasing the USD with created RMB. This operation increases the high-powered base money. • To sterilize the effect of the expanding money base (on inflation), the central bank conducted the following operations: • Issuing the central bank bills (CBB, 央票) • Increasing the required reserve ratio for commercial banks

Foreign Reserve and the Issuance of Central Bank Bills Foreign Reserve and Central Bank Bills Issuance 50 000, 00 45 000, 00 40 000, 00 35 000, 00 30 000, 00 25 000, 00 20 000, 00 15 000, 00 10 000, 00 5 000, 00 2002 -01 2003 -01 2004 -01 2005 -01 2006 -01 2007 -01 2008 -01 2009 -01 2010 -01 Foreign Reserve (USD 100 million) 2011 -01 2012 -01 2013 -01 CBB Issuance (RMB 100 million) 2014 -01 2015 -01 2016 -01 2017 -01 2018 -01

Foreign Reserve and Required Reserve Ratio 45000 25 40000 35000 20 30000 25000 15 20000 15000 10 10000 5000 Foreign Reserve (USD 100 million) 30 20 17 -1 1 - 30 20 16 -1 1 - 30 20 15 -1 1 - 30 20 14 -1 1 - 30 -1 13 20 12 -1 -1 11 20 Required Reserve Ratio (%) 1 - 30 30 1 - 30 20 10 -1 1 - 30 20 09 -1 1 - 30 20 08 -1 1 - 30 20 07 -1 1 - 30 20 06 -1 1 - 30 20 05 -1 1 - 30 -1 04 20 1 -1 03 20 1 - 30 30 20 02 -1 1 - 30 1 -1 01 20 1 -1 00 20 1 -1 99 19 30 5 30 0

Open Market Operations • OMO in China include trading of treasury bonds, issuance of central bank bills, conducting repo and reverse repo. • Bonds trading and repo operations are both limited by the quantity of bonds in the open market. • In the late 1990 s, purchasing treasury bonds was the major source of base money expansion. • From 2003, PBC started to issue central bank bills. CBB became the major instrument for sterilization of money expansion due to the purchase of foreign exchange reserve. • In 2007, the Ministry of Finance increased the supply of treasury bonds. PBC increased the usage of repo and reverse repo in the adjustment of short-term liquidity in the market.

Credit Policy and Window Guidance • Credit policy is still being used in adjusting supply of loans to different sectors, industries, geographic areas. • Window guidance is the central bank’s advice for commercial banks. It is up to banks to accept it or not. • Before 1998, monetary policy was based more on command. It was called “direct management”. • After 1998, monetary policy was achieved more by changing liquidity conditions in the market and by window guidance. This was called “indirect management”.

Content • Basics • Monetary policy instruments • • Reserve requirement Central bank loans Rediscounting Interest rate policy Exchange rate policy Open market operations Credit policy and window guidance • Macroprudential regulation • Recent trends

Macroprudential Regulation • Macroprudential regulation is the financial regulation that aims to mitigate systemic risk to the financial system and the economy as a whole. • In many countries including China, the responsibility of macroprudential regulation falls largely on the central bank.

The Policy Instruments for Macroprudential Regulation • Capital requirement (banking regulation) • The required reserve ratio • Window guidance • Liquidity provision

Event Study: 2013 Liquidity Panic • In June 2013, PBo. C tightened the liquidity in the interbank money market, in an effort to control the runaway leverage buildup and liquidity mismatch in many medium and small-sized banks. • As a result, the short-term borrowing cost in the money market shot up. • There were rumors on bank failures. • The stock market crashed during the panic. • The liquidity panic ended only after the PBo. C stepped in and started to provide liquidity.

0 0 -year 1/12 -year 1 -year 5 -year 10 -year 2013 -12 -27 2013 -12 -20 2013 -12 -13 2013 -12 -06 2013 -11 -29 2013 -11 -22 2013 -11 -15 2013 -11 -08 2013 -11 -01 2013 -10 -25 2013 -10 -18 2013 -10 -11 2013 -10 -04 2013 -09 -27 2013 -09 -20 2013 -09 -13 2013 -09 -06 2013 -08 -30 2013 -08 -23 2013 -08 -16 2013 -08 -09 2013 -08 -02 2013 -07 -26 2013 -07 -19 2013 -07 -12 2013 -07 -05 2013 -06 -28 2013 -06 -21 2013 -06 -14 2013 -06 -07 2013 -05 -31 2013 -05 -24 2013 -05 -17 2013 -05 -10 2013 -05 -03 2013 -04 -26 2013 -04 -19 2013 -04 -12 2013 -04 -05 2013 -03 -29 2013 -03 -22 2013 -03 -15 2013 -03 -08 2013 -03 -01 2013 -02 -22 2013 -02 -15 2013 -02 -08 2013 -02 -01 2013 -01 -25 2013 -01 -18 2013 -01 -11 2013 -01 -04 2013 Liquidity Panic Yield-to-Maturities of the Treasury Bond (%) 14 12 10 8 6 4 2

The Lessons of the 2013 Liquidity Panic • Cutting liquidity, as a punishment, is costly. • The central bank, as the lender of the last resort, should have regulatory power over commercial banks. • The coordination and corporation between regulatory bodies are important for effective financial regulation.

The Recent Regulatory Reform

Content • Basics • Monetary policy instruments • • Reserve requirement Central bank loans Rediscounting Interest rate policy Exchange rate policy Open market operations Credit policy and window guidance • Macroprudential regulation • Recent trends

Recent Trends • Base money expansion relies on lending facilities, rather than purchasing foreign currency (USD). • Quantity target gives way to interest rate target. • More liberalized interest rate and exchange rate policies. • More synchronized cycles of interest rate with the world. • Convergence of the Sino-US interest rates

More Balanced Trade Share of Trade Surplus in GDP 10% 8% 6% 4% 2% 0% -2% -4% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

The Central Bank Lending Facilities • SLF (Standing Lending Facility, 常备借贷便利, from 2013) • MLF (Medium-term Lending Facility, 中期借贷便利操作, from 2014) • PSL (Pledged Supplementary Lending, 补充抵押贷款, from 2014) • The interest rates of the above operations are supposed to guide the market interest rate.

The Phasing-out of the M 2 Target M 2, Industrial Output, and Inflation 35, 00 30, 00 25, 00 20, 00 15, 00 10, 00 5, 00 0, 00 -5, 00 1998 -07 1999 -07 2000 -07 2001 -07 2002 -07 2003 -07 2004 -07 2005 -07 Growth of M 2 (%) 2006 -07 2007 -07 2008 -07 2009 -07 2010 -07 Growth of Industrial-Value-Added (%) 2011 -07 2012 -07 Inflation (%) 2013 -07 2014 -07 2015 -07 2016 -07 2017 -07

12 0 -year 1/12 -year 1 -year 5 -year 10 -year 04 3 - -0 04 04 1 - -0 1 - 04 9 -1 04 7 - -0 04 04 5 -0 18 20 17 20 -0 04 13 - -0 17 20 -0 04 04 1 - -1 04 7 - 04 9 - -0 17 20 16 20 -0 04 04 5 - -0 3 - 1 - 04 1 -0 -0 16 20 -1 04 04 9 - -0 7 - 04 5 -0 15 20 04 04 3 - -0 1 - -0 04 04 1 - -1 9 - -0 04 04 7 - -0 5 - -0 04 04 3 - -0 1 - -0 -0 15 20 14 20 14 20 13 20 13 20 12 20 12 20 20 Market Interest Rate Yield-to-Maturities of the Treasury Bond (%) 14 12 10 8 6 4 2 0

Synchronization of the Chinese and the US Interest Rate

US China 18 20 18 20 01 5 - -0 24 4 - -0 17 4 - -0 10 4 - -0 03 4 - 27 3 - -0 -0 18 20 20 3 - -0 13 3 - -0 06 3 - -0 27 2 - -0 20 2 - -0 13 2 - -0 06 2 - -0 30 1 - -0 23 1 - -0 16 1 - -0 09 1 - -0 02 1 - -0 18 20 18 20 18 20 Convergence of Sino-US Interest Rates 4, 5 4 3, 5 3 2, 5 2