This opening chapter introduces the puzzle the book attempts to solve. The architects of Chinese monetary policy reform in the late 1990s were openly enthusiastic about Western macroeconomics and central banking norms, and proclaimed their intention to abandon credit controls and turn towards market instruments. But by the mid-2000s, policy was relying more heavily on direct bank regulation. Why? We argue that Chinese policymakers departed from Western norms for pragmatic rather than ideological reasons. The ‘new macroeconomic consensus’ was in fact a normative influence on means as well as aims. But ‘normalising’ policy was not as easy as simply ditching old for new strategies. The ‘normal’ instruments of the international macroeconomic consensus depended on financial markets with specific characteristics: (1) a deep money market used by banks and other financial institutions for liquidity management; (2) effective transmission of short-term rates to longer-term rates; and (3) responsiveness of investment to interest rates. These could not be taken for granted in China.
KeywordsMonetary policy China Liquidity Central banking Reform
This book seeks to explain the transformation of Chinese monetary policy in the years before 2008: specifically, why it became increasingly reliant on direct banking controls in the 2000s in spite of intentions to rely more on market instruments after 1998.
In the mid-2010s, the People’s Bank of China (PBC) was announcing moves towards ‘market based policy’. A milestone was reached in October 2015 when the PBC removed the ceiling on bank demand and short-term deposit interest rates—the last remaining limit on bank rates. Deputy Governor Yi Gang presented this liberalisation as providing ‘basic conditions for transforming the monetary policy framework… facilitating the transition towards price-based instruments’ (Yi 2015). Policy would rely more on targeting short- and medium-term interest rates in the interbank market and deregulation of retail rates was necessary to improve transmission out into credit markets. Policy was reaching a ‘new normal’, which would be more like the West’s normal (Deng and Chen 2016; Shevlin 2017; Liu et al. 2017, pp. 1–2; Wang and Mao 2016; Allen et al. 2018, pp. 445–446).
Open market operations had been part of the toolkit in the previous decade, but policy had largely depended on direct controls over commercial banks in tightening policy between 2002 and 2008. Authorities administered deposit and loan interest rates, frequently adjusted reserve requirements, imposed lending limits and issued directives. It would be easy to take a Whig view of the shift to liberalisation: Chinese policy is ‘normalising’ as authorities shrug off the statist legacy of central planning and move towards an international policy consensus. This fits a familiar story about Chinese economic reform, of tension between ideology and economic rationality: reformers promote rational market-based policy; they are sometimes in the ascendant within the Party and bureaucracy, and sometimes not, but the arc of history bends towards reform.
In this book, we take a different view. The bank-control-based policy framework of the 2000s was not an archaic remnant of planning, but deliberately built in response to financial and macroeconomic conditions, under the influence of the Western ‘new macroeconomic consensus’. To understand the transformation of Chinese policy in the 2000s, we need to understand the institutional and market structure of the country’s financial system. Chinese policymakers were pragmatic above all. We understand the evolution of their strategy better by looking in some detail at the nature of the system in which they acted.
The notion that policy change has been driven by an ideological shift from ‘controls’ to ‘markets’ is misleading. First, the control/market distinction is too blunt. Chinese authorities have tried to increase their reliance on market instruments, primarily because these promised tighter and more flexible policy influence over the financial system.1 But their effectiveness depended on certain institutional features of interbank markets, which had to be deliberately promoted by the state, as well as the continued and sometimes intensified use of controls. Controls were not an alternative to market-based policy, but an essential condition of them. This is the case in the West as much as in China, but we often take for granted the regulatory structure underpinning ‘normal’ banking and financial markets.
Second, policymakers could not simply choose to rely on market instruments. Flexible and effective open market operations depend on (1) adequately deep interbank markets; and (2) the dependence of banks on those markets for their liquidity management. These are things we often simply assume in discussing monetary policy, but they cannot be assumed in China’s case. Interbank markets had to be actively fostered by policymakers in the period we discuss.
We focus on the decade leading up to the turning point of 2008. This period has been overshadowed by what came later: the enormous stimulus in response to the international financial crisis of 2008, the reforms of the 2010s and the reckoning with ‘shadow banking’. But the decade between the Asian financial crisis and the global crisis of 2008 is critical to understanding the shape of Chinese monetary policy today.
The ‘old normal’ Chinese monetary policy framework of the 2000s was already the result of a radical transformation under the influence of Western norms. Ideologically, the reforms of the late 1990s involved an enthusiastic adoption of many aspects of international consensus macroeconomic thinking, especially the prioritisation of price stability. But under the macroeconomic conditions of the 2000s, and given the institutional structure of the Chinese financial system, the pursuit of price stability actually led policy to rely more heavily on direct bank controls, reversing an earlier intention to abandon credit targets and rely on market-oriented instruments in the interbank market. This was not because Chinese policymakers had ideological objections to the international macroeconomic consensus, but because certain features of the Chinese interbank market left it unable to play its role as the main venue of policy. The interbank market was new and underdeveloped, and the central bank had trouble draining a structural surplus of reserves which left the banking system unconstrained by liquidity.
The turn to tighter direct bank controls at mid-decade had a further consequence, which has left a lasting mark on the Chinese financial system: it fed the growth of ‘shadow banking’ practices which evaded lending controls in various ways. In 2002, bank lending accounted for 95.5% of net new financing to firms and households. By 2008, its share had fallen to 73%.2 With more financing routing around controls, bank regulation could not remain the lynchpin of policy restraint forever. The outbreak of financial crisis in the United States and Europe in 2008 led Chinese policy to reverse into looseness anyway, leaving this question for the future. But in retrospect, we can see the pre-2008 decade as critical, as controls both helped to foster an interbank market in which policy could be effective, and also promoted the growth of instruments and practices that avoided those controls.
Two norms marked the international ‘new consensus’ on monetary policy that developed in the 1980s and 1990s (Arestis 2007; Arestis and Sawyer 2008; Bofinger 2001): (1) the proper target of monetary policy is low and stable inflation; and (2) the target should be pursued with market-based instruments, specifically by targeting a key short-term interest rate through open market operations and standing facilities. Chinese policy joined this consensus on ends, but departed from it on means.
The PBC had once been tasked with a number of goals—including management of the monetary aspects of central planning—but in the course of the 1990s Party and law increasingly committed it to put currency stability first. Inflation in the 1980s had fed the unrest culminating in the debacle in Tiananmen Square (Naughton 2007, pp. 98–99), and a further wave of high inflation in the mid-1990s strengthened the position of those in the bureaucracy pushing for monetary discipline. The 1995 Central Bank Law stated the aim of monetary policy as ‘to maintain the stability of the value of currency and thereby promote economic growth’. That put price stability first, as a necessary condition of growth, rather than a goal to pursue alongside growth (Bell and Feng 2013, p. 158).3 The inflationary waves of the 1980s and 1990s had been followed by periods of austerity to bring it under control. Prioritising currency stability set a limit to the pursuit of growth in the short run, in order to promote it over the long run. In 1998 the final abandonment of the Credit Plan, which had subordinated central banking to central planning, signalled that the turn was serious.4
But if the new ends of policy were in line with the international consensus, the means were certainly not. Market interest rates were neither the primary policy instrument, nor a major indicative target. The authorities did engage in open market operations, but often with quantity rather than interest rate targets. Instead, policy worked mainly through direct controls on banks: variable reserve requirements, interest rate ceilings and floors, and lending directives. China also set itself apart by remaining committed to a dual target. ‘Stability of the value of the currency’ meant not just domestic price stability, but also a stable exchange rate—fixed until 2005, then with controlled movement (Allen et al. 2018, pp. 446–448). This left a tension at the heart of the policy regime, since maintaining the exchange rate required the PBC to passively exchange domestic for foreign currency as needed.
Chinese policymakers departed from Western norms for pragmatic rather than ideological reasons. The ‘new macroeconomic consensus’ was in fact a normative influence on means as well as aims. But ‘normalising’ policy was not as easy as simply ditching old for new strategies. Dai Xianglong, PBC governor 1995–2002, is said to have distributed to the central bank’s staff 100 copies of Mishkin’s textbook, The Economics of Money, Banking and Financial Markets, a staple of American monetary economics courses. He urged them to consult it regularly and claimed to open it himself every day. The new policy set-up was known as the ‘Mishkin framework’ (Geiger 2010, p. 1). The difference, officials argued, was not doctrinal but institutional: as one told Bell and Feng (2013, p. 160), ‘we are genuine students of Western lectures and doctrines’ but ‘we came to realise that not all Western doctrines could explain issues in China because of the special and unique situation here… We simply don’t have the sort of fully-fledged institutions as the advanced economies’.
Even if policymakers saw ‘market-based’ policy as ultimately desirable, the path was not clear. As PBC Governor Zhou Xiaochuan remarked in 2006, ‘if there is a lack of a transmission mechanism, then we cannot rely on those theoretically tempting monetary policies’ (quoted in Bell and Feng 2013, p. 160). The ‘normal’ instruments of the macroeconomic consensus depended on financial markets with specific characteristics: (1) a deep money market used by banks and other financial institutions for liquidity management; (2) effective transmission of short-term rates to longer term rates; and (3) responsiveness of investment to interest rates.
Our aim in this book is to explain what it was about the ‘special and unique situation’ of the Chinese financial system that made the ‘normal’ transmission channels unworkable, and how the actual transmission channels were built over the decade to 2008—in particular, why policy came to rely more heavily on direct banking controls. The early years of the new regime were marked by the aftermath of the Asian financial crisis, so that monetary policy remained loose, while the global financial crisis of 2008 was a turning point as policy again switched towards stimulus. We are mainly interested in the problems of restraint in between, in which the transmission mechanism was tested and adapted.
In the next chapter, we describe the basic features of the Chinese financial system in the 2000s and explain why the ‘new consensus’ transmission channel was unviable. In Chapter 3, we explain why the PBC worked with quantitative money and credit targets, long out of favour in the West. In Chapters 4 and 5, we open the banking ‘black box’ and explain the logic of the transmission channel through bank balance sheets. In Chapters 6 and 7, we describe how policy met the macroeconomic challenges of the 2000s, and how this drove it to rely increasingly on bank controls and lending directives.
‘Market instruments’ can be defined as those instruments involving the transactions (buying, selling, lending, and borrowing) of official agents with other parties who are taking part voluntarily. ‘Controls’, on the other hand, involve the direction or restriction of other agents. There is no problem analytically distinguishing these instruments while recognising that they are often interdependent in practice. For example, the effectiveness of open market operations in influencing intermediate targets like bank lending may depend on controls such as reserve requirements, as we argue for the case of China.
Net new ‘aggregate financing’ data from the PBC/CEIC.
As the PBC put it in a 2005 report—suggesting this was still a lesson central bankers felt others needed to hear—‘history has proved that oversupply of currency will not bring unchecked acceleration of economic growth, but only price inflation’ (PBC 2005, p. 4).
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