[based on Geiger, 2006: 27-39; and Geiger, 2008: 19-36]
On the search for a nominal anchor, the PBC started to set up target values for the monetary aggregates M1 und M2 in 1993 and 1994. Two years later the PBC announced M1 and M2 growth rates as the official intermediate targets of China’s monetary policy. Nowadays, after the abolishment of the credit plan as the major instrument in monetary policy in 1998, monetary base targeting and the usage of M1 and M2 as the intermediate targets for the monetary policy of the PBC is commonly accepted. Money supply is the most important monetary figure for the conduct of monetary policy under the rule of the People’s Bank of China (Xia et al., 2001: 35; and Xie, 2004a: 2; Yu, 2001). Through its strong emphasis on monetary aggregate M2 the PBC indicates in its series of monetary policy reports and other publications on its webpage2 that M2 represents the main intermediate target of its policy concept. Additionally, domestic loan increase serves as an intermediate target (Xie, 2004a; and Yu, 2001).
For a variable to serve as an intermediate target of monetary policy there has to be a sufficient controllability of the variable itself and it needs to show a relationship to the final target (of price stability). Thus, to assess the strategy of the PBC it is important to ask two questions: Are the intermediate targets of Chinese monetary policy controllable and is a sufficient relationship between these targets and the inflation rate observable?
1 Monetary aggregates
The monetary aggregates M1 and M2 are the most prominent intermediate targets of the PBC. The authorities started to set up target values for M1 and M2 in 1994. Today, these values are published in the annual monetary policy report for the subsequent year online in Chinese and English ( 1 ).
Unlike the ECB, which derives its target for its reference value M3 via the quantitative equation for money (M∙V≡P∙Y) ( 2 ) and its derivation of a “potential formula” (∆M=π+∆Y-∆V and ∆M3*=πtarget +∆Ypotential-∆Vtrend) ( 3 ), the PBC apparently is not using such a formula ( 4 ). In fact, for the time being, the PBC is formulating its monetary target values via a projection in a rather normative way. To take one example, in its Monetary Policy Report 2003 the PBC published its monetary targets for 2004 as follows: “Taking into account the time-lag effect of the faster than desired growth of money and credit in 2003, the growth of money supply and loan increase in 2004 should [bold by MG] be controlled lower than that of 2003. M2 and M1 are projected [bold by MG] to grow by 17 per cent respectively and RMB loans to increase by RMB 2.6 trillion yuan” (PBC, 2004a).
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Table 5: Testing the ECB potential formula for the PBC, 1995-2006
Another way to show the projection character of the monetary targets is in calculating monetary targets according to the quantitative equation of money for a comparison. This is done in table 5, where the “potential formula” is applied to the Chinese situation to calculate the theoretically optimal growth rates for M1 and M2 from 1995 to 2006. Then, these rates are compared to the targets set by the Chinese authorities. Similarity of the values implies a set up of the Chinese monetary targets according to the quantitative equation for money. Table 5 shows that the monetary targets of the PBC were rather close to the quantitative equation for money in 1995 and ever since fell significantly apart up to 2006 ( 5 ).
The question is why the PBC publishes a monetary targeting strategy with monetary targets, while the targets are not theoretically derived. The main reason for this might be in the charming character of applying of a simple rule, which reads: “If monetary growth exceeds (falls short of) the monetary target, short interest rates have to be increased (reduced). If monetary growth is in line with the target, the interest rate should be kept constant” (Bofinger, 2001: 248). Through the publication of monetary targets the PBC just gets into the position to apply this rule. In fact, it might be of secondary importance how the targets are derived but most important that they are installed. However, today, the concept of monetary targeting is under criticism in general, primarily due to the questionable controllability of monetary targets and an insufficient relationship to inflation.
Thus, an important reason for the use of monetary targeting in China certainly is the search for a nominal anchor, i.e. the commitment to a consistent and transparent policy framework that the public could use to monitor the actual policy (Croce et al., 2000). With this nominal anchor the PBC might hope to gain reputation for its monetary policy just as the ECB did once it was established (Mishkin, 2002).
1.1 Controllability of monetary aggregates
Table 6 shows the comparison of the targeted and actual values of the Chinese monetary aggregates M1 and M2 from 1994 to 2006. The targeted and the actual values fell together only three times in the case of M1 and only four times in the case of M2 aggregate. M1 values had less than one percentage point deviation in the years 1996, 2000 and 2001 and M2 aggregates met its targets in 1996, 1998, 1999 and 2001. Obviously, targets were met more easily, when target bands were formulated. Only in the year 1996 the precise targets of 18 and 25 per cent growth for M1 and M2 were met fairly accurately. Strong deviations of more than four percentage points occurred three times for both aggregates M1 and M2. The rather strong deviations particularly arose in the early phase of the formulation of monetary targets, after the high inflation rate of 24 per cent in 1994. From 1999 a more stable control in terms of lower deviations from the targets was realized. However, only two out of six targets were met with deviations of less than one per cent between 1999 and 2006 ( 6 ). Surprisingly, in 2004, when inflationary pressure was rather strong the actual values were 3.4 percentage points less than the M1 target and 2.4 percentage points less than the M2 target (table 6).
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Table 6: Targeted and actual values for the PBC’s monetary aggregates, 1994-2006
As the performance record indicates the central bank’s ability to control the aggregates, the question whether the monetary targets were met is important. In the case of the PBC the comparison of the projected targets with the actual values casts doubt on this controllability. In general, the literature ascribes the uncontrollability of monetary aggregates primarily to the lack of stability of the demand for money. As a consequence, it is very difficult (if not impossible) to steer monetary aggregates with short-term interest rates. In the particular case of the PBC, arguments about constraints induced through the exchange rate regime and an unstable money multiplier are often brought forward to explain the controllability problem of monetary targets in China:
First, some scholars claim that the exchange rate regime with its de facto peg of the RMB to the USD up to July 2005 and the subsequent crawling peg – both of which undervalued – are the main source of uncontrollability of the Chinese money supply. While Chinese scholars observed this problem for the 1990s (Xia et al., 2001; and Yu, na), other proponents see it mainly due to the undervaluation of the RMB in the recent years (Goldstein, 2004; and McCallum, 2004). Accordingly, the undervalued peg of the exchange rate leads to increasing foreign exchange inflows, which have to be converted into RMB and thus increase domestic money supply in China. This is true. However, “the central bank can ‘sterilize’ some or all of this potential increase in liquidity (on base money) by undertaking a number of offsetting operations, the most important of which are typically sales of securities to the banks (i.e., open market operations in government bonds or sale of central bank bills) and increases in the reserve requirement” (Goldstein, 2004: 25). In fact, since 1994 foreign exchange inflows and their associated increase in monetary base were successfully sterilized through the monetary policy instruments of the PBC. Moreover, from 2000 when sterilization operations increased dramatically to offset capital inflows, the impact of the piling up of international reserves on the domestic liquidity conditions was virtually insignificant (Anderson, 2006; and Anderson, 2007).
Second, Xia et al. (2001) as well as Yu (2001) argue, among other factors that an unstable money multiplier is a major cause of uncontrollability of monetary aggregates in China. The instability of the money multiplier would lead to unpredictability of the relationship between the monetary base and the monetary aggregates. A stable relationship, however, is crucial since the monetary aggregates are controlled through the steering of the monetary base. Therefore, an unstable and unsteady money multiplier makes the task of monetary targeting very difficult. Indeed, table 7 shows that the money multiplier was unstable in the period from 1994 to 2004. Money multiplier m1 decreased from 1.14 in 1994 to 1.03 in 1996. Then, from 1996 to 2005 the multiplier m1 was on a stable increasing path and stood at 1.63 in 2005; in 2006 multiplier m1 decreased slightly to 1.62. In the overall perspective the development of the multiplier m1 shows an unstable and up-and-down path between 1994 and 2006. Money multiplier m2 was on an ascending path from 1994 to 2006 with 2.73 in 1994 and 4.45 in 2006. Two breaks of this path are observable, the first one from 1995 to 1996 and the second one from 2005 to 2006. Throughout the period under consideration the standard deviation of m1 was 0.21 with an average value of 1.40; m2 showed a standard deviation of 0.66 with an average of 3.67. Thus, table 7 supports Xia Bin’s observation of an unstable money multiplier.
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Table 7: Monetary base, monetary aggregates and the money multiplier, 1994-2006
It is difficult to argue that this is a particular problem of the Chinese monetary system. The German Bundesbank’s money multipliers were far from being stable, too: Between 1975 and 1989 the multipliers for M1, M2 and M3 (m1, m2, m3) had standard deviations of 0.05, 0.28 and 0.30 with average values of 2.59, 4.41 and 7.60 ( 7 ). Moreover, Germany’s most prominent monetary aggregate M3 had a far unsteadier pace of change than China’s aggregate M2, which was on a trend ascending path between 1994 and 2006. In a nutshell, the conduct of monetary targeting in China seems not to be subject to a particular distortion through an unstable money multiplier.
In the author’s view the main reason for the controllability of monetary aggregates in China comes from a distorted interest rate channel for monetary transmission, which is mainly caused by the transition economy with the simultaneous usage of price- and quantity-based monetary instruments.
1.2 Relationship to inflation
The second condition for a factor to be suitable as an intermediate target of monetary policy is a significant relationship to the overall goal of price stability ( 8 ). Figure 3 displays M2 target growth rates, M2 actual growth rates and inflation rates from 1994 to 2006. At first sight, there is a parallel run of M2 growth rates and the inflation rate recognizable. Over the whole period from 1994 to 2006 the actual M2 growth rates are mirrored by the inflation rate fairly well. From 1997, M2 target growth rates show a particular close development with the inflation rate. This finding might be attributed to the fact that the monetary targets are set up as a projection based on adaptive expectations rather than as a theoretical derivation
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Figure 3: Inflation rate and targeted and actual values of money M2 in China, 1994-2006
In figure 3 six phases of monetary developments can be distinguished from 1994 to 2006:
1. 1994 - 1996: M2 actual > M2 target
According to the monetary targeting approach, a situation in which the actual monetary growth is higher than the target, inflationary pressure would be prevalent. And indeed, inflation was rather high during the three years under consideration. But in fact, the inflation rate was on a declining path and stood at 24.2, 16.9 and 8.3 per cent in 1994, 1995 and 1996, respectively. It appears that the inflation declined along a decreasing trend of actual M2 growth that developed from 34.5 to 29.5 and 25.3 per cent.
2. 1996 - 1999: M2 actual < M2 target
The four years of 1996 to 1999 show actual M2 growth rates that are lower than target M2 growth rates. According to the monetary targeting approach this would indicate deflationary tendencies. Indeed, declining rates of inflation developed from 8.3 to 2.8 to -0.8 to -1.4 per cent in 1996, 1997, 1998 and 1999, respectively.
3. 1999 - 2001: M2 actual < M2 target
After a short time of fitting of the actual and target M2 growth rates in 1999, again the actual values were running below the target values in the subsequent years. This reinforced the prevailing deflationary pressures with inflation rates of -1.4, 0.3 and 0.5 per cent in 1999, 2000 and 2001, respectively.
4. 2001 - 2003: M2 actual > M2 target
In 2001, the situation changed fundamentally for the first time since 1996. The actual growth rates of M2 developed on a higher course than the targeted values, which signaled inflationary pressure. And, in fact, the inflation rate gained momentum and increased from -0.8 per cent in 2002 to 1.2 per cent in 2003 and 3.9 per cent in 2004.
5. 2004: M2 actual < M2 target
To fight the inflationary pressures, restrictive policy measures in 2003/04 led to a decrease of the actual monetary growth and a drop below the initially targeted rate. Due to these measures inflation stabilized at a level below 5 per cent at the end of 2004 and stood at 2.4 per cent in December.
6. 2005 - 2006: M2 actual > M2 target
The restrictive measures taken in 2004 proved successfully in dampening the inflationary pressure with the inflation rate declining from 3.9 per cent in 2004 to 1.4 per cent at the end of 2006. But in terms of monetary growth in 2005 and 2006 actual growth was higher than the targeted growth (2.6 per cent in 2005 and 2.9 per cent in 2006). Thus, the declining inflation rate in this period may be at least partly the time-lagged result of the tightening policy of 2003/04.
The description of the six phases and the visualization of figure 3 demonstrate a fairly close relationship between money M2 and the inflation rate. Moreover, in phases with higher (lower) actual than targeted M2 growth rates, inflationary (deflationary) tendencies were prevalent, with the exception of the two years 2005 and 2006. It shows that by manipulating monetary growth the PBC actually could influence the course of inflation.
1.3 Monetary targeting policy reaction and actual PBC reaction
Another interesting point is the question, whether the PBC followed the “implicit rule” of the quantity theory based monetary policy approach. The simple rule of monetary targeting states: If M2 actual > M2 target the central bank has to increase its interest rates; and if M2 actual < M2 target the authorities have to cut the interest rates. Table 8 summarizes the PBC’s behavior in terms of interest rate changes as compared to the theoretical suggestion. In line with the discussion above six periods are distinguished: In the two phases between 1994 and 1999 the PBC reacted according to the proposals of the quantity theory. In the situation of the actual M2 growth exceeding the targeted growth between 1994 and 1996 (A), the PBC increased its interest rate accordingly. From 1996 to 1999 (B) the actual value ran below the targeted value. As a response, the central bank cut its interest rate in 1997 and 1998.
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Table 8: Monetary targeting policy reaction and actual PBC reaction, 1994-2006
In the two phases of 1999-2001 and 2001-2003 the PBC widely ignored the indications of the theory. From 1999 to 2001 (C) the actual value was still below the targeted value, but the PBC did not cut the interest rate in a timely manner. The moves came very late in 2001 and 2002. In fact, since 2001, the actual value of monetary growth exceeded the targeted value. I.e. the late move reinforced the overall change towards inflationary pressure rather than fighting deflationary pressures of the late 1990s. For the period from 2001 to 2003 (D) actual values increased at a higher pace than the targeted values. The PBC did not react with an interest rate increase until October 2004. However, the actual values already came down to levels below the target levels at the end of 2004 (E). Thus, the interest rate move came too late again. The restrictive stance of 2003/04 had its influence on 2005. Thus, an interest rate increase was not imminent to face the fact that actual monetary growth was higher than the targeted growth rate in that year. Due to the persistence of the situation in 2006 the two interest rate moves in April and August 2006 indeed corresponded to the logic of the monetary targeting framework. Anyhow, the inflation rate continued its declining path in 2006 even though actual monetary growth was considerably higher than targeted growth.
The question is: Why did the PBC not act according to its monetary indicators, particularly from 1999 to 2004? And, additionally, are there any other factors, rather than the interest rate, that have some major influence on the slope of the inflation rate? An answer frequently stated to face the first question is that due to the pegged exchange rate increasing interest rates would trigger capital inflows and thus make it impossible to pursue an autonomous monetary policy in China (Goldstein, 2004; Goldstein et. al, 2007; and McCallum, 2004). This argument, however, ignores the fact that China maintained and still maintains a certain degree of capital controls, and moreover has the instrument of sterilized foreign exchange market interventions (cf. box “sterilization of foreign exchange inflows” in the instruments tab). In my view, there must be other factors that influence the inflation rate and their importance within the current monetary policy set-up in China outweigh the concept of monetary targeting. And in fact the analysis in chapter 2 showed that within the last decade there worked various such instruments: In the 1990s wage- and price- controls were important parts of the macroeconomic steering mechanism. And more recently, the instrument of window guidance gained importance and ever-intensified since the 2003/04 expansionary economic cycle. Besides the limited role of interest rates in China in general there is the distorting influence of the instrument of direct PBC lending in particular. In 2002, 9 per cent of monetary aggregate M2 fell under the category of direct PBC lending and, thus, could not be influenced by interest rate changes at all.
2 Domestic loan increase
Ever since its existence as the central bank in a two-tier banking system in China the PBC has put major considerations on the growth rate of domestic loans (Yu, 2001). Until 1998 the emphasis on credit was embedded into the state credit plan that provided the economy with the necessary credits to reach the given output targets. In 1998, without the credit plan system in place domestic loan increases had been incorporated into the rather indirect monetary policy concept. Accordingly, since then domestic loan increase has to be seen as an intermediate target in addition to monetary aggregates (Xie, 2004a: 2). The most important tool to guide domestic loan increases is the instrument of window guidance, mainly due to the insufficient interest rate elasticity of loans in China. Nowadays, growth targets of domestic loans are published together with the monetary aggregates in the PBC’s monetary policy reports. The focus of the following analysis is on the period of time from 1998 to 2006.
2.1 Controllability of domestic loan increases
Table 9 shows the comparison of the targeted and actual values of domestic loan increases from 1998 to 2006. Similar to the observation about the monetary targets one can see that the domestic loan targets were missed in the majority of years. In fact, only in 2001 the target was met accurately. The remaining seven targets were missed in the range of 2.8 in 1998 and 7.4 percentage points in 2003.
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Table 9: Targeted and real values for domestic loan increases in China, 1994-2006
Generally, the problem in the control of domestic loan growth in China lies in its interest rate inelasticity. This limited influence of interest rate changes mainly comes from the mix of price- and quantity-based monetary instruments, which prevent either of them from working properly. Other specific factors come into play, too. For instance, a Moody’s report analyzed the problems the authorities faced in the 2003/04 economic cycle to (re)gain control over the domestic loan increases with a focus on three specific issues (Wei, 2004):
- Local governments do not have the necessary global perspective on economic matters but do often pursue self-interests. Therefore, since they have the power to influence lending decisions of local commercial banks, there is a shift from former centrally managed policy loans to more locally administered policy loans pursued by local governments.
- Corporate borrowers from the manufacturing sector are faced with rising raw material prices while they have huge capacities, which have been built up in recent years. The consequences are relatively low profit margins. An exit-option of this dilemma is an add-on investment on capacity in the hope of increased output and sales and an increased profitability. These expansion plans are usually financed by bank loans.
- The credit systems of the banks do not sufficiently apply risk related credit policies that price the credits according to the underlying risks. Most loans are still priced around the central bank’s benchmark rates. The price as a tool to regulate the amount of credits cannot be applied and, thus, the total amount of granted loans is higher than the efficient level would be. However, under the guidance of the China Banking Regulatory Commission the Basel Accord capital adequacy ratio is a subject of special consideration. Thus, this effect is declining since the overall lending mentality veers towards more risk related credit policies.
2.2 Relationship to inflation ( 9 )
Figure 4 displays the development of the actual and targeted loan growth in comparison to the inflation rate from December 2000 to December 2006 on a monthly basis.
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Figure 4: Inflation rate compared to targeted and actual values of domestic loan increase, Dec 2000 – Dec 2006
The actual loan growth shows an upward trend for the whole period until the peak of almost 24 per cent monthly y-o-y increase in domestic loans in August 2003. The decline in growth figures from 2003 onwards indicates the efforts of the Chinese authorities to implement a more restrictive monetary stance to face the expansionary economic cycle of 2003/04. At first sight, the figure shows a lagged relationship between domestic loans and the inflation rate. The time lag lies in the range of around 5 to 12 months. To illustrate the development in detail, a closer look on five phases are helpful:
Phase 1, with moderate loan increases of 6 to 9 per cent from December 2000 to May 2001.
In response, the inflation rate drifted into a period of negative rates six months later in November 2001 and stayed deflationary for one year until December 2002.
Phase 2, with stable loan growth rates of 12 to 15 per cent between June 2001 and August 2002.
In reaction, five months after the loan growth rate hit the 15 per cent margin in August 2002, the deflationary pressure eased and the inflation rate showed positive rates from January 2003 on.
Phase 3, with volatile growth rates of loans of 16 to 24 per cent between September 2002 and May 2004 with the culmination of 23.9 per cent in August 2003.
Consequential, the inflation rate showed an upward trend with a time lag of about 6 to 12 months. Due to the time lag and loan growth rates of above 15 per cent until May 2004 the inflation rate kept rising even though the loan growth rates showed a downward trend since the peak point of August 2003.
Phase 4, with stable growth rates between 9 and 11 per cent from August 2004 to May 2006.
In reaction, five months later the loan growth rate calmed down below 15 per cent in June 2004, the inflationary pressure eased and the inflation rate showed a considerable decline to 2.8 per cent in November 2004. After a one-off increase in February 2005 to 3.9 per cent the inflation rate embarked on a stable pace between 0.8 per cent and 1.9 per cent between May 2005 and November 2006.
Phase 5, with increasing loan growth rates to around 15 per cent starting from June 2006.
Consequential, five months after the loan growth rate increased to over 15 per cent in July 2006 the inflation rate increased to 2.8 per cent in December 2006; twelve months later the inflation rate stood at 5.6 per cent in July 2007.
The short analysis above indicates that there is a “neutral stance” of domestic loan increases of 10 to 15 per cent that leads to an inflation rate of around 1 to 3 per cent ( 10 ), within a time lag of 5 to 12 months. This finding is confirmed through some simple econometric tests that show a significant correlation between the domestic loan increases and the development of the inflation rate. For the six years under consideration in figure 4 this relationship is manifested with a time lag of 8 months and a probability of 90 per cent. Additional support to the hypothesis of a “neutral stance” of loan increases comes from the fact that the PBC’s own growth targets ( 11 ), with the exception of 2004 ( 12 ), are within the 10-15 per cent margin. However, figure 4 also shows the main problem of the approach to target loan growth through quantity-based instruments such as window guidance, i.e. the rather volatile growth rates that limit the ability to fine-tune monetary policy.
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Footnotes
( 1 ) Chinese: www.pbc.gov.cn/xinwen/; and English: www.pbc.gov.cn/english/xinwen/.
( 2 ) M stands for the quantity of money, V for the velocity of circulation, P the price level, and T for the transaction volume.
( 3 ) ∆M3* represents the optimum growth rate of M3, πtarget the target inflation rate, ∆Ypotential the potential output growth rate, and ∆Vtrend the trend rate of change in the velocity of circulation of money.
( 4 ) For a detailed explanation of the concept of monetary targeting of the ECB please refer to Bofinger (2001).
( 5 ) The calculation underlying table 5 uses the GDP targets of the respective five-year plans of China as a proxy for the potential output growth (1991-1995: 8.5 per cent; 1996-2000: 8 per cent; 2001-2005: 7 per cent; 2006-2010: 7.5 per cent). This seems to be a good proxy since estimations for China’s potential output growth are between 8 and 9 per cent for the time 1995 to 2006 (Gerlach et al., 2006: 25; and Kuijs et al., 2005: 11).
( 6 ) In this respect the PBC is in good company. The German Bundesbank reached only 11 of its 24 monetary targets in the time from 1975 to 1998, despite occasionally very broad corridors of up to 3.9 per cent. Nevertheless, there is no doubt that the German Bundesbank performed very well in terms of low inflation.
( 7 ) Own calculations, based on IMF, International Financial Statistics.
( 8 ) In this section the focus is solely upon the analysis of the relationship of monetary aggregate M2 to inflation. This is justified through the prominence of M2 within the monetary policy set up of China
( 9 ) The focus is on the period of time from December 2000 to December 2006 due to data constrains. Since December 2000 the PBC has published monthly data for domestic loan developments on its website www.pbc.gov.cn (cf. PBC Statistics Database Online)
( 10 ) This finding can be backed by an “inefficiency stance” of 15 to 20 per cent that is displayed in the gap between the rates of the producer price index (PPI) and the consumer price index (CPI).
( 11 ) The targets for 1998 to 2002 are from Xie (2004a); the targets for 2003 to 2006 are taken from the respective PBC’s China Monetary Policy Reports.
( 12 ) This relatively high target of loan increases in 2004 can be explained through the strong overshooting of the actual loan growth (21.1 per cent) vis-a-vis the targeted growth (13.7 per cent) in 2003 (table 9).
