EF3461 The Economies of Mainland China and Hong Kong Tutorial 10 China’s Monetary Policy City University of Hong Kong Dr. Isabel Yan

The Monetary Policy in China Reference:  Li, Kui-Wai (1997), “Financing China Trade and Investment”, Westport: Praeger Publishers, Chapter 1 and 2

Definitions of Money Supply in China and HK  In China: M0 = currency held by the public M1 = M0 + demand deposits of enterprises, rural collectives and other institutions M2 = M1 + time deposits of enterprises + deposits of self financed funds of capital construction + housing saving deposits + other deposits  In HK: M0 = currency held by the public M1 = M0 + demand deposits with licensed banks M2 = M1 + saving and time deposits with licensed banks + NCDs issued by licensed banks and held by the public M3 = M2 + deposits with restricted licensed banks and deposit taking companies + NCDs issued by restricted licensed banks and deposit taking companies and held by the public

Monetary Policy in China and HK China: After the reform, the central bank attempted to exercise an independent monetary policy to achieve four policy targets: (i) monetary stability (ii) economic growth (iii) full employment (iv) Balance of payment balance HK: Since HK adopts the currency board system which requires all base money to be fully backed by USD, HK does not have independent monetary policy. The money supply is determined passively by the availability of foreign currency.

Instruments of Monetary Policy in China 1. Credit ceiling The PBC set ceilings on the amount of lending that the four specialized banks can make. First of all, a money supply target is calculated by the central bank according to the needs of economic growth, price level increase etc. The plan includes the quota for new loans and targets for deposits for the specialized banks. Then the central bank informs the specialized banks of its tentative plan and allocate the approved credit quotas and required deposit targets to their provincial and regional branches. Note: The four specialized banks include the Agricultural Bank of China (AOC), Bank of China (BOC), The People’s Construction Bank of China (PCBC) and The Industrial and Commercial Bank of China (ICBC).

2. Loan by the Central Bank (PBC) to the Specialized Banks (Reloan): PBOC provides regular and temporary loans to the specialized banks and commercial banks which increases the bank liquidity. 3. Interest rate and discount rate: The central bank decides the discount rate (the rate of the central bank’s loans to other banks) and regulates almost all lending and deposit rates. Interest rate changes affect both the demand for credits and household savings.

4. Reserve requirements Required reserve: Bank deposits are subject to a reserve requirement which is set at 13% for domestic currency deposits in The reserves have to be submitted to the PBOC. Reserve shortfalls are subject to penalty interest rates. The required reserve changes the money supply through the banking multiplier. Excess reserve (standby reserve): Excess reserve (standby reserve): Excess reserves are used to meet cash withdrawals, lending in the interbank market etc. In 1989, the PBC issued a guideline on the level of excess reserves – 5 to 7% of deposits.

5. Open Market Operation: The PBC began to issue central bank financing notes in May 1993 to implement open market operation (to influence the base money through the buying and selling of the financial notes).

Monetary Policies in China for the Period The monetary policy of China is characterized by the “stop-go” cycle: when the economy overheats, tight monetary policy is used. But when output falls, the money supply expands again. Monetary policy in 1985 (the “stop” phase ): In 1984, the central bank pumped too much liquidity into the economy which resulted in economy overhearing. Because of this, the central bank has to tighten the money supply in Five measures were adopted: (i) specialized banks are allowed to make loans only to the extend of their deposits. (ii) strict credit control policy was instituted (iii) the credit funds of People’s Construction Bank of China was incorporated into the credit management of PBC. the credit management of PBC. (iv) the Renminbi was devaluated.

Monetary policy in 1986 (the “go” phase ): By 1986, economic activities had cooled down considerably and the growth of production fell. Subsequently, three measures were applied to relax the tight monetary policy: (i) the PBC increased the amount of reloan by 5 billion Renminbi to clear up the enterprise debts (ii)it canceled the directory credit plan imposed on the specialized banks (iii)temporary loans were granted to the specialized banks Monetary policy in 1988 (the “stop” phase ): In 1987, the economy was overheated. Thus quantity control and structural readjustment was applied again in 1988: (i) credit aggregates were restricted (ii)the long-term interest rate was increased and all short-term loans were recalled (iii)the required reserve was raised to 13% and the reloan rate was increased.

Monetary policy in 1990 (the “go” phase ): From October 1989, the Chinese economy experienced negative growth in income for several months, mainly caused by the triangular-debt problem among different enterprises. In 1990, the State Council relaxed the tight monetary policy. Major measures include: (i) a reloan readjustment plan increased credits from 30 billion to 60 billion Renminbi (ii) PBC increased its technology reconstruction loans to enterprises and loans were granted to solve the triangular-debt problem. (iii) banks’ deposit and loan rates were lowered by an average of 1.26 percent. (iv) a favorable interest rate was granted to import and export enterprises Monetary policy in 1991 (the “stop” phase ): The economy picked up at the end of 1990 which led the State Council to introduce a tight monetary policy again in 1991.

Monetary policy in 1992 (the “go” phase ): In 1992, Deng Xiaoping toured southern China and called for further reform. Monetary policy has to be loosen to promote further reform. Measures taken include: (i) increase the credit aggregate to RMB 350 billion (ii) the high demand for loans had led to a sharp increase in credits Monetary policy in 1993 (the “stop” phase ): In 1993, the Austerity Plan was introduced to strengthen control on the financial sector. Under the Austerity Plan, strict control was imposed on currency issue, all forms of illegal interbank borrowing and lending were stopped etc.

Monetary policy in 1994 (the “go” phase ): The tight monetary policy hurt the economy badly. The industrial growth dropped and the real estate market was in deep recession. Under these circumstances, the State Council and PBS loosened the monetary policy to prevent the economy from sliding further. Monetary policy in 1998 (the “go” phase ): Since the SOE reform and the opening to the outside world, the weight of the non-state-owned economy against the whole national economy kept increasing. Nevertheless, the loans for the non-state-owned economy did not reach 3% of the loan balance, thus it is necessary to increase money supply to stimulate the initiatives of the non-state-owned economy and promote the increase of consumption.