China’s monetary policy is a complex system in which the central bank pursues a number of objectives. The stability of the Chinese renminbi exchange rate plays an important role, especially in the context of the current global economic challenges. China, within the planned economy of which the central bank is part, is actively seeking to strike a balance between supporting the domestic economy and addressing potential problems arising from international capital flows. The dance between liberalisation and maintaining control thus defines China’s monetary policy. This article assesses its evolution and provides comparisons with advanced market economies.[1]
Published in Central bank monitoring – December 2023 (pdf, 750 kB).
China is the second-largest economy in the world. The influence of the Chinese economy was particularly pronounced during, for example, the COVID-19 pandemic. The disruption of global supply chains during the pandemic stemmed mainly from limited exports from China, resulting in negative supply and production effects in many countries. The functioning of Chinese monetary policy is thus also relevant to other economies due to the size of the Chinese economy.[2]
The PBC and monetary policy objectives
PBC functions (external link) are set out in the 2003 Law of the People’s Republic of China on the People’s Bank of China and include, inter alia, monetary policy, currency management, financial-market regulation, financial stability, currency stability, etc. The primary objective is “to safeguard currency stability[3] and promote economic growth”. The Chinese Communist Party Committee Secretary, nominated by the Chairman of the State Council, has a key influence on the management and direction of the PBC, and not the governor. However, Mr. Pan Gongsheng currently holds both of these posts.
The Monetary Policy Commission (MPC) was set up in 2000 and has the task of discussing and proposing: (i) changes in the monetary stance, (ii) monetary policy objectives, (iii) the use of monetary instruments, and (iv) macroeconomic policy coordination measures. Jones and Bowman (2019) describe that the MPC organisational structure adheres to international standards, although its powers are relatively limited – it is merely an advisory body for monetary policy creation. The composition of the MPC is determined by the State Council and currently comprises 14 members. The MPC meets on aquarterly basis, and the minutes of its meetings and recommendations of decisions are submitted to the State Council for approval. Unlike most central banks of advanced economies, therefore, China’s MPC is not an independent executive body. MPC meetings are based on the Monetary Policy Report, which summarises the development of the Chinese economy in the previous quarter and suggests further monetary policy steps. It also includes a qualitative description of expected future developments. However, no quantitative forecast can be found in the Report, unlike in the case of the central banks of advanced economies.
Main monetary policy instruments
Compared to advanced economies, China uses a broader set of monetary policy instruments to achieve its objectives. The monetary policies of advanced economies usually put the emphasis primarily on price instruments, first and foremost on interest rates. However, the Chinese economy (characterised by state ownership of banks and firms) uses an instrument system that combines both price[4] and volume market instruments, and non-market instruments:
- Rates for open market operations (OMO): OMOs are carried out on a regular basis with the aim of correcting liquidity in the banking market. They include operations with PBC treasury bills (repo, reverse repo), and their yield can be considered a monetary policy rate. The key OMO rate is the 7-day reverse repo rate, which affects short-term interest rates like the DR007 repo rate on the interbank market.
- Interest rate corridor: The PBC keeps short-term interest rates within a defined range using an interest rate corridor, where the standing loan facility (SLF) rate serves as the upper bound and the interest rate on excess reserves as the lower bound.
- Additional lending facilities – in particular the medium-term lending facility (MLF): the MLF rate is the one-year central bank interest rate which, together with the 7-day reverse repo rate, forms the overall monetary policy interest rate system. It gives a price for the medium-term funds for which the banking system borrows from the central bank. Since 2019, the PBC has introduced a structured approach to MLF operations, which it conducts on a monthly basis. In 2018, the PBC implemented the TMLF (Targeted MLF) programme, available for three years, to support lending to micro and small enterprises. The relevant rate was 15 basis points lower than the MLF rate.
- Foreign exchange interventions: China also uses foreign exchange market interventions through which it affects the exchange rate. The role of the exchange rate in monetary policy is described in more detail below.
- Window guidance: a non-market instrument, mainly typical of Chinese and Japanese monetary policy. This consists of ‘guidance’ (in the form of directives) to financial institutions to grant and allocate credit in line with official (government) objectives. Jones and Bowman (2019) state that the PBC maintains a strong influence on both the amount of credit provided by the banking system and the sectors that can receive credit financing. However, this instrument is not mentioned in the latest Monetary Policy Reports and is used only occasionally.
- Reserve requirements (RR): by changing the RR rate, the PBC is able to influence interbank liquidity and the availability of funds, and thus seeks to influence lending activity. The PBC applies a multi-layered RR rate system in which it takes into account factors such as bank size, the composition of individual bank loans and financial stability.
The monetary policy framework of the PBC
Prepared based on Jones and Bowman (2019), Das and Song (2023).
* Total Social Financing (TSF) comprises bank loans, non-bank forms of credit intermediation (e.g. trust and entrusted loans) and capital market issues.
Transmission mechanism
When describing the Chinese monetary policy transmission mechanism, it is worth mentioning some factors that complicate this analysis. First, the Chinese monetary framework is complex and not fully transparent in several aspects, including some monetary policy instruments. Second, the institutional environment for macroeconomic policy-making, where the State Council acts as the final decision-making body, leads to a high degree of coordination between monetary and fiscal policy (Das and Song, 2023). The interconnection of monetary policy with banking supervision and financial stability and agreements with banks (in many cases state-owned) is also of considerable importance. For example, supervision has the decisive power to determine who will be granted credit, who, on the contrary, can declare bankruptcy, etc. The main unifying element of these policies is ensuring overall stability.
Despite this, Das and Song (2023) state that monetary policy is increasingly transmitted via interest rates, which now have a greater influence on corporate and household decisions than monetary aggregates. This tendency is confirmed by Jones and Bowman (2019), who state that the transmission of short-term repo rate shocks to asset prices and real economic activity is stronger than those of monetary aggregates. However, China differs significantly from advanced economies in terms of the transmission of the effect of monetary policy instruments on inflation. For example, the PBC does not have independent instruments and does not have a clear nominal anchor, as is customary in the monetary policies of advanced economies and, according to the article, the effect of interest rates on inflation is limited.
The exchange rate as an instrument of China’s monetary and export policies[5]
Since July 2005, a regime of a managed floating renminbi (RMB or CNY, pronounced ‘rɛnmɪnbi’) exchange rate has been officially introduced, but in reality, it has long been a crawling peg against the US dollar. This system allowed the Chinese currency to appreciate slowly until July 2015, except for the two-year period following the start of the global financial crisis, when the exchange rate was kept stable. China intervened intensively in the foreign exchange market between 2005 and 2014 to ease currency appreciation, with foreign exchange reserves rising from USD 733 billion in July 2005 to a peak of USD 3.99 trillion in June 2014. Market sentiment reversed in 2014 towards a feeling that the renminbi is overvalued, exerting pressure on capital outflows. In order to limit the depreciation of the exchange rate against the US dollar, in the summer of 2014 the foreign exchange interventions changed to sales of reserves, which ensured that the exchange rate was stable yet capital outflow pressures remained strong. In effective terms, however, the renminbi appreciated by 14% between the end of 2013 and July 2015. Exports and overall economic growth thus slowed in this period (Das, 2019).
In August 2015, a change in the central parity mechanism (around which some fluctuation is allowed) between the renminbi and the US dollar was announced (external link). Prior to this change, the PBC was essentially arbitrarily determining the parity, and the difference between the hypothetical market rate and the official rate was reflected in changes in the foreign exchange reserves. Following the change, the PBC started to take into account the previous day’s market rate when setting parity, so the effect of market forces on the exchange rate increased. In this context, the central parity rate suddenly shifted downwards. The Chinese government presented this depreciation as a move towards greater renminbi flexibility but,[6] but at the same time, aweaker currency may have supported declining exports due to weak foreign demand.[7] Capital outflows were also accelerated in this period (Das, 2019).
Chart 1 – USD/RMB exchange rate (2000–2023)
Source: FRED.
In this context, it is also possible to mention the composition of international reserves (external link), which the PBC does not disclose in detail, even though some aspects are evident. In September 2023, China held around 10% (external link) of the total US external debt, ranking it second among holders after Japan. There is an effort to diversify, as currently illustrated by a steady rise in gold reserves for the 12th consecutive month. This strategy is in line with a trend through which a number of other central banks are increasing their gold reserves to increase asset diversification, hedge against geopolitical risks, and reduce their dependence on the US dollar (external link).
Monetary policy during the COVID-19 pandemic
In response to the pandemic, the PBC has taken several measures (external link) to directly support the real economy. These included, for example, the provision of special loans from the central bank amounting to RMB 300 billion. The PBC has also provided loans with lower interest rates of RMB 1.8 trillion to support micro and small enterprises (MSEs) as well as rural development. These monetary policy instruments directly supported the sectors of the economy hit by the pandemic. Two other instruments have also been introduced: one allowing a postponement of the repayment of inclusive loans for MSEs, and the other was a support plan for inclusive loans for MSEs. The aim was not only to provide immediate financial assistance, but also to improve the effectiveness of structural monetary policy instruments contributing to more targeted support for micro, small and medium-sized enterprises.
Current state of the economy and the monetary policy stance
The performance of the Chinese economy was rather lacklustre after the post-COVID reopening, but in Q3 the year-on-year GDP growth accelerated to 4.9%, exceeding analysts' expectations. The impact of government stimulus measures had a particularly positive effect. Chinese exports have declined in recent months owing to subdued external demand, while imports have increased. The Chinese economy has fallen into deflation, with annual consumer price inflation of -0.2% in October and falling further to -0.5% in November.[8] In recent years, China has also been struggling with a crisis in the property market (external link).[9] In 2020, the government intervened due to the rapid indebtedness of developers, setting strict limits on three key debt indicators. This has led to the slowdown or suspension of many projects and, in some cases, to the bankruptcy of developers. The property crisis has had an impact on the quality of banks' loan portfolios and on the finances of provincial governments and municipalities. In addition, youth unemployment is increasing (reaching 21.3% in June 2023).
Given the current state of the economy, the PBC has eased monetary policy in recent months. It has already lowered the RR twice this year. The weighted average of the RR for financial institutions is now 7.4% (external link). In recent months, the PBC has provided the banking system with sizeable liquidity injections via a one-year MLF. In November, the net funds amounted to RMB 600 billion, the largest medium-term liquidity injection since 2016. At the same time, it left the MLF rate unchanged at 2.50%. For OMO operations, the 7-day reverse repo rate is now 1.80%. In this context, the renminbi is showing adepreciation trend this year, partly because of a wider interest rate differential – rates remain elevated in the USA and in other major economies. However, the experience of 2014 and 2015 raises concerns that a sharp currency depreciation could cause massive capital outflows. The PBC therefore wishes to maintain the stability of its currency and is taking concrete measures in this context. Even though the central parity of the renminbi-dollar exchange rate is set every day on the basis of market forces, the bank has the option of adding a countercyclical factor (external link). In this way, the bank can set the central parity rate a little stronger every day. It also seeks to support the renminbi by reducing liquidity outside mainland China,[10] which makes it more difficult for speculators to lend the renminbi for sale. According to Wang et al. (2023), the PBC has thus regained control over the value of the renminbi, albeit to the detriment of market-setting of the exchange rate and internationalisation of its currency. Moreover, the interventions are acting in the opposite direction to the easing of other monetary policy instruments.
Chart 2 – DR007 interbank repo rate
Source: Bloomberg.
Chart 3 – GDP and inflation
Note: Year-on-year real GDP growth, annual data.
Year-on-year headline inflation, quarterly data.
Source: World Bank and FRED.
Challenges and outlook
From a long-term perspective, China faces serious challenges at home, such as population ageing, the rural-urban divide, excessive public infrastructure construction, an underdeveloped financial system, a lack of innovation, and dependence on fossil energy sources. In addition, China’s external geopolitical relations with a number of important partners have deteriorated, leading to increasing trade and investment barriers on both sides. According to Yoshina and Miyamota (2019), the gradual ageing of the population and the declining share of the working population are resulting in a declining effectiveness of monetary and fiscal policy.
As regards the potential paths of Chinese monetary policy, the development of the digital currency (CBDC) is at a very advanced stage. The PBC is a leader among central banks in terms of digital currency application and scope of use. Unlike Western economies, China is seeking to replace cash with the digital renminbi rather than simply supplementing it. The motivation for the creation of a CBDC is also different from other economies: the issue of greater control of the population is controversial (at least from an external point of view), and the effort to increase the global importance of the Chinese currency also represents a certain motivation for the introduction of the digital renminbi. Until now, the digital currency has been used mainly for domestic retail payments (external link), and its share in total currency in circulation remains negligible, but the scale of its use continues to grow. The next stage (external link) of its development includes integration into wholesale banking transactions and cross-border payments.
Gradual liberalisation?
With some implementation elements (e.g. the key interest rate corridor), China’s monetary policy is increasingly converging with those of advanced economies as it continues to move from a volume-based monetary policy system to a price-based system (Jones and Bowman, 2019). Das and Song (2023) indicate that the liberalisation of interest rates was essentially completed by the removal of the deposit rate cap in 2015. While the financial system remains largely banknote-oriented, the government is pursuing measures to develop financial markets, including opening the Chinese bond market. According to Schipke et al. (2019), this implies that capital markets will play a relatively larger role in the allocation of savings and investment in the future.
On the other hand, Kawai and Liu (2015) argue that monetary policy autonomy has decreased, constrained by the declining effectiveness of capital controls and the rigid exchange rate regime. Jones and Bowman (2019) further point out that the government’s occasional use of window guidance still influences the flow of credit in China. The authors also summarise that, although monetary policy in China has evolved significantly over the years, it still differs from advanced economies. Given China’s political regime, institutional set-up and economic development measures, the likelihood of further convergence in the monetary policy regime does not seem high.
Conclusion
China’s monetary policy is characterised by a number of objectives, as well as by a relatively wide set of instruments, including non-market instruments. China has no clear nominal anchor and the effect of interest rates on inflation is only limited. An important role is played by the renminbi exchange rate, which the PBC has significantly influenced over a long period through its interventions (although since 2015 market forces have had a greater influence on the exchange rate than in previous years). Moreover, the central bank does not have full control over monetary policy; decisions are subject to approval by the State Council.
The Chinese economy is currently facing many challenges, including the ongoing property market crisis, deteriorating global demand and rising unemployment, which affect overall economic activity. In the longer term, unfavourable demographic developments, among other things, pose a difficult challenge to China’s economy and monetary policy.
Despite the gradual monetary policy easing, the differences between China’s monetary policy and its counterparts from advanced economies remain sizeable. Moreover, given the political regime and concrete steps taken by the Chinese authorities, a further convergence of the monetary policy regime is unlikely. This points to the specificity and individual nature of the path China is taking in its efforts to maintain stability and successful economic development.
Literature
Ahmed, R. (2021). Monetary policy spillovers under intermediate exchange rate regimes. Journal of International Money and Finance, 112, 102342. (external link)
Chen, Y., Liu, D., & Zhuang, Z. (2023). The spillover effects of China's monetary policy shock: Evidence from BaR countries. Emerging Markets Review, 55, 100952. (external link)
Das, M. S. (2019). China’s evolving exchange rate regime. International Monetary Fund. (external link)
Das, S., & Song, W. (2023). Monetary policy transmission and policy coordination in China. China Economic Review, 82, 102032. (external link)
Jones, B., & Bowman, J. (2019). China's evolving monetary policy framework in international context. Reserve Bank of Australia. (external link)
Kawai, M., & Liu, L. G. (2015). Trilemma challenges for the People's Republic of China. Asian development review, 32(1), 49-89. (external link)
Schipke, A., Rodlauer, M., & Zhang, L. (2019). China’s Bond Market: Characteristics, Prospects, and Reforms (p.3–31). The Future of China’s Bond Market. International Monetary Fund. (external link)
Yi, G. (2021). China’s Interest Rate System and Market-based Interest Rate Reform. Journal of Financial Research, Issue 9. (external link)
Yoshino, N., & Miyamoto, H. (2019). How does population aging affect the effectiveness of monetary and fiscal policies? (No. 1064). ADBI Working Paper Series. ((external link))
Wang, P., Ho, T., Liu, X., & Wu, S. (2023). China’s Trilemma: Exchange Rate Marketization, RMB Internationalization, and Exchange Rate Pricing Power. Borsa Istanbul Review. (external link)
[1] China’s monetary policy and its evolution during the first decade of the century was also discussed in the April 2011 issue of Global Economic Outlook.
[2] In the monetary policy context, China’s growing influence on the global economy was examined, for example, in a recent study by Chen et al. (2023). The paper shows that China’s monetary-policy shock has had significant spillover effects on macroeconomic and financial variables in twenty-six countries of the Belt and Road Initiative (BRI), or New Silk Road – China’s initiative, which includes, for example, infrastructure projects to develop connectivity between these countries and China.
[3] Currency stability comprises two dimensions: internal (domestic inflation stability) and external (a stable exchange rate).
[4] The interest-rate system is described in more detail in an article by then Governor Yi (2021).
[5] As far as the stability of the renminbi exchange rate is concerned, supervision of foreign exchange transactions is ensured by the State Administration of Foreign Exchange (SAFE, external link), a body subordinate to the PBC. Thus, for example, the SAFE grants permits for the export or import of capital.
[6] Ahmed (2021) argues that greater renminbi flexibility after 2015 is motivated by efforts to increase the global importance of the currency. At the same time, he considers it may also be that the easing of the renminbi’s link to the US dollar was accelerated by the ongoing trade war between the USA and China in an effort to protect itself against the impacts of tariffs.
[7] See Global Economic Outlook August 2015.
[8] For more details on recent developments in the Chinese economy, see Global Economic Outlook November 2023.
[9] According to an estimate by Rogoff and Yang (2023, external link), the share (including the indirect effect) of the property and infrastructure construction sector in the Chinese economy has exceeded 30% of GDP in recent years.
[10] In an effort to internationalise the renminbi, in the absence of a fully liberalised capital account, China has introduced an offshore RMB market, creating a situation of “one currency, two markets” (onshore CNY and offshore CNH in places such as Singapore and Hong Kong). According to Wang et al. (2023) it now finds itself in a dilemma: while the monetary authorities can regain control over the exchange rate in the onshore market (tighten control of the exchange rate in the onshore market or liquidity in the offshore market), they should be aware that such measures can bring complications in the process of exchange rate marketisation and currency internationalisation.
