People’s Bank of China (PBC)

Monetary Policy Targets and Main Tools

In monetary policy Opens in new window, it is common to distinguish between operational and intermediate targets.

While operational targets can sufficiently be controlled by the central bank and effectively influence the ultimate goals of monetary policy (such as price stability and economic growth), intermediate targets are not under the direct control of the central bank.

The PBC Opens in new window has been referring to three intermediate targets:

  1. quantity-based money supply (M2),
  2. bank lending and
  3. price-based market interest rates.

Traditionally, the focus had been on intermediate quantitative targets, and targets values were defined for monetary or credit aggregates (such as new loan growth).

But, due to “financial innovation and a rapidly changing financial system structure” and the fact that “M2 is correlated less and less with inflation and growth”, and that “M2 outturn has deviated from the target over the past couple of years”, the emphasis is now more on price-based variables.

In a speech in 2018, Governor Yi expressed it as follows:

As the correlation between quantitative indicators and economy gradually declines, the monetary policies of major developed countries and market economies are principally aimed at regulating price indicators. Reforms in China were also focused on nurturing a market-based interest rate system and enhancing a price-oriented regulation and transmission mechanism.

In line with this development, the PBC Opens in new window now focuses, as its operational target, on short-term money-market rates. This applies, in particular, to the 7-day reverse repo rate, which is a weighted average of participating banks (= deposit institutions; hence, its name “DR007”) and which is closely watched by the market, even if the PBC has not yet confirmed this rate as its target interest rate.

Like most other central banks, the PBC uses three main monetary policy tools to ensure that the envisaged level of its operational target is reached in financial markets: open market operations (OMO) Opens in new window, standing facilities Opens in new window and reserve requirements Opens in new window.

1.   Open Market Operations

Open market operations Opens in new window are “central bank transactions with banks at the central bank’s initiative”, and usually take the form of lending operations, but can also consist of outright purchases or sales of financial assets.

2.   Standing Facilities

Standing facilities Opens in new window are “central bank operations at the initiative of banks”, and can be sub-divided into overnight borrowing facilities, in which banks can borrow from the central bank against collateral, deposit facilities, in which they can deposit funds at the central bank, and discount facilities, in which they can sell short-term paper (typically drafts) at a discount to the central bank.

3.   Reserve Requirements

Reserve requirements Opens in new window “oblige banks to hold a certain minimum level of sight deposits on their account with the central banks” and “may apply to single day-ends, or to an average over e.g. a one-month period”.

Unlike other central banks, the PBC has three more tools at its disposal, which it has used and continues to use at times to varying degrees:

  • the issuance of central bank bills (“sterilization bonds”),
  • the administrative setting of deposit and
  • lending benchmark rates and the so-called “window guidance”.

The PBC widely used the first one in the context of its exchange-rate policy until China’s foreign reserves reached their peak of almost 4 trillion USD in June 2014; in order to keep the exchange rate low, the PBC bought USD against RMB, and, in order to “sterilize” the liquidity injections stemming from this foreign-reserve accumulation, it used central bank bills.

The second tool has been of lesser importance, since the remaining ceiling on deposit rates was eliminated in 2015, thereby fully removing interest-rate controls. But the benchmark interest rates still matter for the borrowing costs of the corporate and household sectors, as “banks tend to set their lending rates in line with the benchmark lending rate”.

The third tool, window guidance, can take the form of setting a quarterly quota for the state-owned banks on the total value of their loans, and “guiding” them, regarding which amounts to lend to which sectors.

It works not only because of the discretionary power of the central bank, but also because of the fact that China’s banks are predominantly state-owned, which gives the government, or, more precisely, the Chinese Communist Party (CCP) Opens in new window, huge leverage over their lending.

And window guidance Opens in new window, which usually takes place behind closed doors, also has a large influence on the non-state-owned banks. It depends on the economic and financial conditions, and happens whenever the PBC considers it necessary.

Evolution and Successes in Recent Years

China’s use of its large array of monetary policy instruments has evolved in recent years in a way that can be characterized as a shift from quantity-based to more price-based tools.

The PBC now relies much less on central bank bills and increasingly uses OMOs and liquidity facilities.

In 2015, the PBC introduced an interest-rate corridor mechanism, in which market-based policy rates such as its OMO 7-day reverse repo rate Opens in new window and standing and marginal lending facilities at different maturities are used to affect money-market rates in the desired direction. This has resulted in a big increase in the net liquidity provided by the PBC to banks since 2015.

On the other hand, quantitative tools and, in particular, reverse requirements also continue to play a role, as relatively high reserve requirement ratios (RRR) are still considered necessary to prevent systemic financial risks, and, at the same time, decreasing them is a convenient tool for the PBC to inject liquidity, and this has been widely used as a stimulus recently.

Since April 2018, the PBC has implemented four targeted RRR cuts to boost economic growth, lowering the ratio to 13.5 per cent for large and 11.5 per cent for small institutions, and, in early May 2019, it announced further cuts “aimed at helping small- and medium-sized banks to serve small and private enterprises better, which will, in turn, support the overall economy”.

RRR cuts Opens in new window are effective, as they release central bank money, against which banks can then take additional deposits, thus allowing more loans.

So what has been the track record of China’s monetary policy in recent years?

Despite a challenging and rapidly changing domestic and international environment, the PBC has, with its monetary policy, managed relatively well to contain inflation, in particular, in comparison with its emerging market peers, and, to some extent, also to support growth.

The PBC is proud of the success of the former and communicates it externally, but it also acknowledges that, especially in terms of economic stimulus, authorities are overly relying on monetary policy, and that more should come from fiscal policy.

A frequently asked question in this respect, which the former Governor Zhou also voiced publicly, is whether the PBC’s multiple objectives of ensuring price stability, promoting economic growth and employment, and maintaining the balance of payments and financial stability could not be “in conflict” with one another.

It is true that addressing, for example, financial risks by reigning in shadow banking and local government debt come at the price of lower growth, so potential conflicts are more difficult for the PBC to avoid than for central banks with a purely price-stability mandate.

But, even if great challenges might lie ahead for China, the PBC seems to be surprisingly confident that it will be able to deal with them.

In the context of the recent re-escalation of the US–China trade (and technology) war, the above mentioned MPC member Ma Jun, for example, has been quoted by Reuters with the statement that the Chinese central bank had “sufficient monetary policy tools to cope with current internal and external uncertainties”, and would look to fine-tune policy according to changes in the country’s economic situation.