RDP 2019-11: China's Evolving Monetary Policy Framework in International Context 1. Introduction

Much like the broader economy, monetary policy in China continues to evolve in important ways. Yet the pace of change, China's unique institutional arrangements and the fact that the full scope of China's monetary policy framework has never been officially documented has meant that key elements of the formulation and implementation of monetary policy in China are still not widely known.^[1] This seems an anomaly given China's prominent position in the world economy. As such, this paper takes stock of the evolution of monetary policy in China along several dimensions, and places these developments in international context. Such an approach also allows us to offer some broader perspectives in the context of the emerging discussion over whether the conduct of monetary policy in China is now converging on practices commonly observed in advanced economies. Our comparative focus is directed toward advanced (rather than emerging) economies as this is more relevant for an Australian audience, and also consistent with the direction of the recent literature as the Chinese financial system and economy has become larger and more developed.^[2]

One view of the conduct of monetary policy in China has traditionally held that it bears little-to-no resemblance to that in advanced economies. A shortlist of related arguments reads as follows. First, the nature of China's institutional arrangements has meant that goal setting, accountability mechanisms and decision-making arrangements for monetary policy in China are entirely different from those in advanced economies. Second, the high-level objectives for monetary policy in China, and how they practically find expression in targets and instruments, have no parallels among advanced economies (e.g. Goodfriend and Prasad 2006; Ma 2017). Third, the communication framework has been characterised as ineffective in shaping expectations due to a contemporaneous (rather than forward-looking) orientation, and confusion has sometimes been sowed over the overall stance of monetary policy when many instruments are used to adjust monetary conditions (McMahon, Schipke and Li 2018). A fourth has related to the lack of conventional pass-through of monetary policy, attributed to any number of frictions including interest rate controls, credit quotas, window guidance, soft borrowing constraints of state-owned enterprises, and active management of the exchange rate (e.g. Geiger 2006; Laurens and Maino 2007; Koivu 2009; Mehrotra and Sánchez-Fung 2010; Chen, Chen and Gerlach 2011).

In more recent times, however, a number of researchers have started to challenge the long-standing narrative by contending that in a number of respects, the conduct of monetary policy in China is now converging on established norms in advanced economies. For instance, on the policy framework, it has been suggested that the PBC now effectively operates a price-based system (Chen, Chow and Tillmann 2017; Harjes 2017; Kamber and Mohanty 2018). Some have also asserted that the PBC has been pursuing a de facto inflation-targeting regime with a hybrid forward-looking reaction function (incorporating growth and inflation expectations), similar to that employed by a number of advanced economy central banks. Girardin, Lunven and Ma (2017) contend that the PBC has ‘engaged in a regime that looks a lot like informal inflation targeting’ (p 3) and that ‘a comparison of the Chinese and G3 reaction functions shows some interesting similarities’ (p 17). Others have recently pointed to important aspects of the PBC's communication framework becoming more forward-looking, and thus effective in guiding market expectations (e.g. Garcia-Herrero and Girardin 2013; Sun 2013; McMahon et al 2018). Some researchers have also recently argued that the nature of monetary transmission in China is now comparable to that in advanced economies, where contractionary interest rate adjustments are associated with some combination of higher market-based interest rates, slower money growth, lower industrial output growth, lower consumption and lower inflation. For instance, Fernald, Spiegel and Swanson (2014, p 101) suggest that ongoing institutional changes in China and ‘the liberalization of China's economy to date, particularly in its financial sector, has left [its] monetary transmission mechanism closer to those of Western economies than previously realized’. Kamber and Mohanty (2018, p 4) similarly conclude ‘monetary transmission in China is remarkably similar to that typically found in advanced economies’.

This paper takes stock of the evolution of monetary policy in China across four dimensions: the institutional framework, operational framework, communication framework, and the empirical behaviour of monetary policy pass-through. In relation to the existing literature, this relatively broad scope allows for a clearer identification of interconnections across elements of the policy framework, and how these compare to advanced economies. We view this wide lens approach as particularly relevant as many of the unique features of monetary policy in China can be traced back to the institutional setting for macroeconomic management. It may also be useful in providing context to instances where similarities to advanced economies have been highlighted (at the possible risk of overstatement) in the recent literature. The main findings are as follows.

First, on the institutional framework, while the nature of goal dependence is not materially different in China vis-à-vis advanced economies, the absence of full instrument independence and related accountability mechanisms remain substantial points of difference. This reflects China's unique political and institutional arrangements, among them the single-party state system and the highly coordinated nature of economic policymaking, with the PBC comprising just one of 35 members on China's foremost decision-making body, the State Council. The concept of ‘constrained discretion’ therefore applies to the PBC in a fundamentally different context vis-à-vis advanced economy central banks, with operational autonomy restricted to more technical aspects of monetary policy implementation such as open market operations and the corridor system for interest rates. Differences in the institutional frameworks for monetary policy between China and advanced economies are not just of form, but of substance, and are highly likely to be persistent.

Second, we argue that the high-level objectives for monetary policy and the manner in which they find practical expression in targets and instruments continues to be largely unique to China. That said, we also acknowledge that a range of factors – financial market deepening, moderating current account surpluses, increased tolerance for exchange rate flexibility and the successful introduction of a price-based corridor system (broadly analogous to systems employed in advanced economies) – are according the PBC more scope to independently influence monetary conditions over time, within the context of China's interagency decision-making arrangements.

Third, we find that the PBC's communication framework has evolved considerably, with a number of elements now similar to those observed in advanced economies. Remaining differences relate to institutional constraints over forward guidance (and thus, the management of expectations), unexpected policy deliberations, and the difficulties in clearly characterising the stance of monetary policy due to the large suite of policy instruments deployed by authorities.

Fourth, as observed in many advanced economies in the 1970s and 1980s, we find policy rates in China to contain more leading information for asset prices and output than monetary aggregates, but that impediments to policy rate pass-through remain in the cases of bank lending and inflation. Moreover, we suggest that the Chinese authorities have displayed both the willingness and the ability to deliver low and stable inflation outcomes, but for different reasons and through different means than in advanced economies. One possible explanation for China achieving price stability is as follows: if the prospect of high inflation and deflation is viewed by the authorities as sufficiently politically worrisome to warrant a concerted opposing response from all the levers of government, it may be that standard incentive misalignment and commitment problems cited in the literature on central bank independence and inflation targeting may be less pressing in China's unique institutional setting.

Taken in sum, our analysis suggests that while monetary policy in China has evolved significantly over time, recent assertions that it now operates similarly to advanced economies remain narrowly based. Convergence in monetary policy is neither likely nor even desired by the authorities given China's revealed preference over institutional design and model of economic development.

The remainder of the paper is structured as follows. Section 2 outlines key features of China's institutional framework for monetary policy. Section 3 discusses objective setting and the operational framework, with emphasis on how the setting and pursuit of objectives and targets interacts with the use of various instruments. Key features of monetary policy communication in China are outlined in Section 4. Section 5 presents empirical analysis of the transmission of monetary policy. Section 6 concludes.

Footnotes

As later discussed, the documents closest to setting out the contours of a monetary policy framework are The People's Bank of China's (PBC's) founding legislation of 1995 (updated in 2003) and the PBC's Monetary Policy Committee Regulations of 1997 (updated in 2010). [1]

As set out in the concluding remarks, we leave comparisons of monetary policy in China with other emerging market countries for future research as it would demand a separate treatment in its own right. [2]