RDP 2019-11: China's Evolving Monetary Policy Framework in International Context 2. The Institutional Design Framework for Monetary Policy

2.1 Historical Background

The PBC began life as a hybrid national bank. By itself, this does not make it unique, but the circumstances of the PBC's birth were unquestionably different from other central banks. Prior to the establishment of the PBC in 1948, the Bank of China (the oldest ‘living’ bank in China) had served as a quasi-central bank between 1912 and 1928 based out of its Shanghai headquarters, before evolving into a commercial bank specialising in foreign exchange and trade. It was one of a number of banks that could issue banknotes on behalf of the new Republic following the fall of the Qing Dynasty (1636–1911). The Nationalist Government also created a central bank in 1924, before it relocated to Taiwan at the conclusion of the Chinese Civil War in 1949. Like the Bank of China it was also headquartered in Shanghai and represented in branches throughout the country, though it wielded more expansive monetary powers. However, the combination of grave internal disturbances and foreign occupation meant that China's thriving financial system of the 1920s^[3] – with Shanghai a financial centre of global repute – ground to a halt through the 1930s and 1940s.

In the three decades following the establishment of the PBC in Beijing in 1948, deposit-taking banks in China were either shut down or nationalised and reorganised as PBC divisions.^[4] In 1978, the PBC assumed responsibility for both central banking and commercial operations in what was essentially a mono-bank financial system; in 1978 it accounted for 93 per cent of financial system assets in China (Huang, Ge and Wang forthcoming). The ‘reform and opening up’ era which commenced in 1978 then saw the PBC carved out of the Ministry of Finance, and four years later the State Council clarified that ‘the People's Bank of China is the central bank of the People's Republic of China, and it is a government agency responsible for supervising the financial industry of the country under the leadership of the State Council’ (as quoted in Yi (2018b)). In 1984, the PBC's central banking functions were separated from its industrial and commercial operations, the latter of which were transferred to the newly created Industrial and Commercial Bank of China (which now stands as the country's largest bank).

Despite operating for nearly half a century as the nation's foremost financial institution, the legal status of the PBC was not affirmed until March 1995 – a time of serious domestic monetary instability – when the Law of the People's Republic of China on the People's Bank of China (hereafter, The PBC Law) was adopted at the Eighth National People's Congress (NPC).^[5] Monetary reforms remained in focus in the years following, highlighted by the east Asian financial crisis and a wave of financial sector restructuring activity in China (as non-performing loans peaked above 30 per cent). The PBC Law was subsequently updated at the Tenth NPC in December 2003 to further clarify that ‘[t]he People's Bank of China shall, under the leadership of the State Council, formulate and implement monetary policy, prevent and mitigate financial risks, and maintain financial stability’ (unofficial translation). This places the PBC among the more recent cohort of central banks operating under new or substantially revised primary legislation (Table 1).

2.2 Monetary Policy Decision-making

How monetary policy-related legislation finds practical expression in China, and in particular how it differs from advanced economies, first requires discussion of the political context for decision-making responsibilities and associated institutional arrangements.

The institutional framework that underpins contemporary monetary policy frameworks in democratic multi-party advanced economies was born out of the stagflationary experience of the 1970s and the concurrent pioneering research highlighting the dangers of politically compliant central banks and ‘time inconsistency’ problems. A lack of credibility was shown to lead to higher average inflation with no offsetting benefits in terms of greater output or employment. The general concepts were as follows. Policymakers in a central bank subject to short-term political influence may face pressures to overstimulate the economy to achieve short-term output and employment gains that exceed the economy's underlying potential. Such gains may be popular at first – and especially attractive to politicians seeking near-term re-election – but ultimately prove unsustainable, leaving behind only inflationary pressures that worsen the economy's longer-term prospects.^[6] Empirical research through the 1980s and early 1990s appeared to confirm a clear negative relationship between inflation outcomes and central bank independence.^[7] One influential thread of the subsequent analysis suggested that the macroeconomic benefits from central bank independence stemmed principally from instrument rather than goal independence, at least in advanced economies.^[8],[9] In the context of democratic multi-party political systems, the institutional design features of monetary policy frameworks in advanced economies broadly evolved to embed the following elements:

• Objectives setting – the high-level objectives for monetary policy are reflected in founding legislation passed by the government, and practically translated as set out in secondary legislation and/or subsequent refinements such as policy framework documents (Table 2);
• Instrument independence – in an expression of ‘constrained discretion’ over the powers delegated to it by lawmakers, the central bank is awarded full autonomy in deploying the tools of monetary policy to best achieve the high level objectives set for it;
• Accountability and transparency – the central bank is held accountable by lawmakers for meeting these monetary policy objectives. Over time, the move toward instrument independence has been accompanied by a trend toward increased accountability and transparency.^[10]

Nested in a single-party state system, the institutional design features of China's monetary policy framework are fundamentally different to advanced economies. Conducted largely through the State Council, the formulation of aggregate supply and demand management policies is more tightly coordinated compared with other economies. Policy levers – fiscal, monetary, macroprudential, exchange rate, sectoral – are each capable of being adjusted in a timely and reinforcing manner, in support of specific outcomes desired by the state. In the context of the three elements set out above, instrument decision-making powers and accountability mechanisms are therefore most notably different in China. We step through each in turn below.

The PBC is, and has long been, goal dependent. In the narrow sense of high-level objectives setting (the first of the three elements above), there is at least one similarity between China and advanced economies: the high-level objectives of monetary policy are set out in the PBC's founding legislation, and ratified by China's national legislative body, the NPC.^[11] The PBC Law clearly prescribes that ‘[t]he aim of monetary policies shall be to maintain the stability of the value of the currency and thereby promote economic growth’. Yet there is no secondary piece of legislation or publically available document that sets out how the high-level objectives for monetary policy are practically translated into a target to be achieved by the PBC. The State Council and the central bank have a mutual understanding as to how this operates, but unlike elsewhere, the details are not made public (Table 2).

More substantively, in comparing the institutional design of monetary policy in China vis-à-vis advanced economies, differences over ‘constrained discretion’ in the operation of monetary policy are not merely of form but of substance. The PBC does not have instrument independence, defined as the ability of the central bank to set monetary policy with full autonomy. Under The PBC Law, a modest degree of operational independence is confined to how the PBC implements technical aspects of monetary policy (discussed further in Section 3).^[12] For instance, Article 23 of The PBC Law (2003) states that ‘The People's Bank of China may formulate detailed conditions and procedures’ in applying a wide range of monetary policy instruments in the discharging of its monetary policy responsibilities. And while the existence of multiple policy objectives, as occurs in practice in China, can necessitate more coordination between the central bank and government agencies (Bernanke 2010; Zhou 2016), the more fundamental explanation for the absence of full PBC instrument independence relates to the primacy of the State Council in Chinese policymaking. Article 5 of The PBC Law makes this clear: ‘The People's Bank of China shall report its decisions to the State Council for approval concerning the annual money supply, interest rates, foreign exchange rates and other important matters specified by the State Council before they are implemented’. Befitting its specialised role as China's central bank, the PBC's recommendations carry disproportionate weight on the State Council. But with the PBC comprising one of 26 ministries (and 35 members) on the State Council, the ultimate decision on key monetary policy matters remains a collective one.^[13]

The PBC's founding legislation provides for an advisory monetary policy committee (MPC), with Article 11 determining that it ‘shall establish a monetary policy committee, whose functions, composition and working procedures shall be prescribed by the State Council and reported to the Standing Committee of the National People's Congress for the record'. Established in 2000 under this directive, and as set out in the PBC MPC Regulations established in 1997 (revised in 2010), the PBC makes monetary policy recommendations through the MPC as it determines warranted by economic and financial conditions. The MPC's status as a purely consultative body does however mean that in order for substantive monetary policy changes to take effect, these proposals still require ratification by the State Council. Moreover, changes to monetary policy can and do take place outside of quarterly MPC meetings.

The organisational form of the PBC's MPC appears broadly in keeping with international norms, notwithstanding that its powers are relatively constrained (Table 3). The composition of the MPC is determined by the State Council and currently consists of 14 members, 3 of which are PBC officials: the Governor (who serves as MPC chair), a Deputy Governor and Assistant Governor. External members are appointed on the basis of their ex officio status or are nominated by the PBC (subject to State Council approval) on the basis of their relevant professional experience.^[14] The MPC convenes on a quarterly basis, though interim meetings can be called by the Chair or if endorsed by more than one-third of MPC members. If approved by more than two-thirds of the members of the MPC, meeting minutes are attached as an annex to the proposed decisions of the PBC on monetary policy issues that are elevated to the State Council for approval.

One important manifestation of China's unique institutional arrangements is that monetary policy settings are determined in a highly coordinated way with fiscal policy, reflecting that the overall direction of macroeconomic policy is set by the State Council. In advanced economies, monetary policy takes fiscal (and other policy) settings as given and responds accordingly, while in China, monetary, macroprudential, fiscal and industrial policies are jointly co-determined under the auspices of the State Council.

2.3 Accountability and Transparency

A more prominent role for central bank accountability and transparency emerged from the era in which central banks were awarded independence over the conduct of monetary policy by democratically elected politicians. The global financial crisis, which necessitated a more expansive role for central banks in the operation of the financial system, further accelerated this trend. Increased accountability through improved transparency has enabled the public-at-large (in a direct sense and via elected officials) to maintain oversight into the actions and record of unelected bureaucrats who, like many agencies with links to the state, are imbued with substantial independent powers. It has allowed the public to assess whether the actions of central bankers, and the outcomes generated as a result, are consistent with their mandate.^[15] Increased transparency has also come to be viewed as a helpful way in which central banks can manage and shape expectations, to improve the effectiveness of policy and enhance the credibility of their commitments.

As the case for increased central bank accountability and transparency has been made most vigorously in respect of democratic political systems where central banks wield discretionary powers over the setting of monetary policy, this raises the question as to whether, and how, these concepts might apply in the PBC's context. As discussed below, the mechanisms for transparency are more similar than those for accountability per se. Most related emphasis has been placed on increasing the visibility of the PBC's economic assessments and actions, in order to better manage the expectations of financial markets and domestic economic agents. Within the constraints of China's institutional set-up, increased focus on the management of expectations via increased transparency into the PBC's thinking represents an effort by the monetary authorities to enhance the efficacy of policy transmission (see also Section 4).

Contemporary central banking practices see that the high-level objectives of monetary policy are determined by a separate official body to which the central bank is accountable (Table 4). This said, even central banks that do not enjoy full autonomy in the setting of monetary policy are subject to some form of accountability to an organ of the state, whether its members are democratically elected or not. In the PBC's case this body is the State Council, which serves as China's highest executive organ of state administration and is formally responsible to the NPC.^[16] The 35-member State Council meets twice a year and is comprised of heads of each of the cabinet-level executive departments with the premier serving as Chair. Put another way, the PBC is accountable (on matters where it has at least some discretion) to a higher authority, albeit not directly to the population at large, perhaps more analogous to a senior government department in advanced economies. More in keeping with most central banks in advanced economies (the exceptions being the Bank of England, and to a lesser extent, the Reserve Bank of New Zealand),^[17] there is no requirement that the PBC publicly document instances where its main intermediate target(s) deviate from the numerical value or range set for it.

In addition to reporting to the State Council, Article 6 of The PBC Law requires the PBC to ‘submit a work report to the Standing Committee of the [NPC] concerning matters relating to monetary policies and financial supervision and control’. The NPC Standing Committee includes the premier, one executive vice premier, three vice premiers, and five other state councillors. In between meetings of the State Council the NPC Standing Committee convenes weekly, and it is common at these meetings for the PBC to be called upon to deliver written and oral updates on economic, monetary and financial matters. These briefings are not made public.

More similarly to advanced economy central banks, the PBC now releases periodic and publicly accessible publications (an annual central bank report, a quarterly ‘Monetary Policy Report’, monetary policy press statements, etc). Speeches and press conferences delivered by high-ranking PBC officials have also become more common. The latter often allow for question and answer sessions, providing PBC officials with a forum in which to explain to the public the context for recent monetary policy actions (see also Section 4). While these mechanisms tend to serve a dual purpose for advanced economy central banks – allowing them to derive a degree of public legitimacy and also better shape agent expectations – in the PBC's case, the latter consideration is more prominent.

Footnotes

In the early 20th century, the Chinese financial system was dominated by the so-called ‘Four Northern Banks’ and ‘Three Southern Banks’, located either side of the Yangtze River. In the 1920s, they had more paid-in capital than the next 24 largest private banks combined, with core business lines including securities trading, trade financing and industrial loans (Ray Chaudhuri 2018). [3]

Cooperatives continued to operate in townships, and the Bank of China's foreign operations continued after 1949 albeit under a different ownership structure. [4]

Unless otherwise indicated, references to The PBC Law refer to the 1995 version. [5]

For instance, Buchanan and Wagner (1977) and Sargent and Wallace (1981) emphasised the risk of politically engineered business cycles and the political pressure to finance deficits, while the seminal works of Kydland and Presscot (1977) and Barro and Gordon (1983) emphasised time inconsistency problems whereby a central bank subject to short-term political influences would likely not be credible when it promised low inflation, and the resulting impact on inflation expectations could raise average realised inflation above optimal levels and consequently result in less efficient economic outcomes. Rogoff's (1985) ‘conservative central banker’, who cared relatively more about inflation and less about output than wider society, was proposed as a potential solution to the time inconsistency problem, but even this approach had its shortcomings. In a principal-agent context, Walsh (1995) later sought to design a socially optimal incentive contract for central bank governors, given Rogoff's ‘conservative central banker’ could in fact be too inflation averse to be socially optimal. [6]

This thread of analysis swelled over the years. Key early contributions included Alesina (1988); Grilli, Masciandaro and Tabellini (1991); Cukeirman (1992); Alesina and Summers (1993); Havrilesky and Granato (1993); and de Haan and van't Hag (1995). [7]

Debelle and Fischer (1994) were the first to make the distinction between goal and instrument independence. Their key finding – that instrument independence matters more for inflation outcomes than goal independence – was reaffirmed in de Haan and Kooi (1997), and more recently, Balls, Howat and Stansbury (2016). An often-cited case study of the benefits of instrument independence occurred with the granting of instrument independence to the Bank of England in May 1997. That said, it remains an open question in emerging markets as to whether limiting independence just to the instrument domain is sufficient to guard against the risk of politically engineered business cycles and the political pressure to finance deficits, as legal autonomy may not prevail in practice. [8]

Following Grilli et al (1991), an alternative distinction in the literature is that between political and economic independence, though this is a less useful way of framing the issues most relevant to this paper. [9]

In what has become a voluminous literature, see most recently, Dincer and Eichengreen (2014), Balls et al (2016), and Tucker (2018). [10]

The NPC is structured as a unicameral legislature with powers to legislate, elect major officers of state and oversee the operations of government. It is one of China's two main deliberative bodies, the other being the National Committee of the Chinese People's Political Consultative Conference, whose annual meetings are usually timed to occur alongside those of the NPC. [11]

A broader concept of operational independence (beyond just instrument independence) includes considerations like whether prohibitions are in place on the central bank engaging in monetary financing of the government's deficit. This typically relates to directly bidding for government debt in the primary market, and advancing credit lines to the state at below market interest rates with few restrictions on duration or the volume of lent funds. In the case of the PBC, these aspects of operational independence are established in The PBC Law. As set out in Article 29 of The PBC Law (2003), ‘The People's Bank of China shall not provide overdraft for government or directly subscribe to or underwrite treasury bonds and other government securities’. Article 30 further extends the prohibition on deficit financing to include loans to local governments and government departments. But given China's institutional context, it is not clear how practically binding these prohibitions are. [12]

Ma (forthcoming) suggests that one consequence of this structure has historically been that, ‘many government agencies and stakeholders will attempt to steer monetary policies in their favor through the State Council, often leading to pressures for excessive monetary expansion and a rising leverage ratio in the economy’. [13]

The eleven external members currently comprise the Deputy Secretary-General of the State Council, the Vice Minister of Finance, the Deputy Director of the National Development and Reform Commission, the Chair of the China Banking and Insurance Regulatory Commission, the Chair of the China Securities Regulatory Commission, the Administrator of the State Administration of Foreign Exchange, the Director of the National Bureau of Statistics of China, the President of the China Banking Association, and three academics. The MPC's size and composition has evolved over time. [14]

See Tucker (2018) for a broad-based account of these and related issues for unelected officials. [15]

As to the appointment and dismissal of senior officials, the PBC Governor is nominated by the Premier of the State Council, ratified by the NPC (or its Standing Committee when the NPC is not in session), and appointed and/or dismissed by the country's President. Deputy governors are appointed and dismissed by China's Premier. [16]

In the United Kingdom, the Remit for the Monetary Policy Committee requires an exchange of open letters between the Governor of the Bank of England and the Chancellor of the Exchequer if inflation deviates from the target by more than 1 percentage point in either direction. In the case of New Zealand, the charter for the Monetary Policy Committee requires that the Monetary Policy Statement provide an explanation if inflation outcomes are outside of the target range or are expected to move outside of the target range. This reporting is in addition to the usual requirements of explaining the policy action that the Committee intends to take to meet the inflation objective, and how the current decision contributes to supporting maximum sustainable employment. [17]