Blog Post

How tight is China’s monetary policy?

There have been definite signs of monetary loosening in China in recent weeks. Nevertheless, for almost a year, the debate continues to rage over whether the People’s Bank of China (PBC) should loosen its monetary policy more meaningfully in a situation of weakening domestic demand. Has China’s monetary policy stance been too restrictive lately? If so, how should the PBC ease monetary policy?

By: Date: October 16, 2014 Topic: Global Economics & Governance

See also China’s financial liberalisation: interest rate deregulation or currency flexibility first? Part one and Part two

There have been definite signs of monetary loosening in China in recent weeks. Nevertheless, for almost a year, the debate continues to rage over whether the People’s Bank of China (PBC) should loosen its monetary policy more meaningfully in a situation of weakening domestic demand (see Chinese reports by Caijing). Has China’s monetary policy stance been too restrictive lately? If so, how should the PBC ease monetary policy?

There is little doubt that China’s growth has been losing momentum in recent years (Graph 1). The past few quarters have witnessed clear signs of rising inventories, slumping property sales, producer price deflation, declining consumer price inflation, weakening corporate earnings, slowing investment and anaemic industrial production. Fortunately, private consumption is still holding up.

Graph 1: China’s GDP growth (year-on-year %)

Sources: Datastream

Meanwhile, oddly, the real interest rates and funding costs facing most Chinese companies and home buyers have been on the rise. This is caused by a combination of rising nominal interest rates and slowing inflation (Graph 2). Between 2012 and 2014, the 10-year Chinese government bond yield rose from 2.5 percent to 4.5 percent, as CPI fell from 4 percent to 2.5 percent. While inflation could be weighed down by weaker domestic demand, higher nominal interest rates might in part relate to partial interest rate deregulation and a tight monetary policy.

Thus one immediate question is whether Chinese monetary policy has been too tight. Too tight relative to what? Most economists and central bankers use the well-known Taylor rule to assess the central bank policy stance.

A simple Taylor rule essentially links a short-term nominal policy rate to two gaps for a given real long-run equilibrium interest rate and inflation target: the gap between actual and targeted inflation (“the inflation gap”) and the gap between actual and potential output (“the output gap”). A positive output or inflation gap, or both, suggests a need to tighten by hiking the policy rate. If the actual policy rate is below that implied by the Taylor rule, the policy stance is considered too accommodating. If the actual policy rate is above that implied by the Taylor rule, the policy stance is considered too restrictive.

Obviously, many possible factors, some trickier than others, help shape this “Taylor rate”. Hence the controversy in China over how tight PBC monetary policy has been. In this light, three questions are worth highlighting.

First, how important is the inflation target relative to other policy objectives? The Chinese CPI in the first four months of 2014 averaged 2.2 percent, down from 3 percent plus in late 2013 and way below the official 2014 target of 3.5 percent set out by Premier Li Keqiang. Producer prices even registered outright deflation for more than two years. So China has a negative inflation gap. According to the Taylor rule, the PBC therefore ought to ease monetary policy.

Unless, of course, financial stability concerns dominate, calling for a continued tight monetary policy stance. The rationale is that lower interest rates might fuel shadow banking expansion, excess leverage and asset price booms in China. Thus an accommodative policy could add to the already growing financial imbalances. But tight monetary conditions could also run the risk of a disorderly deleveraging. In any case, the standard Taylor rule might help inform the weights on inflation and output but is silent on the relative weight attached to the policy goals of price and financial stability.

Second, is the Chinese economy operating near full employment? While the observed economic slowdown is beyond dispute, it might simply reflect lower potential output growth, which possibly arises from rebalancing pains, demographic headwinds, less low-hanging fruit in market liberalisation and a less accommodating global economy (see Ma and McCauley 2012). Some Chinese labour statistics, while of questionable quality, suggest that employment has held up well hitherto. Thus weaker growth might not mean a widening negative output gap, and hence there is no need for policy easing.

However, slower potential growth, if true, should point to a lower real equilibrium interest rate. This in itself would justify an easier policy stance of the PBC within the Taylor rule framework. A less stringent policy stance is therefore called for, whether the recent growth slowdown is structural or cyclical.

Puzzlingly, most Chinese companies and home buyers have faced rising borrowing costs in the context of slowing potential growth, at least until the latest monetary easing in the past weeks. Do higher interest rates in the wake of the recent partial deregulation reflect a shift towards equilibrium or mostly the impact of other distortions in the Chinese economy?

Third, how can one tell whether the PBC has or has not loosened? The Taylor rule takes the policy rate as representative of the monetary policy stance. Yet, the policy rate, if there is one, is only one of many instruments in the PBC’s toolkit and might not capture well its overall policy stance. Unlike most OECD central banks, the PBC deploys multiple tools, including administrative moves, regulatory rules, quantity measures and interest rates, both market and administered, to manage both price and quantity targets and to serve multiple policy objectives of price stability, full employment, balance of payments and financial stability (see Giradin et al, 2014). Moreover, monetary policy measures are often not officially announced but are unveiled in bits and pieces. Hence gauging the Chinese policy stance is far from straightforward.

However, there have been plenty of signs of easing in recent weeks. After the bumpy ride in June 2013, the PBC has tried hard to guide interbank rates lower and steadier. No more menacing warnings of punishment for misbehaving banks. The PBC has also selectively lowered the reserve requirements, extended loans to both small banks and policy banks via its refinancing facility, and directly bought treasury bonds to fund government projects. It has even leaned on commercial banks to lend more to first-time home buyers at reasonable mortgage rates.

While these targeted policy moves are sensible, the PBC can still act with greater confidence by cutting outright both interest rates and lowering reserve requirements. In recent months, the PBC appeared to stealthily keep the benchmark overnight and 7-day interbank rates low. It should be more forthright in communicating its desire to hit a lower short rate even if there is so far no official policy target rate.

Also, lowering the benchmark 20 percent reserve requirement ratio and/or raising the 75 percent loan/deposit ratio ceiling would add more permanent liquidity into the system to nudge down the long yields, and would also go some way to mitigate distortions and to contain shadow banking by bringing some off-balance-sheet lending back onto the books (see Ma et al, 2012).

Most importantly, by acting swiftly and decisively now, the PBC can be in a stronger position to tighten again when the cycle eventually turns.

Read more on China

China seeking to cash in on Europe’s crises

China’s financial liberalisation: interest rate deregulation or currency flexibility first?

Review: The China slowdown effect

Financial openness of China and India: Implications for capital account liberalisation

Developing an underlying inflation gauge for China

Are financial conditions in China too lax or too stringent?

The Dragon awakes: Is Chinese competition policy a cause for concern?

How loose is China’s monetary policy?

China gingerly taking the capital account liberalisation path


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic

Blog Post

Implications of the Japan – United States Mini Trade Agreement

Details of the US-Japan mini-trade deal are lacking but the agreements’ direct impact on the US and Japanese economies is likely to be minuscule. The deal seems to have been made to compensate American farmers – a crucial electoral base of the President – for their losses from the trade war with China.

By: Sybrand Brekelmans and Uri Dadush Topic: Global Economics & Governance Date: October 11, 2019
Read about event More on this topic

Upcoming Event

Nov
7
13:45

Russian economy at the crossroads: how to boost long-term growth?

Russia’s convergence to advanced economy income levels has stalled. Long-term growth prospects are still obstructed by sluggish productivity growth, low capital accumulation and shrinking labour inputs. The new government has articulated a set of ambitious policy objectives for the next six years. But are additional reforms necessary to further boost productivity and investments in line with government targets?

Speakers: Marek Dabrowski, Markus Ederer, Elena Flores, Dmitry Polevoy and Niclas Poitiers Topic: Global Economics & Governance Location: Kadashevskaya Naberezhnaya, 14, Moscow, Russia, 115035
Read article More on this topic More by this author

Opinion

The Case for Intelligent Industrial Policy

Although national industrial policies have a bad reputation, there is a strong case for government support to sectors that will increasingly rely on artificial intelligence. In this regard, the German government’s plan to promote production of electric-car batteries may accelerate an industrial renaissance in Europe.

By: Dalia Marin Topic: European Macroeconomics & Governance Date: October 7, 2019
Read article

Opinion

Southbound flows rescuing Hong Kong equity market

China seems to be coming to the rescue as social unrest affects the city’s financial market, but it’s probably only for arbitrage reasons

By: Alicia García-Herrero and Gary Ng Topic: Finance & Financial Regulation, Global Economics & Governance Date: October 2, 2019
Read about event More on this topic

Upcoming Event

Nov
28-29
09:00

EU-Asia trade and investment connectivity

The Asia Europe Economic Forum (AEEF) was established in 2006 as a high level forum for in-depth research-based exchanges on global issues between Asian and European policy makers and experts. This year, the AEEF will be hosted by Bertelsmann Stiftung on 28-29 November, 2019 in Berlin, Germany, and it will focus on “EU-Asia trade and investment connectivity”.

Speakers: Aart de Geus, Guntram B. Wolff, He Fan, Alessia Amighini, John Beirne, Nicolaus Heinen, Jae-Young Lee, Cora Jungbluth, Alicia García-Herrero, Xin Yuan, Andreas Esche, Ken Wu, Sébastien Jean and Amb. Karsten Warnecke Topic: Global Economics & Governance Location: Bertelsmann Representative Office, Unter den Linden 1, 10117 Berlin
Read article More by this author

Blog Post

Questions to the High Representative and Vice-President-designate Josep Borrell

Josep Borrell, the incoming High Representative and Vice-President-designate must explain how von der Leyen’s ‘geopolitical Commission’ intends to adapt to a global landscape dominated by an intensifying rivalry between Washington and Bejing.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance, Global Economics & Governance Date: September 30, 2019
Read article Download PDF

External Publication

European Parliament

Challenges ahead for the European Central Bank: Navigating in the dark?

Since the second half of 2018, signs of a slowdown have been piling up in the euro area. The ECB will face major challenges in this potentially difficult period: its main tools are nearly exhausted, the monetary union in which it operates is still incomplete, and it lacks the understanding of what the ‘new normal’ looks like. The authors, therefore, urge the ECB to review its strategy and framework to be able to face these challenges.

By: Grégory Claeys, Maria Demertzis and Francesco Papadia Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: September 25, 2019
Read article

Blog Post

The EU is in the US trade war crosshairs. It should further raise its game

The incoming European Commission faces a dilemma on the transatlantic trade relationship, because of the unpredictable policies of the Trump administration. The EU must rally its citizens; the greater the divides between member states and EU institutions, the lesser the chances are of forging effective policies toward the United States and China.

By: Anabel González and Nicolas Véron Topic: European Macroeconomics & Governance, Global Economics & Governance Date: September 19, 2019
Read article Download PDF More on this topic

Working Paper

EU trade policy amid the China-US clash: caught in the crossfire?

What risks face the EU with regard to China’s strategic aims in trade policy and how can the EU respond? The US effort to isolate China poses particular risks for Europe. How can the EU counter such efforts with the aim of forging its own distinct trade policy? How should the EU move forward with reform of the World Trade Organization (WTO) in light of differing demands and aims of trading blocs like China and the US?

By: Anabel González and Nicolas Véron Topic: Global Economics & Governance Date: September 17, 2019
Read article More on this topic

Opinion

China's dual banking system: consolidation as the final solution for weak small banks

There are fundamental solvency and liquidity issues for some small Chinese banks, widely influencing both the bond market as well as the broader financial sector. Given the difficulties in creating a level playing field between small and large banks, there is an expectation that small banks will continue to under-perform.

By: Alicia García-Herrero and Gary Ng Topic: Finance & Financial Regulation Date: September 16, 2019
Read about event

Past Event

Past Event

Climate change and the role of central banks

What connections exist between central banks and climate change, and what are the resulting implications?

Speakers: Emanuele Campiglio, Paul Hiebert, Pierre Monnin, Kjell G. Nyborg, Luiz Awazu Pereira da Silva, Mario Quagliariello, Mattia Romani, Paweł Samecki and Dirk Schoenmaker Topic: Energy & Climate, European Macroeconomics & Governance Location: Narodowy Bank Polski, Świętokrzyska 11/21, 00-919 Warsaw Date: September 16, 2019
Read article More on this topic More by this author

Blog Post

Argentina, plus ça change…

Recent primary elections in Argentina saw the defeat by a wide margin of President Macri. This fueled market volatility given expectations of a reversal of reforms after national elections in October; the recent re-introduction of capital controls attests to the extent of the economic fallout. With Macri’s end in sight, this post will review the evolution of the Argentinian economy during his term.

By: Marta Domínguez-Jiménez Topic: Global Economics & Governance Date: September 9, 2019
Load more posts