China’s Monetary Policy and Its RMB Exchange Rate Regime

Guofeng Sun
Sep 20, 2017



With over twenty years of experience at the frontline of China’s monetary policy operations and with two decades of academic research experience, I provide a unique, first-hand perspective on a number of facets dealing with China’s monetary policy and theory. The book opens with an introduction of monetary theories, including my credit monetary theory, followed by a review of some focal issues regarding China’s monetary policy and a discussion of the RMB exchange rate regime and international balance. The book presents China as a country at a crossroads, forced to choose between the free flow of capital and monetary policy independence.

Monetary policy plays a vital role in macroeconomic stabilization. With the tide of economic and financial globalization expanding the impacts of countries’ macroeconomic policies across borders, a comprehensive understanding of China’s monetary policy has become crucial not only for China—now the world’s second largest economy—but also for the global community.

After spending more than twenty years at the frontline of China’s monetary policy operations, a tenure which notably includes the design and implementation of open market operations in domestic and foreign exchange markets, I have recently written a book entitled Reforms in China’s Monetary Policy: A Frontbencher’s Perspective. This book explores my perspective on a number of facets concerning China’s monetary policy and theory. Specifically, the book covers three salient issues: China’s monetary policy instruments, its monetary policy framework, and its RMB exchange rate regime.

China’s Monetary Policy Instruments

The choice of monetary policy instrument is largely determined by the monetary theory in effect. The conventional theory of money creation has given rise to the loan-to-deposit ratio as an instrumental indicator, which turns out to be ineffective and even detrimental in the case of China. My credit monetary theory explains the ineffectiveness of the loan-to-deposit ratio as a policy instrument, and suggests controlling credit growth through liquidity management.

The conventional theory of money creation posits that bank loans are created from deposits, which is also consistent with the intuitional environment in China. Based on the belief that existing deposits place a natural constraint on the amount of new loans that banks can extend, the regulator in China used to apply the loan-to-deposit ratio as an important policy instrument to control credit growth, ruling that outstanding loans should not exceed 75 percent of deposits. Regulators in developed countries also monitor loan-to-deposit ratios based on this conventional theory of money creation, but they usually have no strict control over it.

According to my theory of credit money (in addition to real-world experience), however, banks are actually able to create loans without deposit constraints, as deposits are created from the asset expansion of banks. Given that a portion of all deposits may be withdrawn in cash, loan-to-deposit ratios could be even larger than 100 percent. For example, in order to bypass the loan-to-deposit ratio requirement (and to grant loans to restricted industries), it is a common practice for commercial banks to create deposits through the shadow banking system and to classify the de facto loans as interbank transactions. Since these assets are not noted as loans in accounting statements, the 75 percent loan-to-deposit ratio is met. In this sense, the loan-to-deposit ratio, motivated by the conventional monetary theory, has given rise to shadow banking—an unexpected consequence that will worsen over time if left uncorrected. Fortunately, the supervisory institution, the China Banking Regulatory Commission, did withdraw the loan-to-deposit ratio requirement in the Law of Commercial Banks in late 2015.

The book covers my credit monetary theory in greater detail. The essence of the theory can be summarized as follows: credit money is essentially a debt/credit relation between the banking sector and the non-bank private sector. Banks expand their assets by extending loans, which subsequently create deposits. Central banks expand their assets by creating base money, and they support or restrain commercial banks’ money creation through liquidity management. To control the amount of credit money, a central bank imposes three types of constraints on banks’ credit liabilities, including constraints on cash withdrawals, constraints on settlement, and constraints on the required reserve ratio. Based on my credit monetary theory, I believe that the central bank should control credit growth through liquidity management.

China’s Monetary Policy Framework

Most commenters think that it is unnecessary at the present time for China to create a variety of new monetary policy instruments for liquidity injection while it maintains a relatively high ratio of required reserves. However, an efficient transformation from a direct management framework to an indirect one requires effective control of money market interest rates.

Since the beginning of the 21st century, the continuous, large inflows of foreign exchange have forced the People’s Bank of China (PBC) to purchase large amounts of foreign exchange, which dramatically increased the supply of reserves. Dual liquidity surpluses appeared accordingly, namely a structural liquidity surplus and an exogenous liquidity surplus. The huge liquidity surpluses have impeded PBC’s monetary policy operations. This situation is distinct from developed countries, where the existence of structural liquidity deficit enables monetary policy operations to take effect.

To address this challenge, I propose the following structural deficit liquidity management framework. The central bank should create stable liquidity demand through its required reserve ratio and provide liquidity through asset expansion, adjusting the interest rate of liquidity supply to manage money market interest rates. Faced with dual liquidity surpluses, the PBC should establish a structural deficit liquidity management framework under the required reserve ratio system.

With the sustained decline in the demand for excess reserves among commercial banks in the medium and long run, the PBC has gradually raised the required reserve ratio before June 2011, then has slightly cut required reserve ratio until March 2016. Going forward, the supply and demand of reserves should in general be balanced with a structural liquidity deficit. After the liquidity management framework is formed, the PBC should keep the required reserve ratio relatively stable and actively inject short-term liquidity through open market operations, and inject mid-term liquidity through midterm lending facility (MLF), pledged supplementary lending (PSL) and other monetary policy instruments, meanwhile use standing lending facility (SLF) as the ceilling of interest corridor to keep money market interest relatively stable, so as to ensure the effectiveness and activeness of monetary policy.  Subsequently, based on the (premise) of a continuous structural liquidity deficit framework, the central bank may periodically and gradually lower the required reserve ratio according to the pace of the increase in the demand for required reserves brought about by increased deposits, thereby realizing a structural deficit liquidity management framework with a relatively low required reserve ratio.

RMB Exchange Rate Regime

Since 2003, China’s current account surplus has continued to rise, making its RMB exchange rate and the rebalancing of the global economy hotly debated topics. In 2007, China’s current account surplus peaked at 10.1 percent of GDP, but ever since the 2008 international financial crisis, the country’s current account surplus and its proportion to GDP have been declining steadily. In particular, in 2011, China’s current account surplus fell to only 2.8 percent of GDP, which is an internationally recognized reasonable level (i.e., less than 4 percent).

Is the decline in China’s current account surplus sustainable? Will the ratio of China’s current account surplus to GDP rebound to the pre-crisis level as the impacts of the 2008 financial crisis subside? According to the April 2012 World Economic Outlook of the IMF, the recent changes in China’s current account surplus are cyclical, not structural. The IMF expects the current account surplus to rise to 4.25 percent of GDP in 2017.

A reliable forecast of the current account surplus requires structural analysis with econometric models, considering the influences of other countries’ economic changes. Mainstream economists usually forecast current account surpluses within the decomposition approach, which does not distinguish cyclical influences from structural factors, and it sometimes even overestimates cyclical influences. In contrast, the saving-investment framework disentangles the cyclical and structural influences on savings and investment rates and estimates the current account surplus under various saving-investment scenarios.

Given the advantages of the saving-investment approach, I analyze the medium-to-long run trend of China’s current account surplus based on the saving-investment gap. The result is an expectation that the surplus to GDP ratio will be around 2-4 percent, which has been validated by the latest empirical evidence.

The equilibrium level of the RMB exchange rate largely depends on the current account surplus, which is in turn determined by the saving-investment gap. Because the savings rate is affected by demographic structure and cultural tradition (among other factors), it is difficult to simply adjust an interest rate or the exchange rate if we want to counter the expectation of appreciation. Structural policies are required, and the adjustment of the real exchange rate may also help. Since China’s growth rate of productivity is higher than other countries, the real exchange rate is constantly changing as well. I think that the market mechanism will take effect through the adjustment of the nominal exchange rate and wage level. Before the Lewis Turning Point, a large amount of surplus labor would swarm to the tradable sector and suppress the wage hike. The Balassa-Samuelson effect would play its role after the Lewis Turning Point is reached, which would substantially affect the real exchange rate and counter the current account surplus and appreciation expectation.

I estimate the RMB equilibrium exchange rate by applying multiple methods, including three popular models of NATREX, ERER, and MB, and a new DSGE model, and find that the rate has been close to the equilibrium level. The views on the RMB exchange rate have started to diverge, which means that it has been close to the equilibrium level, and a solid foundation for policy framework transformation has been laid. The portfolio of structural policies plus the dual adjustment of the nominal exchange rate and wage level have also taken effect.

(Sun Guofeng is now the Director General of the Research Institute of the People’s Bank of China.)



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