China’s Monetary Policy, Exchange Rate Regime, Foreign Reserves and Inflation

Jie Li

Director of CUFE Research Center for Foreign ReservesPrepared for Friends from CSU Channel Islands

March 19, 2012

Conclusions

• The accumulation of foreign reserves is due to foreign exchange market intervention in order to keep RMB exchange rate artificially low.

• The rise of inflation is due to foreign exchange market intervention with incomplete monetary sterilization, as well as RMB 4 trillion stimulus package in 2008 - 2009.

• China’s monetary policy is not independent.• Money market rates are market-determined and

are the most important interest rates.

Outline

• Definition of Foreign Reserves• China’s exchange rate regime and its impacts

on inflation, and foreign reserves. • Some specifics of China’s unique monetary

policy: objectives, instruments, intermediate goals, etc.

• Asset bubbles and administrative measures, taking housing prices as an example.

What is Foreign Reserves?

• Foreign assets of a central bank. • Invested usually in foreign government bonds.• China holds US $ 3.2 trillion, top of the world.

Simplified Balance Sheet of China’s Central Bank (unit: RMB Billion)

Items 2011.03 2011.06 2011.09 2011.12

Foreign Assets 22628 23470 24120 23790

Foreign Exchange 21748 22639 23385 23239

Monetary Gold 67 67 67 67 Other Foreign Assets 813 764 668 484 Claims on Government 1540 1540 1540 1540 Of which: Central Gov. 1540 1540 1540 1540

Claims on Other Depositary Corporation 956 968 956 1025

Claims on Other Financial Corporation 1132 1125 1124 1064

Claims on Non-Financial Sector 2 2 2 2 Other Assets 623 702 749 676

Total Assets 26882 27808 28491 28098

Reserve Money 19257 20347 21220 22464

Currency Issue 4927 4882 5220 5585

Deposits of Other depository Corporation 14329 15465 16000 16879

Deposits of Financial Corporation excluded from Reserve Money

98 80 86 91

Bond Issue 3116 2727 2245 2334 Foreign Liabilities 458 487 467 270 Deposits of Gov. 2729 3454 3571 2273 Own Capital 22 22 22 22 Other Liabilities 1203 691 879 644

Total Liabilities 26882 27808 28491 28098

Stylized facts: figures

• Reserves: levels, over three-month imports, sted, m2.

• Sources of reserves: BOP• Exchange rate: bilateral nominal rates and

REER• Inflation rate • Quarterly GDP growth rates

7

Three-month Imports Coverage in China, 1990-2010

Data Source: IMF International Financial Statistics (IFS) Database.

Billions US$

0

500

1000

1500

2000

2500

3000

3500Foreign Reserves3-month Imports

8

The Ratio of Reserves over Short-term External Debt in China, 1990-2010

Ratio

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20100

2

4

6

8

10

12

14Reserves/Short-term Debt

Guidotti-Greenspan-IMF rule

9

The Ratio of Reserves over M2 in China, 1990-2010

Billions US$

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20100

500

1000

1500

2000

2500

3000 Foreign Reserves5% of M220% of M2

10

China’s Exchange Rates

1990M1 1992M091995M05 1998M1 2000M092003M05 2006M1 2008M092011M050

20

40

60

80

100

120

140 0

2

4

6

8

10

12

Real Effective Exchange Rate(REER)-LHSNominal Exchange Rate(CNY/US$)-RHS

Massive Foreign Exchange Market Intervention Leads to:

– Huge foreign reserve accumulation;– Keeping RMB exchange rate artificially low;– Excessive RMB liquidity;– Asset bubbles;– Inflation

11

Is There Any Good?

No good at all!

• But why do our government insist?– Protecting export sector and employment?– Interest group? – Status quo?– Stupid!

More on Inflation

• Regarding China’s inflation, is there anything to do with the U.S.’ Quantitative Easing?– Is inflation in China imported from the U.S.?

Role of Gov. in Chinese Economy

• 1/3 of industrial sector is still state owned;• Gov. owns land, minerals, energy and sets their

prices. These prices are not market determined.

• Gov. is the largest shareholder of almost all commercial banks.

• All big investment projects, private or state owned, needs approval from NDRC (National Development and Reform Commission)

Number of Banking Corporations1990 2000 2005 2009

# of banks 10 116 132 164

Policy Bank (100% State owned)

0 3 3 3

State-owned Commercial Bank

4 4 4 4

Joint stock commercial bank (controlled by SOE)

6 10 12 13

City Commercial Bank (owned by local Gov. and SOE)

0 99 113 143

Postal Saving Bank (100% state owned)

0 0 0 1

Asset Shares of the Banking Corporations (unit: RMB bn)

2000 2005 2009

Total Assets 13,743 31,814 67,204

Policy Bank (100% State owned)

12 9.2 10.3

State-owned Commercial Bank

73.8 61.8 54.7

Joint stock commercial bank (controlled by SOE)

11.1 18.3 22.5

City Commercial Bank (owned by local Gov. and SOE)

6.4 8.5

Postal Saving Bank (100% state owned)

4

Monetary Policy

• Controlled by the State Council instead of People’s Bank of China.

• Multi-objective: stable price and exchange rate, economic growth and economic structure adjustment

• Every Nov., CCP holds a Central Economic Meeting, setting GDP target and Inflation target, based on which the Central Bank decides the corresponding M2 growth rate and bank lending limits.

Year GDP GDP Inflation Inflation M2 M2

Target (%) Actual (%) Target (%) Actual (%) Target (%) Actual (%)

2006 8 12.7 3 1.5 16 16.9

2007 8 14.2 3 4.8 16 16.7

2008 8 9.6 4.8 5.9 16 17.8

2009 8 9.2 4 -0.7 17 27.7

2010 8 10.3 3 3.3 17 19.7

• PBoC adjust monetary base to achieve the goal of M2. In recent years, foreign market intervention is the main channel to release RMB liquidity.

How to reduce RMB liquidity

• Open market operation• Issue central bank bills• Legal reserve requirement rate is more often

used to control liquidity.

21

Monetary Sterilization in China

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

-10000

-5000

0

5000

10000

15000

20000

25000

30000

Monetary BaseNet Foreign AssetNet Domestic Assets

Billions(CNY)

22

Issue of Central Bank Bills

2002 2003 2004 2005 2006 2007 2008 2009 2010 20110

500

1000

1500

2000

2500

3000

3500

4000

4500

5000Cross Debt IssuanceTotal Debt Outstanding

Billions(CNY)

23

China’s Legal Reserve Requirements

1990Q11993Q11996Q11999Q12002Q12005Q1 200701 200801 200901 201001 2011010

5

10

15

20

25 21.5

Stop DeflationPrevent Overheating

Global Fi-nancial Cri-sis

Inflation Pressure

%

Interest Rates I: Policy RatesPolicy Rates 2010 Controlled or not Importance

Re-lending rate 3.85 Controlled No

Re-discount rate 2.25 Controlled no

Reserve required rate

Legal: 1.62;Extra: 0.72

controlled yes

Central bank bill rate

2.51 Semi controlled yes

Interest Rate II: Money Market Rates

Rates Definitions 2010 Controlled or not

Importance

SHIBOR Average of quotes from all banks at 11:30 am

6.39 No yes

CHIBOR Average of inter-bank rates transacted

6.50 No yes

Inter-bank Repo rate

5.17 No Yes

Bond Yields and Benchmark RatesRates 2010 Controlled or not Importance

Bond yield 3.86 No Soso

Deposit and lending rates

Lending: 5.81Deposit: 2.75

Controlled Yes

Interest Rates

Spreads of Lending and Deposit Rates

• Not everyone can get the loans at the lending rate. Only those large SOE can! SME can’t! Lending rates for SME are usually around 30 – 40%.

• Deposit rates are kept artificially low. • Why?• Consequences

Housing Bubbles

• China, a country built on bricks and stones! • Why are the housing prices skyrocketing? – Land sales revenue takes 60 – 70% of local gov.’s

total revenue– Tax system: central gov. takes ¾ of value added

tax.– Over 50% of housing revenue goes to gov. in terms

of all kinds of taxes and fees.

31

Debate on exchange rate regime

• Fixed and flexible exchange rates each have advantages (Frankel, 2006).

• Advantages of fixed exchange rate regime– The provision of a nominal anchor to prevent

inflationary monetary policies and expectations. – The facilitation of trade with those countries that

use the dollar, or at least are pegged to the dollar. • The de facto fixed has served China over past

years, but it may now have outlived its usefulness for China.

32

Fixed Exchange Rate v.s. Flexible Rate

• Some arguments support flexible rate– China’s current level of foreign reserves is fully (or

over) adequate even though they are a useful shield against currency crises. • Optimal level of reserves?• The law of “3-month imports” coverage• Guidotti-Greenspan-IMF rule: holding reserves equal to

at least 1-year short-term external debt• A country should not only focus on foreign capital flights

(external drains) but also runs from domestic bank deposits to currency (domestic drains).

33

Fixed Exchange Rate v.s. Flexible Rate

• It may become increasingly difficult to sterilize the capital inflow over time. – Based on impossible triangle, a country with fixed

exchange rate regime cannot fully sterilize the capital inflows under perfect capital mobility.

– Monetary sterilization instruments: Open market operations (OMOs) or reserve requirement rate.

– Potential problems: quasi-fiscal cost; weaken the balance sheets of banks and raises the odds of a banking crisis.

34

The Quasi-Fiscal Costs of Sterilization• PBoC is selling high-yielding domestic assets for low-yielding

foreign ones

1990 Jan 1992 Jul 1995 Jan 1997 Jul 2000 Jan 2002 Jul 2005 Jan 2007 Jul 2010 Jan0.0

2.0

4.0

6.0

8.0

10.0

12.0 Chinese bank rateUS Treasury Bill Rate

Data Source: IMF International Financial Statistics (IFS) Database.

35

Fixed Exchange Rate v.s. Flexible Rate

• Balassa-Samuelson relationship suggest that the real value of the RMB is low, not just compared to the US$ or of other rich countries, but substantially below even the equilibrium value for a country at China’s stage of development. – There is no consensus of equilibrium exchange rate of

RMB. Model and sample dependent. – Cline and Williamson (2007) survey 18 studies, and

suggest that China’s real effective exchange rate (REER) is 20% undervalued (simple average of 14 estimates) , while the bilateral rate against the dollar is 40% (simple average of 16 estimates).

36

Fixed Exchange Rate v.s. Flexible Rate

• A larger economy like China can achieve adjustment in the real exchange rate via flexibility in the nominal exchange rate more easily than via price flexibility.

• The experience of other emerging markets points toward exiting from a peg when times are good and the currency is strong, rather than waiting until times are bad and the currency is under attack.

• “I have listened to both sides of this debate. Here is what I think. I think those who call for a fixed exchange rate are right in the short run. And those who call for a floating exchange rate are right in the long run. How long is the short run, you ask? You must understand. China is 8000 years old. So when I say, short run, it could be 100 years.”

— Li Ruogu, Deputy Governor, People’s Bank of China, Dalian, May 2004.

• Thank you for your attention!• Comments, doubts, questions, and critiques

are welcome!

Concept• QE is a monetary policy tool used by some central banks to

stimulate their economy when conventional monetary policy has become ineffective.

• The central bank buys government bonds and other financial assets, with new money that the bank creates, in order to increase money supply and the excess reserves of the banking system.

• This action raises the prices of the financial assets bought, which lowers their yield.

Characteristics

• Quantitative easing shifts monetary policy instruments away from interest rates, towards targeting the quantity of money.

• When short-term interest rates are either at, or close to, zero, normal monetary policy can no longer function as the purchase of short-term government bonds will no longer lower interest rates.

• Compared to the policy of open market instrument, QE is considered to be an abnormal instrument. The amount of government bond involved in this policy is much larger and the duration is much longer.

Implementation

• QE : The central bank buys government bonds and other financial assets.

• Balance sheet:

Enhance the scale of B.S.

Influence inflation expectation

Change the structure of B.S. Influence the price of assets

About QE1

• QE has been used by the United States, the United Kingdom ,Euro zone and Japan during the Financial crisis of 2007–2010.

• QE was used by these countries as their interbank interest rates are either at, or close to, zero.

QE1 in US

• Fed pushed forward QE1 in Sep25,2008 after the shock of broke of Lehman Brothers in Sep15,2008. Fed announced its purchase of direct debt of GSE ,Fannie Mae, Freddie Mac and Federal Home Loan Banks. In addition, MBS insured by Ginnie Mae.

• In late November 2008, the Fed started buying $600 billion Mortgage-backed securities.

• By March 2009, it held $1.75 trillion of bank debt, MBS, and Treasury notes, and reached a peak of $2.1 trillion in June 2010.

QE1 in UK and EU• UK: The Bank of England had purchased around £165 billion of assets by

September 2009 and around £175 billion of assets by end of October 2010. At its meeting in November 2010, the Monetary Policy Committee (MPC) voted to increase total asset purchases to £200 billion. Most of the assets purchased have been UK government securities.

• EU: The European Central Bank (ECB) said it would focus efforts on buying covered bonds, a form of corporate debt. It signaled initial purchases would be worth about €60 billion in May 2009.

QE1 in Japan• The Bank of Japan(BOJ) increased the commercial bank current account

balance from ¥5 trillion yen to ¥35 trillion (approximately US$300 billion) over a 4 year period starting in March 2001.

• BOJ tripled the quantity of long-term Japan government bonds it could purchase on a monthly basis.

• In early October 2010, the BOJ announced that it would examine the purchase of $60 billion in assets.

About QE2• Concept : QE2 has been used to refer to a second round of quantitative easing by central

banks.• Background: Fed announced to push forward a second round of QE in Nov 3rd,2010 under the

great pressure of the disappointing macro economic data.• Measure: August 2010 the Fed decided to renew QE, its goal was to keep holdings at the

$2.054 trillion level. To maintain that level, the Fed bought $30 billion in 2-10 year Treasury notes a month. In November 2010, the Fed announced it would increase quantitative easing, buying $600 billion of Treasury securities by the end of the second quarter of 2011.