Question

What type of fiscal and monetary policies has China been implementing in the past five years? How would this affect exchange rates? Please include screenshots of all the articles used to formulate the answer.

Answer 1

China’s rising prominence in the world economy has meant that the efficacy of its

macroeconomic management has taken on considerable importance, not just from a

domestic perspective but also from broader regional and international perspectives. In this

paper, we review the functioning of one of the key tools of macroeconomic management –

monetary policy. Although China’s government deficit and public debt to GDP ratios are quite

low by international standards, the existence of large contingent fiscal liabilities implies that

there may be less room for maneuver on fiscal policy. Thus, monetary policy has a

particularly important role to play in buffering the economy from domestic and external

shocks.

We begin, in Section II, by reviewing developments in the exchange rate and capital control

regimes. Although China has had a de facto fixed exchange rate regime for about a decade

now, the existence of capital controls has meant that there is still some room for monetary

policy manoeuvre, but this room tends to be rather limited in practice. Indeed, in recent

years, controlling credit and investment growth has become especially complicated due to

the large inflows of speculative capital that have been testing the exchange rate peg to the

US dollar (and, since July 2005, the tightly managed peg to a currency basket that looks to

all intents and purposes like a continued peg to the dollar).

Having an independent monetary policy is obviously desirable for this policy tool to be

effective. But a move towards greater exchange rate flexibility is not the solution by itself.

Indeed, enhancing the effectiveness of the monetary transmission mechanism poses difficult

challenges independent of the constraints related to the exchange rate regime. Principal

among these is the reform of the financial system, since that is the conduit through which

monetary policy has an influence on economic activity. Indeed, financial sector reform is one

of the most important and challenging tasks facing Chinese policymakers. In Section 3, we

review the current state of the financial system, with particular emphasis on the banking

system, which still dominates China’s financial landscape.

We then review the People’s Bank of China’s (PBC) approach to the implementation of

monetary policy. Given the weaknesses in the monetary transmission mechanism, the

authorities have relied on a variety of direct and indirect instruments. In Section 4, we

discuss these instruments, problems in using them and their relative effectiveness.

In Section 5, we discuss the direction in which, in our view, the monetary policy framework

should be developed. We argue that there may be merit to using a low inflation objective as

the nominal anchor. Our view is that making low inflation the main objective of monetary

policy is the most reliable way to enable the PBC to stabilise domestic inflation andemployment against macroeconomic shocks. An inflation objective would provide a firm and

credible nominal anchor that would contribute to overall macroeconomic stability, which in

turn would provide the basis for sustained employment growth and help safeguard financial

stability.

This framework could accommodate a continued role for the monitoring and management of

a monetary aggregate (and credit) by the PBC, thereby allowing for continuity in the

operational approach to monetary policy. However, our view is that money would not

constitute a good stand-alone nominal anchor for an economy that is undergoing major

structural changes and financial innovations. We should also emphasise that we are not

necessarily advocating a full-fledged inflation targeting regime, although this could serve as a

useful long-term goal.

There are of course a number of institutional reforms that will be required before this

framework can be put in place. We discuss some of the basic reforms that we think are

essential, and may be adequate, to putting in place this alternative nominal anchor in the

next few years. Exchange rate flexibility is a basic and essential requirement for the

operation of independent monetary policy. However, while full modernisation of the banking

system will no doubt take a long time, a more modest set of reforms that would make the

banks robust to interest rate fluctuations would be adequate to enable the PBC to credibly

commit to a low inflation objective as a nominal anchor.

Open market operations

It refers to the central bank ’s policy of buying and selling government bonds to control the money supply and interest rate in the financial market .

Deposit reserve policy

It means that the central bank imposes a deposit reserve ratio on deposits of commercial banks, etc.

Central Bank Loans

It refers to the central bank to use monetary base to specialized banks, other financial institutions, in a variety of ways of financial intermediation general term.

Interest rate policy

Central bank ’s policies and measures to control and regulate market interest rates in order to influence the supply and demand of social funds .

Exchange rate policy

Lifting of a government using the national currency exchange rate to control the feed exports and capital flows in order to reach the international balance of payments purposes.

Permanent loan facilities Edit

It is a Short-term Liquidity Operation, it is used when there is a temporary fluctuation in the liquidity of the banking system.

2010s policy tools

As well as heralding a market-based approach, the system and its range of tools offers the central bank more autonomy to set policy and marks a significant change for monetary policy making in China.

Starting in 2016, the People’s Bank of China has used a market-based approach involving closer management of liquidity in the banking system and an expanded range of tools, such as repos (or reverse repurchase agreements) and lending facilities, to promote better capital allocation and guide market interest rates to more closely match People’s Bank of China objectives. The new tools allow the central bank to be more proactive and targeted in how it goes about handling monetary policy.

The renminbi currency value is also heavily influenced by other government policy instruments such as capital controls and trade policy, for instance restrictions on the import of gold paid in dollars.