China Monetary Policy and Its Effect on United States Economy - Literature review Example

China Monetary Policy and Its Effect on United s Economy The People’s Bank of China plays a key role in the country’s monetary policies. It functions exclusively as the central bank of China. It formally began its function as a central bank 1984 (Anderson 112). Over the years, the People’s Bank of China has made significant improvements in the way it conducts China’s monetary policy. This implies that the country’s monetary policy framework has transformed from an administrative system that is based on credit rationing towards a more market-oriented regime that is based on money growth as its major intermediate target. One salient feature about China’s monetary policy is that the interest rates have significantly been liberalized. This has improved their responsiveness to market signals. Most importantly, the tools of China’s monetary policy have been modernized and made more effective and efficient. This paper provides and insightful analysis of China’s monetary policy and its effect on the economy of the United States. The main objective of China’s monetary policy is to ensure that it maintains the stability and value of the country’s economy and consequently promote economic growth. This includes maintaining the domestic purchasing power or the Chinese currency as well. This is done through maintaining stability in the price level as well as the exchange rate. People’s Bank of China is also charged with the responsibility of achieving price stability, enhancing employment growth, external balance as well as financial stability in the country. In addition, the People’s Bank of China is responsible for ensuring that the financial sector maintains its liberalization(Frankel and Wei 239). It is important to note that the People’s Bank of China is not independent. In performing its duties, it requires permission from the State Council. This implies that the People’s Bank of China needs approval from the state council for it to change and implement economic policy in the country. China’s eleventh plan is accredited for promoting interest rates liberation as well as championing for major improvements in the country’s transmission mechanism of monetary policy. Many economists contend that China’s monetary market is progressively becoming more integrated. It is characterized by different market segments that are linked through arbitrage. For this reason, People’s Bank of China has a great control over interest rates in the interbank market. This way, it increases its leverage over short term interest rates as well. Anderson (213) however believes that the monetary policy framework in China need to shift its focus from quantity-based liquidity to interest rates changes. For instance, its role of benchmarking the lending rate and deposit rates of commercial banks should be phased out. This is because lending and deposit rates so are progressively becoming irrelevant in determining monetary policy. In order to understand China’s monetary policy, it important to analyze the major developments in the country’s monetary policy framework. Laurens and Maino (94) contends that China’s monetary policy framework has undergone major evolutions since the mid 1980. Between 1984 and 1977, the People’s Bank of China issued base money and championed for major changes in the monetary policy that was based on the system of central bank lending and credit controls (Laurens and Maino 94) During this period, the People’s Bank of China offered liquidity to banks that are owned by the state. These are banks that lend money to state-owned enterprises at negative real interest rates. Since the year 1994, development banks began to emerge in China. This meant that the People’s Bank of China’s lending was used to subsidize rural credit cooperatives as well as rescue financial institutions. It did not focus more on influencing monetary conditions in the country. In the recent years, there has been a shift in the main intermediate target of monetary policy in China. In this regard, money growth has replaced credit rationing as the country’s main intermediate target of monetary policy. Based on this shift, the People’s Bank of China sets annual targets for growth rates of the money supply and bank credits that are consistent with the country’s policy objectives. After the elapse of this period, the People’s Bank of China adjusts policy settings to ensure that they are consistent with the developments in the intermediate targets as well as other macroeconomic variables. Evidently, the People’s Bank of China has effectively achieved its money supply and back credit targets in the recent years. This is attained facilitated through a number of instruments. One of the most prominent tools that are used by the People’s Bank of China to influence money market conditions is the open market conditions. In this regard, the People’s Bank of China conducts open market operations using repos and central bank bills. Moreover, the People’s Bank of China uses periodic changes in reserve requirements as a tool of achieving money supply and credit growth targets. Periodic changes in reserve changes are accredited for sterilizing foreign reserve inflows. In addition, the People’s Bank of China controls interest rates in the economy. In the light of this, People’s Bank of China sets a range of benchmark interest rates for commercial bank lending and deposit. This is done across a range of maturities. Moreover, it sets interest rates on refinancing credit. It also sets the rediscount rates as well as the rate that are paid on excess reserves of commercial banks that are deposited at the central bank. The People’s Bank of China also controls the yields on central banks bills that are used in the process of sterilizing foreign currency inflows. Besides the quantity-based and price-based instruments of controlling money supply and credit growth, the People’s Bank of China utilizes various forms of administrative guidance with the aim of influencing back lending. In 1998, bank-specific ceilings were eliminated. Since then, the People’s Bank of China holds monthly meetings with commercial banks with the aim of outlining various concerns regarding credit conditions across sectors. This is also supplemented by the regular reports by the People’s Bank of China in its Quarterly Monetary Policy Reports. In the recent years, administrative guidance has become a major component in the People’s Bank of China’s goal of slowing credit growth especially during periods of rapid economic expansion such as the global recession. One perfect example of such administrative guidance is the window guidance. It is important to analyze China’s financial market and interest rates in order to have an insightful understanding of its monetary policy. The year 1997 market the onset of interbank market for banks in China(Anderson 248). This has developed rapidly and therefore impacted greatly on the country’s momentary policy. Economists attribute the rapid growth in the country’s bond market to the financial sector liberalization as well as the establishment of the market infrastructure that facilitates borrowing and lending reserves between and among banks. In the recent years, few government bonds have been issued. Alternatively, offerings by the People’s Bank of China have dominated the market. Until 2004, the National Development Reform Commission had imposed restrictive regulation in the corporate paper market. For this reason, the corporate paper market in China was underdeveloped. However, the People’s Bank of China opened a corporate paper market as from 2007. This allowed the trading of medium-term corporate notes. Consequently, the period between 2007 and 2009 was marked by an increase in the number of commercial paper and bids that are issued by local governments and non-financial cooperate sector (Girardin and Liu 512). Despite this, economist contend that the outstanding stock of bonds in China is still relatively smaller as compared with other countries. One salient feature about China’s economy is that it is characterized by a variety of different money markets. For instance, the market for uncollaterized loans takes place in the repurchase market using bonds as collateral. The uncollaterized loans are traded between banks. In the repo markets, loans are often traded on stock exchanges as well as between banks. The market interest rates in China, including interbank interest rates, bond yields and discounting rates are fully liberalized. They therefore move flexibly with the aim of clearing markets for borrowing and lending reserves. In 2005, the People’s Bank of China established minimum rates through which these rates can be set. In the year 2003, People’s Bank of China converted all the repurchase agreements into Central Bank Bills (Frankel and Wei 243). This was aimed at creating a new instrument for its intervention in the money market. This marked the development of a relatively deep and liquid monetary market in China. Consequently, the People’s Bank of China uses these bills to conduct open market operation that are geared towards achieving its liquidity targets. Major changes were also made in the open market operations. In 2004 for instance, the People’s Bank of China introduced various innovation that were aimed at improving the effectiveness of open market operations. It lengthened the trading period. In addition, it linked the bill trading system with the payment system. This was meant to ensure that settlement is done on the basis of payment-on-delivery. As mentioned earlier, the People’s Bank of China has a great leverage over short-term monetary markets interest rates. Consequently, it sets interest rates it pays on excess reserves. This enables the bank to effectively impose a floor and control the interbank market. The People’s Bank of China’s base or benchmark rate also imposes a ceiling in the interbank market. This has an implicating that the People’s Bank of China influences market interest rates to large extents. At the beginning of the 1990s, the People’s Bank of China widened the margin between benchmark lending as well as deposit rates from zero to 350 basis point. Consequently, the profitability if the banking sector was restored (Frankel and Wei 246). In 2002, the People’s Bank of China set the regulated lending rate consistent with the repo rate. Prior to 2004, bank interest rates were not to deviate from the set benchmark rates by more than ten percent. After 2004 however, the permissible interest rates based on the benchmark rates have progressively widened. This implies that commercial banks lending rates are now subject to a floor and deposit rates are subject to a ceiling alone. This has consequently increased the extent to which banks set interest rates. According to Laurens and Maino(97) , monetary markets provide a link between a country’s financial system and its real economy. However, this depends on the ability of the banks to absorb and pass on changes in the cost of funds in the monetary market to its clients. This explains why bank lending is the largest sources of outside financing for investment. In China for instance, the banking sector intermediates approximately 75 percent of the country’s financial capital. This means that bank lending rates determine the marginal cost of capital for a country’s economy to large extents. According to Lin(118), China’s monetary policy implementation framework requires a number of improvement to ensure that it keeps pace with the ever-changing economy. Failure to improvise changes in the county’s monetary policy will render it ineffective. As analyzed in the foregoing discussion, the Chinese monetary policy targets money growth using quantity-based instruments. Whereas the quantity-based framework play in important role, it is evident that interest rates play a key role in ensuring that economies operate freely and respond to chase in the monetary policy. It is therefore recommended that the Chinese monetary policy should make more use of policy interest rates. This will significantly reduce its reliance on changes in required reserves as a method of controlling liquidity. According to Siklos and Burdekin (117), this hampers financial market development. A shift towards policy interest rates will also lessen the People’s Bank of China’s reliance on window guidance to commercial banks. The window guidance is criticized for weakening competition and undermining the market determination of interest rates. In addition, the impact of window guidance on bank behavior is often unpredictable and asymmetric. This imposes a number of disadvantages to commercial banks that adhere to the wishes of the People’s Bank of China in times of economic hardships. Reliance on quantity-based tools have also proved to be detrimental because state-controlled companies are still accessible to bank fiancé. For this reason, a reduction in credit often affects private firms disproportionately. Overwhelming evidence ascertains that private-sector firms are the most reproductive in China. This implies that hiking interest rates in price-based framework has the disadvantage of inducing such firms to suspend investment projects. On the other hand, a reduction in interest rates tends to stimulate investment projects. A number of aspects in China’s interest rate monetary policy framework tend to hinder competition in the banking sector to large extents. The fact that commercial banks interest rates are linked to money market conditions implies that the purpose of the People’s Bank of China’s lending rate floor and deposit rate ceiling controls the profitability of the banking sector. Siklos and Burdekin (118) attributes this to the fact that the banking sector in China is dominated by state-owned banks. According to Laurens and Maino (93) , models of oligopolistic markets hold that while the deregulation of lending and borrowing rates makes as light change to bank borrowing and lending rates, it makes a significant change in the distribution of deposits across banks. This allows smaller banks to grow significantly. Currently, the money market provides banks with an interest rate benchmark. This implies that there is no more need for the People’s Bank of China to provide the interest rate benchmarks. As such, economists argue that the benchmark lending and deposit rates should be phased out. The most controversial monetary policy in China is the policy if intervention to limit the appreciating of its currency against the dollar and other currencies. This has been the major source of tension between China and most its trading partners, especially the United States. A number of economic analysts criticize China for deliberately manipulating its currency with the aim of gaining unfair trading advantage over most of its trading partners. According to these critics, China has an undervalued currency. This explains why there is often a larger annual trade deficit between the United States and China. Economists contend that the China’s undervalued currency places US firms and corporations at a large competitive disadvantage. It is therefore necessary to analyze the historical background of the Chinese currency policy with the aim of having a better undressing of its effect on the United States. Before, China had a dual exchange rate system. It was comprised of an official fixed rate system that was used by the government, and a market-based exchange system that was mainly used by exporters and importers in the swap markets. During this time, the government imposed a number of restrictions towards accessing foreign exchange, which were aimed at limiting imports. This consequently resulted to a massive black market for foreign exchange. According to Siklos and Burdekin (120), the two exchange rates maintained by the dual exchange rate systems differed significantly. This was the major source of criticism from the United States. In 1994, the government of China eventually unified the two exchange rate system. This was done at initial rate of 8.70 Yuan against the dollar. By 1997, the exchange rate had raised to 8.28 Yuan against the dollar(Lin, 314). This rate was kept constant until 2005. Between the period of 1994 and 2005, the country maintained a monetary policy that pegged the RMB to the US dollar at a relatively constant rate of 8.29 Yuan to the dollar. This was largely aimed at promoting a stable environment to enhance foreign trade and investment in China. The pegging of the RMS at a constant rate was aimed at preventing large swings in the exchange rate. The People’s Bank of China maintained this pegging. In July 2005, the Chinese government modified its currency policy. In this regard, the government announces that the RMB exchange would be subjected to adjustments based on market demand and supply with reference to the exchange rate movements of currencies. This implied that the exchange rate of the RMB against the US dollar would be adjusted from 8.28 to 8.11(Girardin and Liu 514). It would then be allowed to fluctuate by 0.3 percent on daily basis against currencies in a basket. Due to declining global demand for Chinese products as result of the global financial crisis, the Chinese government halted China’s currency in 2008. In 2009, there was a drastic fall of Chinese exports. This promoted a massive closure of export-oriented factories and loss of millions of jobs. In response, the government prevented further appreciation of the RMB to the dollar. This implied that the RMB to dollar exchange rate was pegged at a constant 6.83 until 2010(McKinnon and Schnabl 22). In June 2010, the People’s Bank of China imposed major reforms in the RMB exchange rate regime with the aim of enhancing the RMB exchange rate flexibility. According to the People’s Bank of China, this move was based on the prevailing economic conditions and was aimed at avoiding sharp and massive fluctuation of the RMB exchange rates. Consequently, the RMB appreciation resumed with the Yuan/dollar exchange rate rising from 6.83 to 6.17 (Girardin and Liu 513). China’s monetary policies have a number of effects on the U.S. In the recent years, the United States has increasingly raised its concerns over China’s currency policy. Many U.S economists, policymakers, and business representatives have often criticized the Chinese government for manipulating its currency with the aim of making it significantly undervalued against the U.S dollar. This, according to the critics, is a move engineered by the Chinese government to ensure that Chinese exports to the United States is les expensive and the exports from the United States to China are more expensive. In addition, they argue that while a pegged currency may have been necessary during the early stages of China’s economic development, its current use cannot be justified, considering the size of China’s economy and trade flows. Overwhelming evidence also ascertains that the move by the Chinese government to undervalue its currency accounts for the increased US trade deficit with China in the recent years. According to McKinnon and Schnabl (24), the U.S trade deficit with China increased from $84 billion in 2000 to $315 billion in 2012 and $325 billion in 2013. In addition, the Chinese massive accumulation of foreign exchange reserve and its increased size of account surpluses have been cited to be evidence of Chinese currency manipulation. Currently, China is ranked as the world’s largest holder of foreign exchange reserves. Siklos and Burdekin (88) contend that Chinese foreign exchange reserves grew to $3.3 trillion in 2012 from $212 billion in 2001. This increase is largely attributed to the Chinese government intervention in the currency market with the aim of holding down the value of the RMB. The country’s current account surplus has also grown from $69 in 2004 to $412 billion in 2012 based on the statistics by the International Monetary Fund (Geiger 56). The currently increased unemployment rates in the United States have intensified concerns over the impact of the Chinese monetary policies especially the currency policy on the United States economy. Economists argue that China’s currency policy is detrimental on the U.S economy in terms of employment. According to them, RMB appreciation will significantly increase the level of jobs in the United States. McKinnon and Schnabl (261) contend that there is a great correlation between the U.S increased trade deficit and the U.S job losses. A study carried out by the Economic Policy Institute in 2012 revealed that the large U.S trade deficit with China is a direct result of China’s currency policy. According to this study, this led to the loss of close to 2.7 million jobs in the United States between 2001 and 2011, most of which were in the manufacturing sector (Girardin and Liu 247). In addition, some economists argue that the undervaluing of the RMB as perpetrated by the Chinese currency policy is responsible for the slowed global economic recovery. This explains why most scholars believe that China manipulates its currency with the aim of gaining unfair trade advantage. This has instigated a number of legislative proposals aimed at addressing the move by China to undervalue its currency. In the recent years, a number of bills have been introduced in congress, with the aim of inducing China to reform its monetary policies as a move towards addressing their effect on the U.S economy. Such bills include that which sought to impose additional duties on imported Chinese products unless the Chinese government appreciated its currency to match the market levels. Another legislative proposal sought to impose U.S anti-dumping and countervailing duty measures with the aim of addressing the effects of the undervalued Chinese currency. McKinnon and Schnabl (25) contend that the greatest disadvantage of the China’s exchange rate regime that it has imposed a number of constraints on the People’s Bank of China’s ability to adopt a monetary policy that conforms to the domestic objectives. This is attributed to Robert Mundell’s principle of inconsistent trinity which argue that it is impossible to run an independent monetary system under a fixed exchange rate regime especially when financial capital is mobile across borders. Consequently, the lack of exchange rate adjustment enhances cross-country differences in interest rates, which in turn lead to capital flows that affect domestic financial conditions. Resisting currency appreciation as well as sterilizing the foreign reserve inflow as perpetrated by the Chinese currency policy prevents the domestic interest rates from falling. This consequently attracts more inflows and necessitates more sterilization. The sterilization costs eventually become prohibitive. In such instances, the central bank has no choice but to allow the currency to appreciate or risk the falling of interest rates. This consequently invokes domestic inflation. In such cases, the appreciation of real exchange rates becomes unavoidable. In China however, the capital controls provide the People’s Bank of China with some level of independent monetary policy notwithstanding the heavy-managed exchange rate regime. Nevertheless, there have been increased concerns as to whether the degree of autonomy that is currently afforded by China’s capital control will be efficient in allowing the People’s Bank of China to carry out monetary policy effectively in the future. In conclusion, a number of reforms have been instituted within China’s monetary policy. As a result of these reforms, the People’s Bank of China plays a pivotal role in the formulation and implementation of the country’s economic policy. It exerts great control over money market interest rates. Currently, money market conditions increasingly influence effective commercial lending rates. This impales that the People’s Bank of China is able to include the cost of credit through the benchmark commercial bank rates. In addition, interest rates significantly determining investment spending. For this reason, the People’s Bank of China is able to effectively tailor monetary policies. One of the most prominent monetary policies in the country is the currency policy. The Chinese government has instituted a number of changes in the Chinese currency policy since 1994. This has had a number of effects on the economy of the United States in terms of trade deficit and employment rates. 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Investigating the People’s Bank of China Policy Rule”, East-West Center Working Papers. 85.1(2005): 115-129.Print. Read More