Monetary Policy and the Stock Market in China - Research Paper Example

Monetary policy and the stock market in China Abstract The rationale for the topic of this dissertation is the accession of China as a global economic power that has risen to the point where it influences global investment events. At the core of the above are the country’s economic policies that have been devised using its Five Year Plans that include the use of deft monetary policies to control inflation, interest rates, and currency exchange. It is these areas that have played a large part in providing the stability that has helped to attract FDI inflows, consistent value for stock market prices, and aid in increased exports. The low exchange rate of the Renminbi has helped to make Chinese exports more attractive and to ensure the affordability and value of stock market prices as a result of consistent currency exchange rates. This means that domestic and international investors in Chinese stock do not have the added concern that exchange rates will erode stock price values or company valuations. This represented one of the key problems this study has sought to solve as the aim represented a combination of a highly complex set of areas. The approach used to address this aspect represented the use of journals and other sources that included statistics to uncover the answers to the research questions. Through extensive research it was found that monetary policy in China has been an integral part of the country’s Five Year Plans and economic policies. This study uncovered that whilst China’s economic policies are the central point of its Five Year Plans it is monetary policy that helps to actuate the above. Table of Contents 1.0 Introduction 4 1.1 Aim and Research Questions 5 1.2 Organisation of this Study 5 2.0 Methodology and Research Methods 7 2.1 Research Methodology 7 2.2 Literature Based Methodology for the Research 7 2.3 Source Materials 8 3.0 Analysis of Literature 10 3.1 China’s Monetary Policy and Economic Development 10 3.2 Impact of Stock Market Movements on China’s Monetary Policies 14 3.3 The Manner Monetary Policies Affect China’s Stock Market 17 4.0 Conclusion 23 References 25 Tables Table 1 - Benefits of Qualitative and Quantitative Research in Combination 7 Table 2 - China’s Five Year Plans Summary 11 Table 3 - China’s Total and Household Consumption 18 Figures Figure 1 - China GDP 12 Figure 2 - CNY to USD Exchange Rate 13 Figure 3 - China Interest Rate, Inflation Example 19 Figure 4 - China Inflation Rate, Inflation Example 19 Figure 5 - Shanghai Composite Index 20 Figure 6 - China Inflation Rate Second Diagram for years 2000 to 2015 20 Figure 7 - China GDP Annual Growth Rate 21 1.0 Introduction This study represents the exploration of two areas connected to economics, monetary policies and the stock market. Monetary policies differ from fiscal policies as the latter consists of governmental spending, budgets, borrowing associated with this process, and taxation laws (Woodford and Walsh, 2005, pp. 467-470). Monetary policy is primarily controlled by a country’s central bank that indirectly controls the money supply in a country. This is accomplished through the manipulating the costs associated with borrowing money by shifting short term rates of interest (Christiano et al, 2005, pp. 12-15). The stock market represents a highly important monetary source for companies as it is a source to raise funds for operations through the issuance of stock (Coval and Stafford, 2007, pp. 482-485). Research by Christiano et al (2010, pp. 4-5) found there is a correlation between low-interest rate adjustments by a country’s central bank and stock market booms. China has been selected as the subject country because it represents a three-decade transformation from an underdeveloped country to the world’s second-largest economy that has resulted in a vast array of studies exploring the manner how the Chinese have transformed their economy (Brockmann et al, 2009, pp. 391-397). As shall be explained under the review of literature, China’s government control of banks extends to monetary policy and its stock market. China is a socialist market economy where the state controls all monetary, fiscal and important areas (the stock market included) (Sigley, 2006, pp. 493-496). This differs from an open market economy where the decisions are based on supply and demand, and the prices for services and goods are determined under a free price mechanism. Whilst there are different types of government interventions (interest rate changes, inflation adjustments, etc.) under most forms of open market economies, these are based on market forces and international developments as opposed to governmental interference (Sigley, 2006, pp. 493-496). China has intervened in its economy through varied monetary policies concerning the Renminbi (RMB) that have caused comments by the United States and other countries (Blanchard, 2011, pp. 7-9). The argument contends that China has been keeping the value of the Renminbi artificially low to boost exports that have helped to increase its trade surplus, along with making an investment in the stock market attractive due to the low price of its currency (Glick and Hutchison, 2009, pp. 211-215). 1.1 Aim and Research Questions The aim of this study seeks to explore the correlation of Chinese monetary policy and its impact on the country’s economy and the stock market. In order to develop the aim, the following research questions have been formulated. The complexity of the subject has precluded the use of the main research question in favour of three questions that will provide the basis for adequately exploring the aim: A. How has the monetary policy of China impacted the economic development of the country? B. To what extent has the stock market movement affected China’s monetary policies? C. The manner that monetary policies in China are affecting stock market prices and foreign investment in domestic companies? 1.2 Organisation of this Study The approach to this examination was crafted to provide a systematic and logical organisational format designed to guide the flow of its content to address the aim of this examination. The following summarises the framework used: 1.0 Introduction This defined the research topic along with providing the reasons why the exploration of monetary policy and the stock market in China was selected. 1.1 Aim and Research Questions This specified the purpose of this study and the research questions used to develop it. 2.0 Methodology and Research Methods This section explained the choice of exploratory research as the methodology that included qualitative and quantitative methods. In terms of the literature based method used for the research, the source materials section discusses how varied journals, books and other sources were utilised to address the aim and research questions. 2.1 Research Methodology 2.2 Literature Based Methodology for the Research 2.3 Source Materials 3.0 Analysis of Literature The research questions formed the sections for this chapter as this provided a means to delve into the salient points needed to develop the aim. 3.1 China’s Monetary Policy and Economic Development 3.2 Impact of Stock Market Movements on China’s Monetary Policies 3.3 The Manner Monetary Policies Affect China’s Stock Market 4.0 Conclusion The findings under the analysis of literature sections were used to explain what was uncovered regarding the aim and research questions 2.0 Methodology and Research Methods 2.1 Research Methodology Exploratory research was selected for this study as it represents a way to find answers to a problem that has not been clearly defined (Cooper and Schindler, 2006, pp. 143-148). This approach was taken as it aids in determining the research design best suited for this type of study where the research questions entailed a search for information needed to uncover the answers. 2.2 Literature Based Methodology for the Research In order to accomplish the above, a literature-based approach to the research methodology was used. It is where the data gathered represents the source materials for information analysis (Saltzmann et al, 2005, pp. 31-35). The approach to the literature based review was systematic as it used the research questions as the basis for exploring the needed information. This study used qualitative and quantitative research as it provided a way to introduce balance and reliability in terms of the research (Hair et al, 2007, pp. 336 - 337). The reliability aspect that qualitative and quantitative research brought to this examination was the different approach of these two methods that added contrast in terms of the approach to information: Table 1 - Benefits of Qualitative and Quantitative Research in Combination (Hair et al, 2007, pp. 336 - 337) The above sections have provided insight concerning the manner this study has been conducted. 2.3 Source Materials The approach to the literature review entailed the use of peer-reviewed papers, books, and journals to provide insights concerning the research questions. This process also included statistical data primarily gathered from Trading Economics (2015a, p.1) as this source provided a location to obtain important information that helped to support the information obtained from other sources. Journal articles by Woodford and Walsh (2005, pp. 467-470) and, Christiano et al (2005, pp. 12-15) provided explanations regarding monetary policies. These aided in understanding the manner such policies apply in China’s socialist market economy that also included Sigley (2006, pp. 493-496). Another important source represented Mack’s (2015, p.1) information regarding China’s Five Year Plans that was used in conjunction with Hamilton and Wu (2012, pp. 5-7) that helped to explain the country’s monetary policy and economic development. This also entailed the use of extensive statistics gathered from Trading Economics (2015a, p.1) that provided important statistical data to help expand on the information gathered from journals, books and other sources. This aided in helping to explain China’s low exchange rate that used Eichengreen (2006, pp. 315-317) as the main source for explanations, and Scarfe (2011, p. 1) who discussed the country’s artificially low exchange rate. In terms of investigating the impact of the stock market movements on China’s monetary policies, the journal article by Scarfe (2011, p. 1) explained the role of the central bank in setting interest rates that respond to inflationary pressures. This was needed to help understand the Taylor rule that was elaborated on in an article by Hofmann and Bogdanova (2012, pp. 37-39). By referring to statistics gleaned from Trading Economics (2015a, p. 1), the combination of journals and other sources showed that the stock market is a reflection of monetary and economic policies as opposed to it guiding monetary prices. The third research question looked at the way monetary policies impact China’s stock market. In discussing economic growth and its linkage to monetary policy, Hertwich (2005, pp. 86-89) and Ma (2009, pp. 67-69) discussed the significance of how the government control of the economy serves the dual purpose of satisfying the populace and achieving economic objectives. A study by Fernald et al (2014, p. 1) that looked into the complexities of monetary policies found that monetary policies are reflected in stock market movements. The entire study relied on the extensive use of peer-reviewed journals, books, and articles that used statistics to support the points being made. 3.0 Analysis of Literature 3.1 China’s Monetary Policy and Economic Development In looking into the correlation of the country’s monetary policy and its economic development, it is necessary to understand that policies are crafted in China’s Five Year Plans that started back in 1953 under Mao Zedong (Yuan and Zuo, 2011, pp. 3856-3859). The country is now in its Twelfth Five Year Plan (2011 to 2015) that concentrates on economic infrastructure and social development (KMPG, 2011, pp. 1-4). The significance of Five Year plans in helping China achieve its economic objectives has been instrumental in achieving economic growth, thus a summarisation of this area needs to be included. Whilst economic aspects have been a part of China’s Five Year Plans, monetary policy has been a recent development. Table 2 - China’s Five Year Plans Summary *The RED Five Year Plans indication where there is a mention of monetary policy. (Mack, 2015, p. 1) As shown by the above, monetary policy entered the latter stages of the Five Year Plans. Bauer and Rudebusch (2015, p. 1) explain that to a large degree monetary policy represents a government’s management of expectations. He explains that it is the relationship of the interest rates in the economy of a country, the cost of borrowing money and the overall monetary supply. Hamilton and Wu (2012, pp. 5-7) add that monetary policy utilises a range of different tools to control these areas, in order to influence economic growth, exchange rates, inflation, and unemployment. The above table uncovered that there was no mention of any monetary policy until the 6th Five Year Plan (1981-1985). In terms of China’s monetary policy, the introduction segment mentioned that the government has maintained an artificially low currency exchange level for the Renminbi. Phillips (2010, p. 6) explains that the two terms are used interchangeably and that the Renminbi is the preferred term used by Chinese government officials. The Renminbi was originally pegged to the U.S. dollar at approximately 8.28 (Morrison and Labonte, 2013, p. 2). The complaint is that China’s economy has grown dramatically since that time, yet the value of the Renminbi is actually below that 1994 peg (8.28 to the U.S. dollar), even though the currency presently floats on the exchange market (Proctor, 2006, pp. 1340-1345). Since that time, China’s GDP has grown dramatically. Figure 1 - China GDP (Trading Economics, 2015b, p. 1) China argues that the growth of its economy is not indicative of the value of its currency since the country’s money supply has also increased significantly, thus offsetting economic performance gains (Frankel, 2006, pp. 251-255). Today, the Renminbi under a free exchange rate float is actually considerably lower than the peg in 1994 (8.28 to the U.S. dollar), at 6.3 (XE Currency Charts, 2015, p. 1). This point, concerning the present floating value of the Renminbi, is covered by Morrison and Labonte (2013, p. 2), but the reasons for the current low float value are not explained Figure 2 - CNY to USD Exchange Rate (XE Currency Charts, 2015, p. 1) On the other side of this argument, some analysts contend that during the past few years China’s current account surplus has declined significantly and that its foreign exchange reserves accumulation has slowed considerably (Chinability, 2015, p. 1; Silk, 2013, p. 1). This means they tend to side with the view that the currency is undervalued. Zhang (2009, pp. 481-484) argue that the country’s increased monetary supply has made funds available to domestic Chinese companies and more money being in circulation for consumers. China’s low exchange rate makes exports more attractive on global markets and this has been a source of earnings for the country (Eichengreen, 2006, pp. 315-317). Eichengreen (2006, pp. 315-317) advises that one of the weaknesses of the Chinese economy is that as becomes more sophisticated, it has had to resort to more joint venture agreements where profits are shared with foreign firms. Scarfe (2011, p. 1) advises that China has been manipulating its monetary policy to aid its economy by setting an artificially low exchange rate to aid exports. He states that under usual fixed exchange rate models, the country’s large current account surpluses and huge foreign exchange reserves from exports would cause internal inflation. Scarfe (2011, p. 1) explains that China has been “sterilizing foreign exchange inflows” by increasing its central and commercial bank reserves to stem inflation caused by its dramatic money supply increase. The impact of these monetary policies has heightened the demand for Chinese exports at the expense of other countries (Yao, 2011, p. 1). 3.2 Impact of Stock Market Movements on China’s Monetary Policies In exploring the manner that stock market movements impact China’s monetary policies, the Taylor rule provides some insights. In explaining how this works, Taylor and Davradakis (2006, pp. 1560-1567) advise that it is a monetary policy that states the degree a country’s central bank should change the country’s nominal interest rate in response to inflationary changes and other economic conditions. The Taylor rule also states that the central bank of a country should raise the nominal interest rate more than one point for each one percent inflation increase (Taylor and Davradakis, 2006, pp. 1560-1567). There are those who question the Taylor rule as representing a solution for inflation. The most notable is former U.S. Federal Reserve Chairman Ben Bernanke (Hofmann and Bogdanova, 2012, pp. 37-39). He states that a simple rule alone cannot correct inflationary pressures using interest rate adjustments. Bernanke adds that the Taylor rule has been a way to assess the performance of monetary policy, in some advanced economies the interest rates were beneath the levels stated by Taylor in examples cited for the 1970s, 80s, mid 1990s and early part of 2000 (Hofmann and Bogdanova, 2012, pp. 37-39). Bernanke argues that since the early part of 2000 and the global financial crisis that most developed countries interest policy rates were beneath the Taylor rule rates, but that the rule has not been proven as a means to aid in controlling inflation. In commenting on the Taylor rule Shi (2013, p. 1) states that it has undergone modifications from a “linear function” to an equation that added expectation and time variable factors. He adds that in a study of twenty countries in the 1990s found that the Taylor rule showed a decrease in the velocity of inflation, but that the developing aspects of the Chinese economy differ from the Western country applications the Taylor rule has worked for. He adds that Chinese researchers have not confirmed that the Taylor rule is applicable to the country’s unique economic situation in terms of raising interest rates to control inflation. In fact, the opposite has been shown to be the case as shown by the following: Figure 3 - China Interest Rate, Inflation Example (Trading Economics, 2015f. p. 1) Figure 4 - China Inflation Rate, Inflation Example (Trading Economics, 2015g, p. 1) Despite the misgivings by Bernanke (Hofmann and Bogdanova, 2012, pp. 37-39) and Shi (2013, p. 1), China has apparently applied the Taylor rule to combat inflation as the above indicates that the timing of interest rate increases coincided with inflationary spikes s shown in the above Figures. The rise in interest rates saw a corresponding drop in the inflation rate. The significance of exploring the Taylor rule is that inflation represents an increase in the price of goods and services due to the reduced purchasing power of the affected currency (Taylor and Davradakis, 2006, pp. 1560-1567). Other potential impacts are that as consumers and businesses purchase fewer goods, revenues and profits undergo a decline and the economy slows. Studies that have looked into the impact of inflation on stock returns have been inconclusive as they have had conflicting results (Gay, 2011, pp. 4-7). It has been found that inflation can negatively or positively impact the stock, with the latter determined by the government’s monetary policy. In terms of China, inflation means that foreign investors and domestic purchasers could wind up paying more for the stock, thus the government has a vested interest in controlling inflation (Gay, 2011, pp. 4-7). The Figures below show that China has met each inflationary challenge and the resulting stock market performance has indicated a resistance to inflationary impacts. This reveals that the country has applied the Taylor rule successfully, however, a correlation with the performance of the stock market could not be found in any supporting literature. Figure 5 - Shanghai Composite Index (2000 to 2015) (Trading Economics, 2015k, p. 1) Figure 6 - China Inflation Rate Second Diagram for years 2000 to 2015 (Trading Economics, 2015l, p. 1) Monetary policies in China are not dictated by the stock market, but rather the broader Five Year Plan economic concerns along with export and trade policies (Gay, 2011, pp. 4-7). This is because as the economy expands, the stock market is a reflection of this upward trending as opposed to the reverse (Taylor and Davradakis, 2006, pp. 1560-1567). 3.3 The Manner Monetary Policies Affect China’s Stock Market The foundation of all of China’s Five Year Plans has been to further the state of the economy, with all other areas arranged in support of this (Mack, 2015, p. 1). With a population of over one billion, China has separated itself from the use of military and police power to control its populace (Allen et al, 2005, pp. 61-67). The government has concentrated its efforts on a long term consistent improvement of the living standard. The standard of living is measured using household consumption as it reveals that the underpinnings of the economy is providing jobs, income, and education to reflects an increased standard of living (Ross, 2013, p. 1). Table 3 - China’s Total and Household Consumption (Ross, 2013, p. 1) Hertwich (2005, pp. 86-89) advises that economic growth results in increased consumer consumption, reduced unemployment and heightened public services. The lack of an elected government in China provides it with inherent power, along with the increased potential for dissent and demonstration (Ma, 2009, pp. 67-69). Through the consistent growth of the economy, the government has dramatically improved the standard of living for its population which has helped to quell most political dissent (ChinaDaily, 2012, p. 1). The above areas include monetary policy that was analysed in an Economic Letter by the Federal Reserve Bank of San Francisco (Fernald et al, 2014, p. 1). Their study pointed out “that market-based monetary policies, such as interest rates and reserve requirements, are unimportant in China relative to more direct, blunt credit policies such as window guidance for commercial bank lending levels” (Fernald et al, 2014, p. 1). Their findings suggest that the increased complexity of the country’s economy has caused its monetary policy to become more similar to that used in the United States and other Western countries as China’s economy has moved to the point where it is an advanced economy. The above was also mentioned in an article by The Economist (2014, p. 1). The article stated that central bank rate cuts generally spur more lending, but that this is not necessarily the case in China as its State-owned commercial and regional banks have government imposed lending limits. This means the government, despite low-interest rates, controls the flow of lending to the industries it wants and when. In describing China’s monetary policies The Economist (2014, p. 1) stated there are three major considerations and components. The first represents the fact that there is more give and take in China’s current monetary policy. This is what Fernald et al (2014, p. 1) uncovered in mentioning that China has had to adopt a different approach to monetary policy as its economy has become more complex. The control of the economy by the government and the banking structure means that interest rates are not the “main determinant if credit growth” (The Economist, 2014, p. 1). The second factor uncovered in the report by The Economist (2014, p. 1) is that the economic environment has changed considerably in the last decade. The recent lessons from the global financial crisis caused the country to look inward for continued growth which meant more emphasis on consumer spending and lending to domestic companies. This entailed lowering interest rates to help spur growth: The last area mentioned by The Economist (2014, p. 1) is that the loosening of credit in response to the 2008 financial crisis caused a credit binge in 2009. This resulted in the creation of a large amount of debt (private and public) that rose to 250 percent of GDP in 2009. This has caused municipalities and companies to struggle repaying their debt and has resulted in a severe curtailing of new lending requests. The controls on lending imposed by the government that does not have a strong correlation to interest rates are shown by the Shanghai Composite Index. A spike in interest rates in 2007, also saw a dramatic upturn in stock market prices. Under most cases, the reverse would be the case as higher interest rates mean less lending by banks and lower stock prices because money is more expensive (The Economist, 2014, p. 1). In terms of the latter (lower stock market prices), this tends to occur in a period of high interest because corporations generally take a more conservative approach to expanding facilities, plants or new programmes due to the higher cost of money (The Economist, 2014, p. 1). Figure 5 - Shanghai Composite Index (2000 to 2015) (Trading Economics, 2015k, p. 1) The stock market trends correlate to some degree to the country’s annual GDP growth rate. This is normal for developed economies as the stock market is a reflection of economic health (Anderson et al, 2007, pp. 257-261). Figure 7 - China GDP Annual Growth Rate (Trading Economics, 2015f, p. 1) In China, the government’s control of central, commercial and regional bank lending allocations means that monetary policy is tied to economic policy. In terms of the impact of monetary policy on FDI, an article by Bruno and Shim (2015, pp. 122-125) state the factors that influence this area such as interest rates generally do not represent the important factor. This is because the foreign company usually lines up its FDI investment from internal funds, its own stock market (equity financing) or through banks. FDI determinants used to make investment decisions represent the following (Blonigen, 2005, pp. 389-293): A. A high country growth rate (economic) B. Stability in terms of exchange rates C. Overall general macroeconomic stability D. Strong central bank foreign exchange reserves. E. Condition (health) of the country’s banking system F. General liquidity of the country’s bond and stock markets G. Moderate interest rates China scores high in all of these categories, thus it is the economy that represents the determining factor. An article by Wang and Ajit, (2001, pp. 3-6) found that monetary policies do not affect stock market prices as the latter represents a part of economic policies that is part of a much broader array of areas. In terms of interest rates, it has been uncovered that the government control of lending through central, commercial and regional banks means that lower interest rates do not have a real impact on loans as these levels are set by the government for each industrial classification. This is because monetary policy is tied closely to economic policies and needs. 4.0 Conclusion In seeking to develop the aim of this study that represented the exploration of ‘the correlation of Chinese monetary policy and its impact on the country’s economy as well as stock market’ it was found that monetary policy does impact both areas. The above conclusion was reached through the exploration of the three research questions devised for this study. They helped to provide the needed information to reach the above conclusion. In terms of ‘How has the monetary policy of China impacted the economic development of the country’ research looked into the history of China’s twelve Five Year Plans that started in 1953. The investigation of this area revealed that since 1981 (the 6th Five Year Plan), through to the 10th and 12th of these Plans, there were specific references to varied aspects of monetary policy included with the extensive economic objectives. This was an important finding as it provided proof of the inclusion of monetary policy in economic planning. The main findings uncovered monetary policy adjustment of the countries interest rates and currency exchange rates to boost exports and help finance domestic industrial development. These entailed the central bank that controls China’s commercial and regional banking system where the government allocates specific sums for various economic areas. As monetary policy is an integral part of the above, evidence of this connection was found in the review of the Five Year Plans. One key aspect is that the Renminbi was originally pegged to the United States Dollar at 8.28 in 1994. The currency now floats against the dollar and through central bank invention along with controls the exchange rate is presently 6.3. The policy of the Chinese government has been to maintain a low Renminbi in order to make exports highly attractive. The dramatic rise in the country’s exports (Figure 9) is a combination of China’s domestic development and FDI policies connected to maintaining a low Renminbi exchange rate. The contribution of monetary policy in the country’s economic plans was also uncovered a significant rise in Chain’s balance of trade (Figure 10) and the reduction of the inflation rate to a range between 6 to 8 percent (Figure 7). The government’s management of inflation represented interest rate adjustments that is a part of monetary policy that helped to contribute to the country’s economic development. In terms of the exploration of the extent the movements in the stock market have affected China’s monetary policy, the Taylor rule helped to explain the correlation between interest rate adjustments and inflation. Inflation was an important discussion as high inflation slows economic growth due to reduced consumption that causes lower company earnings. Inflation is a drag on economic growth that the Chinese government has effectively sought to prevent through monetary policy. This means that monetary policy impacts stock price movement as opposed to the reverse being the case. The above correlation concerning the manner that monetary policy affects stock market prices and FDI inflows for domestic companies represents financial stability. 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