China’s unorthodox unconventional monetary policies: what are they and can they be applied elsewhere?
Author: Oscar To | GMCC Director 2021
China has often operated in its own unique way. From its complex trade laws to its heavy presence of state ownership, differences in political and economic systems are stark between China and Western society. Its take on central banking is no exception to this. While there has been some convergence of China’s monetary policy framework towards that of advanced economies’, the People’s Bank of China (PBC) remains distinct through its structural monetary policies - blurring the lines between fiscal and monetary responsibility. These targeted monetary policies allow the PBC to be precise in how it affects the economy and have been instrumental in directing credit towards sectors that needed it most during COVID, all the while serving as a foundation for future economic growth in an evolving world. The establishment of central bank independence - the idea that governments and central banks should operate detached from each other - likely prohibits the introduction of targeted monetary policy in advanced economies due to the possibility of political interference. However, developing countries with more loosely defined central bank frameworks may have a place for these structural policies, both for crisis mitigation and as a means of catalysing economic growth.
Taking a step back
But let’s backtrack slightly and understand what a typical central bank actually does. The role of a nation’s monetary authority, or central bank, is to achieve a set of economic objectives that contribute to the social welfare of its people. These goals vary between countries but there is a common focus on price stability and level of employment[1]. For example, the Reserve Bank of Australia (RBA) strives to maintain the stability of the currency, full employment, and the economic prosperity and welfare of the Australian people. In other countries, central banks may decide to focus more narrowly on a single goal, like price stability in the case of the European Central Bank.
One of the ways that central banks can achieve these objectives is through the conduct of monetary policy, which involves the setting of interest rates. Monetary policy refers to a number of tools that central banks can use to change interest rates, and these can be classed as either conventional or unconventional tools. Focusing firstly on conventional tools, the most well-known of these is a central bank’s policy interest rate. These may differ between countries but typically the policy interest rate is a short-term interest rate. In Australia, the RBA sets the interest rate on overnight loans between commercial banks. On the other hand, unconventional monetary policy refers to the use of tools outside of the policy interest rate. Examples include large-scale asset purchases, funding facilities, and forward guidance[2]. Unconventional tools are designed to provide central banks with additional firepower when conventional tools diminish in their effectiveness to control the economy[3]. All of these aforementioned measures and instruments work towards changing interest rates across the economy, such as on bank deposits and home loans, with the ultimate objective of affecting inflation, output, and unemployment in the macroeconomy.
How then does the People’s Bank of China (PBC) differ in its conduct of monetary policy to that of a ‘typical’ central bank?
Source: https://www.hks.harvard.edu/sites/default/files/centers/mrcbg/working.papers/x87_final.pdf
The PBC still strives to deliver favourable economic outcomes for its people, in particular focusing on price stability and economic growth. However, two key differences separate China’s monetary policy framework from that of advanced economy norms:
· Institutional set-up: there is an absence of instrument independence, reflecting China’s single-party state system in which macroeconomic management tends to be highly coordinated under the State Council.
· Objectives for monetary policy in China and the implementation of monetary policy itself has few parallels in other advanced economies.
The first point alludes to the concept of central bank independence, or rather lack thereof in China’s case. Central bank independence refers to the separation of a central bank’s operations and management from the government, with the rationale being to prevent political manipulation. Historically, it has been observed that higher levels of independence tend to be associated with lower levels of inflation.
That is not to say that central bank independence is necessarily the right way forward, despite having increased in popularity over the past century. For China, its low level of independence has paved the way for a unique set of monetary policies, noted in the second point above. Since 2014, the PBC has introduced over ten separate target tools known collectively as “structural monetary policies”. These are unconventional monetary policy tools that channel financial support to specific sectors, something that has traditionally been the role of government. Examples of structural policy tools include credit facilities for small-medium enterprises (SMEs) and farmers, new money for the construction of affordable housing, and favourable adjustments on reserve requirements if commercial banks lend to certain sectors[4]. This amalgamation of both fiscal and monetary policy elements through these tools has worked wonders for China in its economic recovery against COVID-19, delivering timely and targeted assistance to vulnerable industries in a budget-neutral fashion.
However, the benefits of structural policies go beyond purely crisis management. In fact, the initial attraction of these policies was their ability to generate economic growth without increasing the already high levels of indebtedness especially among state-owned enterprises. By incentivising commercial banks to lend out to lesser leveraged companies in promising and innovative sectors such renewable energy and digital technologies, the PBC achieves three important goals simultaneously: fostering growth, maintaining healthy debt levels, and future-proofing the economy.
So why don’t these structural policies exist in advanced economies if they supposedly deliver so many benefits?
The answer to this is two-fold. Firstly, central banks in advanced economies have mandates to achieve objectives related to aggregate measures, such as inflation and unemployment, and to focus mainly on these objectives. Existing policy tools that affect the economy as a whole are simply much better suited for these goals and hence structural policies do not really have a place in advanced economies’ monetary policy systems. Moreover, central bank independence is typically quite strong across advanced economies, meaning that introducing policies that target this or that sector may be subject to political influence.
But there is some potential for structural policies to be implemented in developing nations, where monetary policy frameworks are less stringent and binding. For many developing countries, indebtedness has increased over the past twenty years, particularly after the Global Financial Crisis. Structural policies can be effective in addressing this, reallocating credit from high- to low-debt sectors. On top of this, they can act as the catalyst for economic development by directing finance to industries where countries have competitive advantages and allowing these industries to drive growth in the economy.
At the end of the day, China’s structural policies are unlikely to be implemented in advanced economies any time soon. Regardless, they make an interesting example of how monetary policies do not have to be one-dimensional and might even go as far as to appear in countries with similar economic characteristics to China.