[外文]China′s Monetary Policy and Interest Rate Liberalization: Lessons from International Experiences
Prepared by Wei Liao and Sampawende J.-A. Tapsoba
Authorized for distribution by Steven Barnett
China has been moving to a more market oriented financial system, which has implications for the monetary policy environment. The paper investigates the stability of the money demand function (MDF) in light of progress in financial sector reforms that, for example, have resulted in significant financial innovation (so-called shadow banking) and more liberalized interest rates. The analysis of international experience suggests that rapid development of the financial system often leads to structural shifts in the MDF. For example, financial innovation and liberalization alter the sensitivity of money balances to income and the interest rate. For China, we find that the stable long-run relationship between money demand, output, and interest rates that existed between 2000 and 2000 disappears after 2000. This coincides with the period of rapid financial innovation, especially the growth in off-balance sheet and non-bank financial intermediation. The results suggest that usefulness of M2 as an intermediate monetary target has declined with financial innovation and reform. A result that underscores the importance of moving toward increased reliance on more price-based targets such as interest rates.
We thank, without implication, Markus Rodlauer, Steven Barnett, Papa N′Diaye, and Franziska Ohnsorge for their invaluable comments and suggestions, and Rosanne Heller for her editorial assistance.
The success of targeting a monetary aggregate depends on the stability of the money demand function (MDF). If a monetary aggregate has a stable relationship with real income and interest rates, then it also has useful information near-term outlook for the economy and, of most relevance to monetary policy, output and inflation. In such cases, monetary policy can be successfully implemented by targeting money or credit supply. Structural changes in the financial system could affect the stability of the MDF. For instance, financial innovation and liberalization could alter the link between money aggregates, output, and interest rates, which makes monetary aggregate targeting less effective.The emergence of new interest-bearing assets triggered by financial development may increase the interest rate sensitivity of money holdings; and the extensive use of credit cards and leveraging tools may reduce the dependence of money demand on income. In this
circumstance, a monetary policy framework heavily centered on direct instruments may no longer be able to influence real output effectively. As a result, central banks may have to shift toward the use of indirect monetary instruments such as interest rates to exercise macroeconomic control. In the case of China, the monetary policy environment has undergone significant change, especially since 2000 as financial innovation and the pace of reforms have accelerated. China has embarked on a series of bold reforms of its financial sector since 1980 to make the exchange rate more flexible; expand the interbank money, bond, and stock markets; open the banking sector to more competition; and liberalize interest rates. Consistent with the more liberalized financial system, the breadth and depth of financial markets has increased. Modern financial products―such as wealth management products (WMP), mutual funds, and options—have been developed and banking services and modern payment systems have been extended to almost every major city. In 2000, around half of financial intermediation took place outside the traditional banking sector, compared to only about 10 percent in the early 2000s. Meanwhile, China′s monetary policy has historically been exercised with quantity controls on bank lending (window guidance) and direct instruments (reserve requirements) guided by monetary aggregate targets
(Laurens and Maino, 2000). With such a fast-changing financial system, however, the stability of the MDF becomes a crucial ingredient of monetary policy effectiveness. Despite these change, China has continued to rely heavily on M2 targets and active use of window guidance. It is, therefore, relevant to understand the stability and instability of the MDF.
II. DRIVERS OF STABILITY AND INSTABILITY OF THE MONEY DEMAND FUNCTION
Understanding the stability of money demand is important for conducting monetary policy, especially in frameworks that rely on quantitative targets. In a stable monetary policy environment, central bankers can adjust the money supply to achieve the desired growth objectives. Several studies have assessed the stability of the MDF by estimating a long-run relationship between money holdings, income, and interest rates. A number of papers have documented MDF instability (Ball, 2000 for the United States; Miyao, 1996 for Japan; and Pradhan and Subramanian, 2000 for India). Money holding depends on several factors and abrupt changes in those drivers can create instability of the MDF. Financial innovation is a key determinant of the MDF. Financial sophistication affects the MDF through several channels such as financial deepening, the development of new financial products, deposit substitutes, and technological advancements in payments and transactions systems. The Sharma and Ericsson (1998) and Pradhan and Subramanian (2000) find that financial advancement, such as the rapid introduction of interest-bearing assets and rapid development of financial infrastructure, can cause the MDF to become unstable. money substitutes and efficient payment mechanisms decrease the transaction demand for money through lower transactions costs and therefore reduce income elasticity. The stock of monetary aggregates toward liquid assets, which could lower the income elasticity. At the same time, the emergence of new interest-bearing money substitutes may improve the sensitivity of money holdings to interest rates. However, other papers highlight the liquidity effect. It consists in a central bank′s purchase of bonds that creates a once-and-for-all increase in liquidity, but a persistent decrease in interest rates (Ireland, 2000 and Alvarez and Lippi, 2001). This effect would reduce or even flip the sign of the interest sensitivity of money demand. The second important determinant of the MDF identified in the literature is financial liberalization. There is an established literature arguing that financial market reform may affect the demand for money, especially through financial innovation. In addition, increased competition among financial institutions will lower transactions costs and favor financial deepening. These changes may cause money demand to respond more rapidly to interest rate changes, and thereby increase the interest elasticity of money demand. Conversely, income elasticity decreases with improved competition in the banking system. In a competitive banking environment, new interest-bearing assets are rapidly developed, and these developments make it easier to convert money substitutes into money.
III. CHINA′S FINANCIAL LIBERALIZATION AND LESSONS FROM INTERNATIONAL EXPERIENCES
International experience can provide some useful insights for China. We examine a sample of countries that went through bold financial market reforms (including China), focusing on how financial sector liberalization impacted the monetary policy environment and how the central bank responded to the changing environment.
Starting in the early 1980s, China has been gradually reforming its financial sector. State-owned banks have been commercialized and restructured onto a more market-oriented footing since the early 1990s; shareholding banks have been set up and recognized since 1996; and markets have been gradually opened up to foreign-owned banks and to Chinese-foreign joint-venture financial institutions since the early 2000s. Interest rates have become considerably more flexible, with the ceiling on deposit interest rates the most prominent remaining restriction. Some recent steps include the expansion of the floating range of deposit and lending rates in mid-2000, and eliminating the floor on lending rates in July 2000. Outside the banking sector, the financial system has also been significantly modernized. For instance, the Shanghai and Shenzhen stock exchanges were set up in 1990 and 1991, and interbank money and bond markets have been developed since the late 1980s. As a result, the financial market structure is changing quickly. Equity, bond, and bank acceptance bills, as well as trust loans and private equity, are the major forms of financing other than the traditional bank loans .
Before 1980, Japan′s financial system was highly regulated, with interest rates below market-clearing levels and limited competition among domestic banks . On the
heels of significant macroeconomic changes in the mid-1970s (the oil price shock, a decline of corporate borrowing, and the country′s deteriorating fiscal situation), Japan liberalized the domestic financial market. The deregulation focused mainly on expanding market access, liberalizing deposit interest rates, increasing the availability of financial instruments, and removing barriers between the operations of banking institutions and securities dealers. With interest rate liberalization, money velocity and multiplier have been altered. Money velocity trended down from the end of the 1970s, reflecting financial deepening and an increase in national saving, the latter reflected a demand for deposits and financial assets that were considered more attractive.Velocity is computed as the ratio of nominal GDP over nominal money balance. Multiplier is defined as the ratio of nominal money balance over the nominal value of reserve money. Velocity and multiplier series are seasonally adjsuted. These structural shifts changed the conduct of monetary policy. Market-determined interest
rates were introduced as both a target and an indicator of policy stance.
Financial reforms in Korea took place in the late 1980s, a little later than in Japan. Before that, Korea tightly regulated its financial markets to support their export-led growth strategy. The regulation distorted resource allocation and led to financial disintermediation toward off-balance-sheet activities. Monetary control based on direct instruments was no longer effective. Reforms included liberalization of interest rates on interbank money transactions and prime commercial paper; privatization of government-owned commercial banks; and relaxation of direct controls on bank credit. Financial deregulation structurally changed the monetary policy environment in Korea. The money multiplier increased sharply owing to the decline in reserve requirements and increases in interest rates associated with financial reforms. The velocity trended steadily downward after interest rate liberalization reflecting. Contributing factors include financialdeepening driven by the growth of nonbank financial institutions, improved financial intermediation in the formal sector, and higher national saving fueled by availability of more attractive deposit instruments and financial assets. As a result, the Korean monetary policy framework shifted toward greater reliance on indirect instruments of monetary control.
In the United States, the lending interest rate ceiling was lifted in the late nineteenth century. However, a maximum deposit rate (Regulation Q) was in place from 1933 to 2001. The purpose was to guard against excessive bank competition that was considered a contributing factor to the Great Depression. Regulation Q ceilings for saving accounts and all other types of accounts except for demand deposits was gradually phased out between 1978–86. Investors and banks were finding ways to bypass the deposit rate ceiling, such as investing in commercial paper through money market funds and creating Negotiable Order of Withdrawal (NOW) accounts (effectively equivalent to demand deposits but interest bearing). As a result,
money velocity and money multiplier experienced gradual changes during that period. The money multiplier increased until early 1986. Unlike the case in Korea and Japan, the velocity declined only briefly then fluctuated after interest rate liberalization, and gradually climbed up in the 1990s . Such fluctuation may be related to changes in the U.S. monetary policy stance as well as to the savings and loan crisis in the 1980s and the 1990s.
V. MONEY DEMAND FUNCTION IN CHINA: A DISCUSSION
This section examines the stability of the MDF in China using the same approach as in the previous section. Owing to data availability, our sample covers the periods from 1998:Q4 to 2000:Q3. We use M2 since it is the PBC′s intermediate monetary policy target.As documented previously, velocity began a downward trend from 2000 . This is coincident with the rapid increase of the money supply and nonbank financial activities starting from the same year. To address the issue formally, we conduct a structural break test for money velocity in China. Both the Chow test and the Quandt-Andrews unknown breakpoint test identify 2000:Q1 as a break point, when the large countercyclical stimulus started and nonbank activity took off . As velocity is also subject to changes in interest rates and other variables, the shift in it is only indicative for instability in the MDF. We then estimate the long-run cointegration equation using M2, income, and interest rates. The results are consistent with the structural break observed in velocity. A cointegration test for the subsample 2000:Q1 to 2000:Q4 shows that there is a stable MDF. However, when we extend the sample to 2000:Q3, such stability breaks down, which again suggests a structural shift around 2000:Q1.
Using cross-country data, we evidence of instability of MDFs. In particular, financial innovation and liberalization both have a significant impact on the income and interest rate sensitivity in the MDF. For the particular case of China, we have identified a structural break in 2000，which based on international experience, is possibly caused by the strong growth of off-balance-sheet activities and nonbank products in China since 2000. The instability resulting from reforms and innovation suggests that M2 is becoming less useful as an intermediate monetary target. Moreover, continuing financial reforms and deepening are increasingly making it even more important to accelerate the shift to more price-based instruments (interest rates) to conduct monetary policy. Furthermore, the evidence suggests that ongoing interest rate liberalization will enhance the effectiveness of indirect monetary policy and the usefulness of using interest rates as price signals. In addition, such market-based monetary instruments, if appropriately incorporated into the monetary policy design, provide a powerful tool for promoting economic stability. China′s transition to more market-based monetary instruments, while clearly beneficial, will nonetheless not be easy, especially in an environment that is undergoing rapid change. Therefore, a period learning-by-doing will be necessary to successfully transition to the new monetary policy framework.[/外文]