A Forward-looking Liquidity
Stability Paradigm in China
By Zhu Zhui1
May 2013

Graduate School of Public Policy, University of Tokyo
Research Paper 2013 Summer Semester

1) International Program Course MPP/IP,
Second-year, 51-118231
Academic Supervisor: Professor Amaya TomokoiTable of Contents
A Forward-looking Liquidity Stability Paradigm in China ..................................................... i
A Forward-looking Liquidity Stability Paradigm in China ....................................................1
I. Literature review ................................................................................................................................1
II. The necessity of housing price surveillance in China.......................................................2
III. The dilemma of conventional policy framework ..............................................................4
IV．A forward-looking liquidity stability paradigm in China ..........................................5V.

The forward-looking liquidity stability policy framework .......................................9

VI. Conclusion and aspects that needs attention.................................................................. 11
Acknowledgements ............................................................................................................................ 12
References .............................................................................................................................................. 13

List of Figures and Tables
Figure 1: Beijing New Resident Property Price Index monthly data ...............................3
Figure 2: Credit to Private Sector in China quarterly data...................................................3
Figure 3:Foreign Direct Investment Net Inflow in China yearly data..............................4
Figure 4: A forward-looking liquidity stability paradigm in China...................................8
Figure 5: General comparison between conventional policy framework andforward-looking policy framework.................................................................................... 10

Table 1: General comparison between conventional policy framework andforward-looking policy framework.......................................................................................9ii

A Forward-looking Liquidity Stability Paradigm in China
From earlier financial crises to crisis occurred recently, there are signs fromreal estate market that the housing prices usually increased dramatically before
the crisis, even when the CPI inflation was not significant. Whether the housing
price should be under surveillance? Can we construct a forward-looking policy
framework to prevent financial instability? In this paper, I reviewed research
results on this issue, by introducing housing price as a pre-alarming indicator we
could subtle adjusts the conventional policy framework. Through working on thetransmission mechanism of liquidity and how it causes the housing price inflation,
I construct a forward-looking liquidity stability paradigm in China. By surveillance
housing price, we could build a forward-looking policy framework to absorb
shock from possible future bust for maintaining the financial stability.

I. Literature review
Recent researches have found that price stability alone as a goal of central
banks might not enough. The pursuit of price stability may not enough for central
bank to maintain financial stability as changes in indicators they look at whensetting monetary goal matters. (William R White, 2006) In some situation, assets
and credit expansion indicates the excessive demand pressure, rather than ingoods and service prices. (Claudio Borio and Philip Lowe, 2002) On the prudentialside, thinking further to address the potential excessive risk accumulation; whileon monetary side, stay alert at the anchor that could detect the financial instability
even if the inflation pressures are not apparent. Hence, the subtle modification ofcurrent policy framework in both the financial and monetary spheres is needed.
(Claudio Borio and William White, 2004) Meanwhile scholars have different
opinion on using housing price as surveillance indicator. The housing price ismainly relevant to countries dominated by a single cosmopolitan area. According
to Stock and Watson’s paper, housing price per se has no stable power to forecast
the economic activity. (Mark Gertler, 2004)
For curbing the boom and burst into a mild range, the previous researches
have already reached some outcomes. The basic principle we learn from thefinancial cycle is to build reserve cushion in doom time and delusion it in bust
period. If policy failed to constrain the boom period sufficiently, they had toaddress the coming balance-sheet imbalance in consequence. (Claudio Borio,2012) The Federal Reserve Bank of Kansas city annual conference held in Jackson
Hole, Wyoming had reached Jackson Hole consensus on the mandate of monetary1policy.1 Unconventional instrument like asset purchasing maybe conducted like a
conventional toolkit in normal times. The pursuit of price stability alone is not
sufficient although it worked well in Great Moderation period. The
macro-prudential policies focusing on the source of irrational exuberance seems
more appropriate. (Charles Bean, Matthias Paustian, Adrian and Tim Taylor, 2010)
On the progress report to G20 regarding the macro-prudential tools andframeworks, three consensuses has been build in framing the whole picture ofmaintaining financial stability. Tools and macro-prudential principle should bepromoted in a common understanding. While each nation has to cooperate with
their own authorities in implementing these toolkits with their local historicalexperiences. (FSB, IMF, BIS, 2011) Above all, the forward-looking financial stability
paradigm is not a generally common but have own freedom to tailor it into eachnation’s own circumstance.

II. The necessity of housing price surveillance in China
Facts in past financial crisis also evidenced the importance of real estatemarket surveillance. The Great Depression in US in 1930s, while inflation is not sosignificant, there is rapid rise in equity and real estate prices. In Japan’s lost
decade, the sharp increase in credit and asset price also explicated the pressure offinancial instability. Asian Financial Crisis in 1990s, the real estate price increaseaccompanied with large amount of capital inflow. In recent Europe crisis, asignificant asset price hike is one of the main features.
Previous researchers have already worked on the relationship between
housing price, credit easing and capital investment. The preliminary statisticalanalysis of credit, asset price and investment indicates that a credit gap and an
asset price gap provide the optimum forward-looking indicators for implementing
forward-looking policy instruments. While investment gap has no significant
improvement in predicting the future instability. (Claudio Borio and Philip Lowe,
2002) They look at three particular combinations among credit, asset prices andinvestment and figure out the optimum threshold and combination. The result
found that a credit gap of 4 percentage points and an asset price gap of 40
percent could be the combined threshold values. (Claudio Borio and Philip Lowe,
2002) Hence, the above results could be used as a reference of calibration to judge
when a forward-looking policy should be conduct. The value needs to be tailoredaccording to each economy’s own practical experience.
In China, take Beijing’s new property price index as an observe indicator, wefound similar trend among real estate price, the credit to private sector increase
1 Charles Bean, Matthias Paustian, Adrian Penalver, Tim Taylor. (2010). Monetary
Policy after the Fall. Federal Reserve Bank of Kansas City Annual Conference.
Jackson Hole, Wyoming.

2

and FDI net capital inflow. In Beijing, the housing price was booming from 1981
until now, as we could see, there is sharp increase since 2001. (See Figure 1)
Although housing reform began from 2005 may speed up the price hike, we could
still see the credit booming and foreign direct investment net inflow raise theirheads as early as 1990s. (See Figure 2) Though in FDI capital inflow chart there
was a trough around year 2008 indicating the global financial crisis, it still
maintains the upward trend after the crisis. (See Figure 3)
Figure 1: Beijing New Resident Property Price Index monthly data
(2007=100, Structures & Land/ m2, non-seasonal adjusted)

Sources: BIS database
Figure 2: Credit to Private Sector in China quarterly data
(1985-2012, billion Yuan, Seasonal Adjusted)

Sources: BIS database3

Figure 3:Foreign Direct Investment Net Inflow in China yearly data
(1982-2011, billion US$, non-seasonal adjusted)

Sources: World Bank database
The data problem could be the major problem for me to verify thatconnection between housing price and its effectiveness as forward-looking
indicators. Due to lack of data and different calibration, we could hardly use
empirical analysis model to testify the contribution of each factor that influenced
the housing price in Beijing. However, by comparing the fluctuation of each chart,
we could tell that the dependent variable----housing price has log-level connection
with independent variables----bank credit to private sector and FDI net capital
inflow. If we need to put the paradigm into practice, more empirical analysis isneeded. The housing price data needs to be well organized and transparent for
further research.

III. The dilemma of conventional policy framework
The weakness of conventional policy framework represents in three aspects:
First, the conventional policy has less toolkits in curbing the upcoming bust. It
only contains monetary policies as well as fiscal policies. Despise the evolving ofmonetary policies has reached far way since the formation of Great Moderation,
the limited instruments and regulation tools have constrained the effectiveness ofthese policies and its scope in preventing significant bust from happening.
Second, the goal of price stability for monetary authority is not enough tomaintain the financial stability. From previous research, except the price stability
we still need more supplementary. Inflation in goods and service sector whichused to be the key anchor for maintaining price stability has disadvantage, since4the assets price has been regarded to be more sensitive in forecasting theupcoming instability. Housing price, which is the main constitutional part of assets
price, is the most superficial and easy to observe indicator for alarming the early
over-heated economy.
Third, the instruments for conducting the monetary and fiscal policies aremainly not so effective in controlling the excessive liquidity. Conventional policy
instruments like interest rate, reserve rate requirement of commercial banks anddiscounting rate of loans from central bank largely influenced by the public’s
expectation of the future. Which means that they are not so effective in tightening
the market when optimistic future assures more risk-taking behavior by the
public. Same mechanism for the fiscal policy instruments, as they are much more
effective for stimulating the market rather than regulating. (Claudio Borio, 2012)
Therefore, the conventional policy instruments need more evolvement or
supplementary to put on regulation perspective.
The dilemma of conventional policy framework is that the policies forstabilizing the liquidity always have lagging effects on the currently hot economy.
First, it takes time for housing price inflation transmits to CPI inflation. The
overheated economy has syndromes like assets bubble, stock hike price etc. Whilethese excessive liquidity pressure might not transmit immediately to the goods
and service sector, which is CPI inflation. The burning housing price stimulates
the profit-seeking (risk-taking) behavior of credit intermediaries, hence induces
more credit liquidity. Also, inflationary expectation will drives FDI and other sorts
of capital inflow more aggressively. Both of the liquidity flooding circles may resultin an irrational exuberance with housing price fever but moderate CPI inflation.
As liquidity continues booming with inflationary expectation cooling down
becomes the worry of over-heated economy, the capital flight and financial
instability may occur.
Second, conventional policy framework anchors on CPI inflation only, hence,
not until there is significant CPI inflation will policy authorities response. This
could be lagging behind the de facto housing price inflation. Boom period coexists
with the assets price inflation; the lagging response of central bank may conduct
the tightening policy to economy when actually a bust has already on the way.
This policy may actually deteriorate the situation of economy and speed itheading to trough. It has a high probability of being wrongly used or has contraryeffectiveness because of the misjudgments. In order to avoid such misjudgments, aforward-looking liquidity stability paradigm should be build to prevent suddenbust of economy.

IV．A forward-looking liquidity stability paradigm in China
The transmission of financial liquidity generally floats from monetary base to5

housing market. (See Figure 4) There are internal sources and external sourcesthat aggregate liquidity. The internal sources mainly from domestic credit
booming by credit intermediaries such as commercial banks; while the externalsources mainly from international capital inflow such as FDI, portfolio investment
etc. These two sources contribute to over liquidity in domestic market, andincrease the monetary base if the currency exchange rate is not resilient inaddressing the appreciation pressure. Without the sterilization from central bankor other authorities, the increase of monetary base could reflect on stock market
and assets price, causing the increase of fixed assets price such as housing price.
(Hiroyuki Taguchi, 2011) This could be more serious if the domestic government
policies mainly targeting on curbing the housing price inflation, as theover-liquidity may find other channels like goods or service sectors to release its
pressure, hence the increase of CPI. (Claudio Borio and Philip Lowe, 2002)
The policy responses to calm down the excessive liquidity and control thefinancial stability could be different according to the reaction of market. First, forthe liquidity sources, there are two corresponding ways for addressing the
problems. For internal sources----the excessive credit booming, macro-prudential
instruments are the optimal choice. The requirement of capital credit ratio could
directly regulate the behavior of commercial banks; meanwhile build the capitalcushion in the boom period. For external sources----the excessive capital inflow, it
is almost impossible to predict the capital flow direction since they are controlled
in the hands of international investors. The uncertainty of capital flight could
create huge damage to the economy, for it had been proved in 1970s Asian
Financial Crisis. Hence, the newly issued instrument----Capital Flow Management(CFM) could be one of the unconventional tools for maintaining financial stabilityin special period. CFM is one measurement that recently proposed by IMF inorder to formulating a framework for the further and maintaining risk-lessliberalization of one economy. It is part of the financial stability framework rather
than merely macroeconomic policies. The aim of CFM is to help recipient
countries better stabilizing its market and liquidity, by coordinating, adjusting andsequencing structure reform in its own pace. Following this step, the liberalization
process would be harmless for the economy, and maximize policy effectiveness ina risk-less gradual procedure. (See Figure 4)
Second, polices compounds should be coordinated to absorb the excessive
liquidity in the market. Especially the macro-prudential monetary instruments
should be considered once the monetary base is detected increased significantly
over certain thresholds. The conventional policy tools could still be effective in
addressing the over liquidity problem in the market. We base on these policies aspillars of forward-looking liquidity stability paradigm with consideration of thepolicy time.
Third, in the real economy sector, a matured surveillance and pre-alarming
framework is always beneficial for transmitting the signal of deteriorate risks in6

real economy sector to policy makers. Since the domestic policy might be usefulfor calming down the market fanaticism, but it may also hurt the confidence ofinvestors and cause the unwanted inflationary expectation. The possible capitalflight by pessimistic inflationary expectation brings more risk to financial stability
and economic development as a whole. Hence, the assets price that has been
regarded as to be more sensitive to stock price, is necessary to be a
supplementary to consumer price for central bank. (Claudio Borio, 2004) The
housing price that occupies the large proportion of assets price is relatively easy
to detect, could be used in build this pre-alarming framework. As it is volatilely byregion, its surveillance should be based on regional aggregation. Central bank in
China, the PBoC, which has branches homogenously in geography, could be theleading authority in building the housing price surveillance and pre-alarming
framework.
One of the critical anchors of central bank that needs to put an eye on is the
inflationary expectation. As we looking back at the sources of excessive liquidity,
one comes from internal sources----the excessive credit booming; the othercomes from external sources----the huge amount of capital inflow, both are
originated from the aggregate demand in the domestic market. The aggregate
demand based from the optimistic view on the economic outlook, which is the
positive inflationary expectation. The positive expectation encouraged risk-taking
from both private sectors and credit intermediaries; hence the behaviors fromtwo sources are strengthened and encouraged. Two liquidity injection circles areformulated. (See Figure 4)
The over-liquidity boom may hardly be detected in its boom period withpositive expectation of future outlook. This could be evidenced from thephenomenon in China that people would rush to buy houses before the domestic
tightening policy issues. The phenomenon could hardly fulfill the assumption of“rational individual” in economic theory. (Shujie Yao, Dan Luo and Lixia Loh ,2011)
The positive expectation will cause irrational exuberance even if the tightening
policy may come out soon. If the positive expectation spoiled the investors’
confidence, that is too say, the market becomes over-heated or show some signsof slow down, then the capital flight may occur, reversing the continuity ofliquidity injection to the market. What policy authority can do when liquidity
supply chain broken is releasing the liquidity in the market, meanwhile
implement CFM instrument to delay or reverse the situation.
The reasons that why aggregate demand shows significantly in housing pricerather than other channels like stock price in China depends on various reasons.
This field calls for further research.

7

Figure 4: A forward-looking liquidity stability paradigm in China
China Banking Regulatory
Committee (CBRC)
Macro-prudential
Instruments

Credit booming

Ministry of Finance (MOF)
Fiscal Policy
Intervention

Excessiveliquidity

Monetary baseincrease

Housing pricesharp increase

Inflationary
expectation

Capital inflow

Capital Flow
Management
CBRC and People’s Bankof China (PBoC)

Monetary Policy
Intervention

Housing Price
Surveillance

PBoC

PBoC

8

V.

The forward-looking liquidity stability policy framework

The forward-looking liquidity stability policy framework has differences withconventional policy framework in general. (See Figure 5) It has three advantages
than conventional policy framework.
First, it combines the macro-prudential policy and CFM instrument into thepolicy compound. Macro-prudential policy aims at regulating the credit
intermediaries; the Basel III mainly constrains the capital capacity of credit easing
institutions. By counter-cyclical leverage tool, they could efficiently build thecapital reserve during the boom period for cushioning further shock to financial
system. To achieve both capital reserve and not impeding the normal operation offinancial institution, these instruments needs thresholds to exert optimum effects.
CFM instrument assists object economy in managing capital inflow and stabilizing
its liquidity flow in a sequential way.
Second, the anchor of policy authority should be changed from mere inflation
to inflationary expectation for forward-looking purpose. The expectation of the
public and investors arrives more prevail than actual inflation become significant
in consumer price level. By assessing the expectation of economy market, theforward-looking policy paradigm could save time for the policy authority insteadof tracking the turning point and responding in the misjudged time, andeffectively curb the peak and trough extension into a mild range.
Third, the asset gap and credit gap have been considered to be complementary
indicators of CPI price, to assess whether forward-looking policies needed to be
implemented or not. The build up of housing price surveillance and pre-alarming
framework could be an efficient transit media between the policy authority andimplicit risk in real economy sector.
Table 1: General comparison between conventional policy framework andforward-looking policy framework
Conventional framework
Forward-looking framework
Macro-prudential Policy
Monetary Policy
Capital Flow Management
Constitution
Fiscal Policy
Monetary Policy
Fiscal Policy
Price Stability
Objective
Price Stability
Financial Stability
Asset Gap
Indicators
CPI
Credit Gap
Free floating foreign exchange
Surveillance on housing priceContext
market9

Figure 5: General comparison between conventional policy framework andforward-looking policy framework
Forward-looking policy framework

Conventional policy framework10VI. Conclusion and aspects that needs attention
The main function of forward-looking liquidity stability paradigm is putting
safety net of financial regulation instruments at their places before the significant
indicator show the sign of over-heating, taking actions based on the performanceof leading indicators to curb the excessive liquidity and risk-taking behavior in
financial system as a whole. By adopting this paradigm, we do not need to wait for
the turning point or significant change in CPI indicator, but surveillance on the
housing price together with other leading indicators and conduct forward-looking
policy instruments with proper jurisdiction, so as to absorb the shock of possible
future bust in economy.
There are several aspects that need attention before we put thisforward-looking liquidity paradigm in China into practice.
First, ensure the coordination between the policy authorities. The liquidity
stability paradigm needs coordination between policy authorities to make surethe policy directions are consistent, so that the policies effects will not becounteract. In forward-looking paradigm in China, CBRC and PBoC, as well as
MOF need to coordinate under one regulation goal to maintain liquidity stability.
Second, set up intermediary financial stability authority that responsible forcommunication between international organization, such as IMF and BIS, WB etc,
and China’s domestic authority. The guideline for maintaining financial stability
from international organizations are general, China has its own unique economic
development situation and regional geography differences, hence theintermediary authority has its function to tailor the international principles into its
own size. Meanwhile, international organizations can also get immediate
feedback directly from this authority. This authority could be one of the mainfunctions within PBoC, for both convenient for accessing the resources in PBoC
and maintain good coordination channel.
Third, more empirical analysis with clean data series is needed. Besides
refining the continuity of data collection from housing market and setting up the
housing price surveillance and pre-alarming framework, more experiences fromlearning, researching and practicing in maintaining liquidity stability are needed.
For example, to conduct a forward-looking policy, PBoC and CBRC needs moreexperience in exploring the thresholds of policy calibration, the extent ofjurisdiction etc. The housing price surveillance can be coordinated within theregional branches of PBoC in China. Thus, it is surveillance on a regional level. The
practical experience for implementing forward-looking policy instruments inspecific city needs long time practice. Hence, both horizontal and verticalcommunications among policy implementers are needed.

11

Acknowledgements
In writing this paper, I would like to express my gratitude to Professor Amaya
Tomoko, University of Tokyo for providing many valuable papers andbibliography books ranging from central banking supervisory to financial stability.
She is my research paper supervisor, who always kindly provides pertinentadvises and tremendous assistant for improving the paper. I am fortunate to havethe opportunity to follow her advice in conducting this research. Meanwhile, I
would like to express my appreciation to Professor Faye who helped me building afoundation on how to write an academic paper in a more professional way, also
thanks for taking his precious time in helping me correct the grammar mistakes.
And teacher’s assistant George Hageman for giving me very helpful comments
and feedback. Thanks IMF for offering me the Japan-IMF Scholarship Program for
Asia (JISPA) to enhance my academic research capability in University of Tokyo inJapan. Thanks graduate school of public policy (GraSPP) MPP/IP program forproviding such a nice study opportunity for international student. Thanks myemployer People’s Bank of China for permitting and supporting me to study here.
Thanks professors in GraSPP for capacity building in these two years. Thanks mycolleagues who burden my work assignments when I am studying abroad. Thanks
my parents and friends’ supporting when I was writing this paper. All errors andomissions are my responsibility.

12References[1] William R White. (2006). Is Price Stability Enough?. BIS Working Papers No 205.
Monetary and Economic Department.
[2] Claudio Borio, Pholip Lowe. (2002). Assets Prices, Financial and Monetary
Stability: Exploring the Nexus. BIS Working Papers No 114. Monetary andEconomic Department.
[3] Claudio Borio, William White. (2004). Whiter Monetary and Financial Stability?
The Implication of Evolving Policy Regimes. BIS Working Papers No147.
Monetary and Economic Department.
[4] Mark Gertler. (2004). Commentary: Whiter Monetary and Financial Stability?
The Implication of Evolving Policy Regimes.
[5] Chair: Guillerm Ortiz. (2004). General Discussion: Whiter Monetary and
Financial Stability? The Implication of Evolving Policy Regimes.
[6] James R. Barth, Tong Li, Wenling Lu, Triphone Phumiwasana, Glenn Yago.
(2009). The Rise and Fall of the U.S. Mortgage and Credit Markets-A
Comprehensive Analysis of the Market Meltdown. Published by John Wiley ^Sons, Inc., Hoboken, New Jersey.
[7] FSB, IMF, BIS. (2011). Macroprudential Policy Tools and Frameworks: Progress
Report to G20.
[8] Claudio Borio. (2012). The Financial Cycle and Macroeconomics: What have welearnt? Monetary and Economic Department. BIS Working Papers No. 395[9] Charles Bean, Matthias Paustian, Adrian Penalver, Tim Taylor. (2010). Monetary
Policy after the Fall. Federal Reserve Bank of Kansas City Annual Conference.
Jackson Hole, Wyoming.
[10] Howard Davis, David Green. (2010). Banking on the Future: The Fall and Riseof Central Banking. Princeton University Press.
[11] Andrew Bailey. (2013) The New Approach to Financial Regulation. Speech at theCharted Banker Dinner, Edinburgh.
[12] Shujie Yao, Dan Luo and Lixiao Loh. (2011) On China’s Monetary Policy andAsset Prices. The University of Nottingham, China Policy Institution Discussion
Paper 71.
[13] Hiroyuki Taguchi. (2011). Capital Inflows and Asset Prices: The Recent
Evidence of Selected East Asian Economies. Policy Research Institute, Ministryof Finance. PRI Discussion Paper Series No. 11A-05.
[14] IMF. (2013). Do Central Bank Policies Since the Crisis Carry Risks to Financial
Stability? Global Financial Stability Report. Chapter 3.
[15] IMF survey online. (2011). IMF Develops Framework to Manage Capital
Inflows. IMF Survey Magazine: In the News.
http://www.imf.org/external/pubs/ft/survey/so/2011/NEW040511B.htm

13