Wu Xiaolin: China's monetary and interest rate policy in year 2004
Speech by Miss Wu Xiaolin, Deputy Governor of the People's Bank of China, at the Forum of Financial
Opening and Commercial Bank Reform of China, Beijing, 17 April 2004.
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The 3rd Plenum of the 16th CPC National Congress calls for deepening financial reform through
pushing forward financial institutions reform and improving financial supervisory and regulatory
regime. Commercial bank reform, one important component of financial reform, is inseparable from the
improvement of financial regulatory regime, which will not only lay the foundation for commercial bank
reform, but also intensify the requirements for the operation and management of commercial banks.
Given current economic and financial situation, central bank's monetary policy stance in year 2004 is
to rein in excessive money and credit growth, avoid excessive volatility of interest rates and accelerate
interest rate liberalization. Next, I would like to focus on China's Monetary and Interest Rate Policy in
Year 2004.
I. Monetary policy targets in 2004
We expect to keep the M2 and M1 growth rates at around 17%, new RMB lending around
RMB 2.6 trillion yuan, and CPI around 3%. The ultimate objective of our monetary policy is to maintain
balanced economic growth. Large population and comparatively insufficient resources in China pose
constraints on economic growth. Therefore, the economy should be developed in a pragmatic,
coordinated and balanced way. According to the 7% growth rate target for 2004 set by the Central
Committee, and considering that money supply growth and new lending in 2004 should be lower than
those in previous year due to the time lag of excessive credit growth in 2003, we decided on the
aforementioned monetary policy targets. With appropriate macroeconomic adjustment and regulation,
the CPI in year 2004 is expected to be kept at around 3%. To be more specific, hangover effect may
contribute 2.2 pp to CPI, new inflation factors and price adjustment policies contribute 1 pp. Combined
with other non-quantifiable upward price pressure, the CPI growth rate could maintain at around 3% if
macroeconomic adjustment measures gradually take effect.
Given that China's economy, in recent years, has been in the process of transition and integration into
the world economy, the correlations among economic variables kept changing; hence the selection of
intermediate monetary policy targets provoked debate in academia. Before any clear conclusion is
reached, we have to make the intermediate targets a synthetic target, focusing on M2 and credit scale
while considering money market rates.
II. Apply various monetary policy instruments in a flexible manner to reach monetary
policy targets
China's economy, currently right in the transition period, is not comparable to command or developed
market economy. The complexity of macroeconomic development poses challenges to monetary
policy. In this connection, only if we utilize various monetary policy instruments in a flexible manner,
can we reach the monetary policy targets. At present, the major monetary policy instruments include:
open market operation, reserve requirement, interest rate policy, re-lending and rediscount, and credit
policy.
i. Sterilize excessive forex position through open market operation while maintaining
sufficient liquidity in the market
Over the past two years, China's foreign exchange reserve has grown fast, leading to substantial
increase in base money injection as a result of Forex purchase. In line with the overall money and
credit plan, the People's Bank of China (PBC) has maintained the stable growth of base money
through open market operation. Since 22nd April 2004, the central bank has intensified currency
withdraw from circulation through issuing central bank bills. By the end of 2003, the central bank has
made 63 issues of central bank bills, with a total issuance amount of RMB 722.68 billion yuan, and
outstanding amount of RMB 337.68 billion yuan. In 2003, base money injection as a result of Forex
purchase added up to RMB 1,145.9 billion yuan, while open market operation withdrew
RMB 269.4 billion yuan base money, resulting in a net base money injection of RMB 876.5 billion
yuan.
At the same time, the PBC has provided sufficient liquidity to financial institutions through flexible
market operation. At the end of last August, the IPO of Huaxia Bank led to relatively large liquidity
shortage in the commercial banks. Under such circumstance, the PBC, on August 26 and
September 2nd, 2003, twice reduced the issuance scale of 3-month central bank bills and injected
liquidity to commercial banks through 7-day reverse repo transaction; At the time of Changjiang Power
IPO on November 11 last year, the PBC again conducted 7-day reserve repo transaction. Under the
guidance of open market operation, the 7-day repo rates, typical inter-bank interest ratea, have
remained stable at around 2.15% despite of the liquidity fluctuations resulted from IPOs, which
indicates that open market operation has reached expected target.
Given sufficient liquidity of financial institutions and falling trend of money market rates during the first
quarter of this year, the PBC intensified sterilization operation. In this period, the cumulative amount of
central bill issuance reached RMB 435.2 billion yuan and outstanding amount stood at
RMB 615.45 billion yuan; Base money injection as a result of Forex purchase amounted to
RMB 291.6 billion yuan, and open market operation withdrew RMB 281 billion yuan, resulting in a net
base money injection of RMB 10.6 billion yuan and basically offsetting the Forex position of base
money.
ii. Use reserve requirement policy in a flexible way to lower the cost of currency
withdraw and improve the operation of commercial banks
In order to rein in the obviously excessive credit growth, the PBC raised the required reserve ratio by
one pp on September 21, 2003. Traditional Money and Banking theories regard required reserve ratio
hike as a relatively drastic measure, nevertheless the central bank interpreted it as a mild move. The
major reason is that the central bank has to withdraw a large amount of excess liquidity because of
fast growth of foreign exchange reserves, To do so, if the central bank only issue CB bills without any
other measure, it has to raise the interest rates on CB bills to a very high level given strong economic
expansion momentum and commercial banks' wide interest rate differentials which is larger than the
returns on CB bills, however, high interest rate would have significant implications on the economy. In
contrast, the 1 pp rise of required reserve ratio enabled the central bank to reduced at a lower cost the
commercial banks' excess reserve by around RMB150 billion yuan, accounting for only 6% of their
holdings of treasury bills, financial bonds and CB bills. Therefore, the required reserve ratio hike is
actually a mild policy measure. Moreover, the policy was announced one month in advance, giving
sufficient time for financial institutions to manage their liquidity. The PBC also provided timely support
to those financial institutions with short-term liquidity difficulties, so as to maintain the overall stable
developments of financial operation and money market interest rates.
With the approval of the State Council, the PBC announced on March 25, 2004 that the required
reserve ratio for financial institutions with capital adequacy ratio below a specific level would rise
0.5 pp to 7.5%, while the ratio for other financial institutions remained unchanged. State-owned
commercial banks, urban and rural credit cooperatives were exempt from the differentiated required
reserve ratio policy. On April 11, 2004, the PBC announced again that the required reserve ratio for all
financial institutions except from urban and rural credit cooperatives would rise 0.5 pp since April 25,
2004.
The differentiated required reserve ratio scheme is both a transitional policy in line with China's current
financial system, and an innovation based on the original purpose of required reserve ratio policy, i.e.
to ensure the payment and settlement of commercial banks, and to prevent over-lending by financial
institutions attracted to favorable loan terms which may undermine their liquidity and payment
capacity. The required reserve ratio policy then gradually evolved into a monetary policy instrument,
and the deposit insurance regime combined with supervision on capital adequacy ratio started to
replace it as policy tools to impose prompt corrective actions on financial institutions based on different
risk profiles. Given the fact that China has yet to establish deposit insurance system, and quite a
number of financial institutions failed to reach the 8% capital adequacy ratio, the differentiated required
reserve ratio scheme is conducive to curb excessive credit expansion of the financial institutions with
low capital adequacy ratio and poor asset quality, and to prevent the one-size-fits-all approach in
macro financial adjustment and regulation.
iii. Utilize other monetary policy instruments
At the same time, the PBC will strengthen credit management by rigorously curbing loans to
overinvested industries, and keeping the proportion of medium and long term loans at reasonable level.
The PBC will also endeavor to adjust loan structure, urge financial institutions to implement credit
policy, promote financial ecological development, enhance re-lending and rediscount management,
continue to improve financial service to rural economy, and further promote inter-bank market
development.
III. The priority of China's current interest rate policy is to enhance institutional reform so
as to facilitate monetary policy transmission mechanism
In a market economy, interest rate policy is conducted through adjusting interest rates to influence
market financing costs and signal the central bank's judgment on economic development and liquidity
position. In the games between central bank and the public, the signal effect is bigger than financing
cost.
i. Adjust interest rates flexibly on the condition of maintaining both internal and external
equilibrium
Since September 2003, the Year-on-Year (YOY) consumption price level has grown fast to 3.2% at
the end of December, implying increasing inflation pressure. From January to March 2004, the YOY
CPI rose 3.2%, 2.1%, and 3.1% respectively and month-to-month (MOM) rose 1.1%, -0.2% and 0.3%
respectively. The CPI in the first half of this year may continue to rise, but current one-year loan rate is
only 5.31%. If real loan rates fall negative at some point of time, the behavior of economic agents will
be distorted. The enterprises will accumulate raw materials because they can make profits simply by
borrowing, thus aggravating raw material shortage, pushing price level further up and leading funds to
circulate in retailing rather than be invested in manufacturing. Therefore, price level is one indicator the
central bank must closely monitor when considering interest rate policy.
In addition, the central bank must also take into account the issue of Forex arbitrage. Over the past
two years, capital inflows have led to substantial rise in Forex position. The amount of capital inflow is
directly linked to domestic and foreign interest rate differentials. Currently the one-year domestic RMB
deposit rate is 1.98%, 1.4 pp higher than the 0.5625% one-year domestic USD deposit rate and
0.92 pp higher than the 1.06% one-year US CD rate. In this connection, we must flexibly adjust
interest rates on the condition of maintaining both internal and external equilibrium.
ii. Establish floating benchmark interest rate regime and signal to the public in a timely
manner
With the approval of the State Council, the PBC decided to adopt floating relending rate regime.
Relendings refers to the loans central bank grants to financial institutions. Floating relending rate
regime means that the PBC, according to macroeconomic and financial situation, can set and
announce the extent by which the relending rates move above benchmark rates within the fluctuation
band authorized by the State Council. Effective on March 25, 2004, the rates on one-year-or-less
liquidity relendings rose by 0.63 pp from existing benchmark level. In order to support agricultural
development, floating relending rate regime for rural credit cooperatives will be implemented gradually
in three years, and three years later, the rate increments for RCCs will be half those for other financial
institutions.
The adoption of floating relending rate regime is another important step toward interest rate
liberalization. It helps not only improve interest rate formation mechanism and the central bank's
capability of guiding market rates, but also upgrade the effectiveness and transparency of relending
management.
iii. Change the ways of resetting loan rates to guide commercial banks to enhance risk
management and make positive reaction to the interest rate changes by central bank
With the approval of the State Council, the PBC changed the way of resetting loan rates. Effective on
January 1st, 2004, the ways of resetting loan (excluding household mortgages) rates are determined
by borrowers and lenders through negotiation. The frequency of resetting rates on medium and long
term RMB loans, previously once a year and now determined by borrowers and lenders, can be
monthly, quarterly, annual, or fixed. This policy move has corrected the asymmetry between fixed
deposit rates and annually changed loan rates. Consequently, commercial banks can determine the
way of resetting loan rates according to customer's credit rating, and flexibly design loan products.
Also, shortened resetting intervals help commercial banks spot problems the customer's solvency
problem. In addition, when central bank changes benchmark rates, commercial banks can promptly
adjust loan rates based on lending agreement, thus mitigating interest rate risk, facilitating the
transmission of monetary policy to manufacturing and consumption. The change of loan rates resetting
policy forced commercial banks to establish offer system, to factor in credit risk and interest risk when
estimating profits, and to set up internal transfer pricing mechanism.
iv. Speed up the adoption of loan rate floor and deposit rate ceiling policy and urge
commercial banks to improve asset/liability management (ALM)
With the control of lending scale and deposit/lending rates, the commercial banks' ALM only focuses
on the ratio of deposit to lendings. Interest rate liberalization, nevertheless, requires commercial banks
to focus on interest rate risk and capital adequacy ratio.
(i) Loan rates floor management
Loan rate floor management calls for commercial banks to adjust asset structure with risk pricing.
According to a survey on September 2002, less than half of the outstanding commercial bank lendings
are fixed rate, while in stock-holding commercial banks, the percentage of fixed rate loans is only 36%.
Since the 0.9-1.7 pp floating range has basically liberalized the lending rates, commercial banks must
learn how to price risk.
Loan pricing must take into account such factors as fund cost, direct and indirect costs, loan taxation
cost, loan maturity, loan risk and target profit.
Fund cost rate refers to the cost for commercial banks to obtain fund in the market with similar maturity
and cash flows as the loan extended to clients, i.e. the internal transfer price of the loan. Direct costs,
including all costs related to loan product and client services, can be derived from direct cost rate
using activity-based-cost (ABC) or average-cost method. Indirect costs, generated from operations
other than loan activities, can be calculated using average-cost method. Because the calculation of
direct and indirect costs both use historical data, the data must be updated regularly so as to ensure
its effectiveness and applicability. In China, taxation cost rate is the operating tax rate plus added cost
per loan. Credit risk premium is used to cover expected loan loss and the expected loan loss rate
equals default rate multiplied by loan loss rate. To estimate loan loss, commercial banks must set up
internal rating modes. The longer the loan's maturity, the higher the lendings rate. The logic behind is
that longer maturity means longer financing period, consequently higher financing cost and greater
possibility of changing cost, therefore, the loan rates should rise accordingly. Target profit can be
estimated using return on capital and the ratio of capital to lending.
At present, loan pricing is one weakness of our commercial banks, because in the past they didn't
have much chance to do it due to interest rate control. In the process of interest rate liberalization in
coming years, commercial banks need step up efforts in pricing product, accumulate experience and
basic data, and strengthen international competitiveness.
(ii) Deposit rate ceiling management
Deposit rate ceiling management requires commercial banks to actively adjust their liability scale and
structure, and adapt themselves to capital adequacy ratio management.
Western commercial banking management theories have evolved from asset management, to liability
management, finally to asset/liability management. Liability management originated at the end of
the1960's, when high inflation and sharp and unexpected interest rate hike, combined with rigorous
interest rate control in many countries, led to disintermediation and fund shortage in commercial
banks. Commercial banks then had to attach great importance to liability management and attract fund
back into commercial banks through innovation.
However, China's liability management originated in a very different backdrop. In China, funds and
risks are over-concentrated in banks while capital adequacy ratio of most commercial banks are low.
To meet capital adequacy ratio requirements, commercial banks must reduce either asset or liability.
With deposit rate ceiling policy, commercial banks can tailor deposit price to specific situation.
Commercial banks with low capital adequacy ratio can reduce deposit by lowering deposit rates so as
to mitigate the pressure of excessively expanding loans to avoid loss due to large liability. Therefore,
deposit rate ceiling policy not only helps rein in excessive credit growth and mitigate inflation pressure
and non-performing loan risks, but also guide funds into capital market to promote capital market
development.
v. Actively push forward financial derivatives transaction with a purpose of providing
commercial banks and customers with hedging instruments during interest
liberalization.
Both financial institutions and their customers need instruments to hedge interest rate risks after
interest rates are liberalized. In fact, according to option-pricing theory, financial institutions, even
without derivatives, can use basic instruments to create transactions with the same nature as
derivatives to hedge risks. But the pitfall is its relatively high cost and risk. Derivative hedging is
costeffective and convenient, but risky due to high leverage, which was reflected to some extent in the
meltdown of Barrings and LTCM. In this regard, we will enhance the internal control of financial
institutions before pushing forward derivative transactions and finally provide commercial banks and
customers with hedging instruments.
With the approaching of fully opening up of China's banking sector, commercial bank reform is urgent.
I believe that, with clear policy and development direction set by Central Committee and State Council
and more favorable reform environment, commercial bank reform will proceed successfully through
joint efforts by all staff in banking sector.