Yi Gang: China's monetary policy framework - supporting the real
economy and striking a balance between internal and external
equilibrium
Lecture by Mr Yi Gang, Governor of the People's Bank of China, at Chang'an Forum, held by the
Chinese Economists 50 Forum, Tsinghua University, Beijing, 13 December 2018.
* * *
It is a great pleasure to attend Chang'an Forum held by the Chinese Economists 50 Forum in
Tsinghua University. The title of my speech today is "China's Monetary Policy Framework:
Supporting the Real Economy and Striking a Balance between Internal and External Equilibrium."
The major task of monetary policy is to support the real economy, and meanwhile China is an
open economy, so we must give consideration to both internal and external equilibrium in
formulating monetary policy. When there are contradictions between internal and external
equilibrium, we need to strike a balance between them. This is the overall framework of my
speech.
My speech is composed of four parts. The first part is an introduction to China's monetary policy
framework, the second part clarifies how monetary policy supports the real economy, the third
part is about how to prevent and resolve financial risks, and the last part focuses on how to strike
a balance between internal and external equilibrium. As we know, the Law of the People's Bank of
China explicitly stipulates that the ultimate goal of China's monetary policy is to maintain currency
stability and thereby facilitating economic growth. To maintain currency stability has two tiers of
meanings: internally it means to maintain prices stable and externally it means to keep RMB
exchange rate basically stable at an adaptive and equilibrium level.
Now I'd like to come to the first part, China's monetary policy framework. As we can see, over the
two decades since the promulgation of the Law of the People's Bank of China, the monetary
policy has been generally successful in maintaining currency stability. Throughout the 40 years
since reform and opening-up, the inflation rate has remained low with the exception of only a few
years. In recent years, the inflation rate has been kept around 2% and 3% on the whole. It was
somewhat high in 1988 and 1994, but that was a long time ago. Deflation risks also occurred
sometime after the year of 1998. In maintaining currency stability, we need not only to prevent
inflation, but also to forestall economic harms caused by deflation. Meanwhile when it comes to
maintaining stable prices, it doesn't mean lower prices are necessarily better. Rather, it is the
concept of stability that should be emphasized.
Maintaining currency stability also involves exchange rate issues. The RMB exchange rates are
the values of RMB quoted against other currencies, which can reflect China's economic strength
and the purchasing power of RMB in the world. We have been doing well in maintaining RMB
exchange rate basically stable at an adaptive and equilibrium level. The single exchange rate
regime of RMB was established in the mid-1990s. Before that, there were both market-based
and official RMB exchange rates. In 1994, the dual exchange rates were unified, and then RMB
exchange rate against US dollar stood at 8.7. Over the past a few decades, RMB has
appreciated against the US dollar and a basket of currencies in terms of both real effective
exchange rate and nominal effective exchange rate, and it has been revalued about 20% against
the US dollar. With RMB exchange rate maintaining basically stable at an adaptive and
equilibrium level, the Chinese people got tangible benefits. By ensuring basic stability of the value
of RMB, we can help promote economic growth, and therby meeting the ultimate goal of
monetary policy specified in the Law of the People's Bank of China.
It is the ultimate goal of monetary policy to maintain currency stability. But how? To this end, we
need to set an intermediate goal. In China, M2 is chosen as the intermediate goal of monetary
policy, as it can be measured and controlled. However, international experiences show that with
an economy becoming more and more developed and market-oriented, the correlation between
M2 and the real economy will decline. Therefore, in 2012 we adopted aggregate financing to the
real economy as a reference indicator, which measures the financing offered by the financial
sector to the real economy, covering loans, bonds, stock, trust, etc.
As the correlation between quantitative indicators and economy gradually declines, the monetary
policies of major developed countries and market economies are principally aimed at regulating
price indicators. Reforms in China were also focused on nurturing a market-based interest rate
system and enhancing a price-oriented regulation and transmission mechanism. What is interest
rate? It is the price of money. We should give the market a decisive role to play in resource
allocation. Then, how does the market allocate resources? It is through prices, which are
determined by the supply-demand relationship.
Money is also a resource, a scarce resource. Hence, the marketization of interest rate is very
important, and the RMB interest rate, which is determined by the supply-demand relationship of
the market, must not be distorted. Only in this way can the resources be allocated in a
marketbased manner. The interest rate shaped by the supply-demand relationship also reflects risk
premium. If your risk is relatively high, then the market will require a higher interest rate. By
contrast, if your risk is relatively low, then your risk premium will be low as well, which enables
you to borrow at a lower interest rate. There is profound knowledge in market allocation of funds.
Regulation tools are necessary in achieving the goal of monetary policy. The tool system of
China's monetary policy is relatively simple. First of all, there is open market operations (OMO)
for injecting or withdrawing liquidity; second, the PBC can adjust money supply with central bank
lending and central bank discount; third, depository financial institutions can be required to park
deposit reserves in the PBC; additionally, we can also supply liquidity to the market with the
medium-term lending facility (MLF), the standing lending facility (SLF) and other tools.
Just now I mentioned marketization of the interest rate. You may have heard a phrase called
"interest rate corridor". The central bank can adjust and control the interest rate between a floor
and a ceiling level, which is called "interest rate corridor". In the times of planned economy, loan
quotas were set and resources allocated through administrative measures. After that,
commercial banks came into existence, the planned economy was replaced by market
economy, and the interest rate determined by market supply and demand came among. At this
point, an important question is, "What is the appropriate level of the interest rate?" We can see
that central banks in various countries all concentrate on the adjustment and control of the
interest rate. The Federal Reserve mainly regulates the federal funds rate by adjusting it to a level
deemed as appropriate, which will then affect the interest rates on deposits, loans and treasury
bonds and thus forming market interest rates.
At present, the focus of China's monetary policy is gradually shifting from quantity control to price
control. You may ask, "currently what is on earth the focus of the PBC, quantity control or price
control?" My answer is, we are in a transition from quantity to price control, and both tools are
employed during this process. Price control has been more important than it used to be, but at
the same time, with the impact of our basis and systems as well as people's thinking pattern,
quantity control is not yet discarded and remains very important. Hence at present, both quantity
and price controls are playing their part.
This figure is an illustration of interest rate corridor. In the corridor an important interest rate is
DR007, namely the seven-day repo rate in the inter-bank market. A repo is a loan secured
against collateral, which is a transaction between institutions. Why is it important? Because it
involves enormous trading volumes and can affect all market interest rates.
As you can see, the red line of DR007 lies between the blue line on the upper side and the green
line on the lower side. The blue line represents the interest rate of SLF and the green one is the
interest rate of excess reserves. The interest rate of excess reserves stands at 0.72% now, so
the market interest rate must be higher. Why? Because as an absolute minimum, you can enjoy
a 0.72% return by putting your money in the central bank, and this is also the safest way to keep
your money - hence this is the lower limit of interest rates. The upper limit is the interest rate of
SLF. When financial institutions run out of money, they can borrow from the central bank via
SLF, and the interest rate is moderately higher than DR007. Why? Because the incentive
mechanism will not work if it is lower than DR007. You can see that the market interest rates
fluctuate between the upper and lower limits. You may consider the figure quite simple; but it is
not easy to establish such a mechanism in the market, nor is it effortless to keep DR007
between the two limits.
Recently there is a buzzword called "macro-prudence." We know that the requirement of
establishing two-pillar regulatory framework of monetary and macro-prudential policies has been
proposed in the report to the 19th National Congress of the CPC. I have just explained the goal,
transmission and tools of monetary policy. Then I'd like to explain what is macro-prudential
policy. It is mainly aimed at ensuring financial stability and forestalling systemic risks and
characterized by counter-cyclical adjustments. The monetary policy can practice both quantity
and price control. Quantity control is a simple tool, as quantity can be specified clearly. However,
it still has drawbacks, and the biggest problem is that the specified or allocated quantities may be
wrong and fail to conform to market conditions. Moreover, the quantities, which are allocated in
Beijing, may go wrong when it comes to provincial, municipal and county levels. Also, problems
like rent-seeking, tunneling and corruption may also arise in the process. Price control sounds
like a fine tool, but sometimes it is not very efficient and may not achieve regulatory goals. Hence
in practice, especially following the global financial crisis, countries around the world have been
increasingly aware of the importance of macro-prudential policy. This is also why we have
decided to establish two-pillar regulatory framework of monetary and macro-prudential policies.
The following four items can give us some direct impression of macro-prudential policies. Firstly,
the PBC has established the macro-prudential assessment (MPA) system to assess whether
financial institutions work in line with macro-prudential requirements. The MPA system contains a
number of indicators, such as capital adequacy ratio and liquidity measures. We all know the
Basel Accords, and Basel III has proposed many requirements centered on capital adequacy
ratio. The MPA system should assess whether commercial banks have satisfied these
requirements.
Secondly, macro-prudential policies shall be in place for cross-border capital flows. Sometimes
the inflow and outflow of capital may cause herd behavior or irrational panics among market
entities. In such a case, we need to consider employing macro-prudential policies.
Thirdly, macro-prudential policies concerning housing finance. For example, we all know there is
down payment ratio of housing loans, and this ratio can be used for counter-cyclical
adjustments. It varies from country to country and from stage to stage in the economic cycle.
Differentiated measures can also be taken for first-time and second-time homebuyers. All these
are effective practices of macro-prudential policies in different countries, and the core is making
counter-cyclical adjustments to protect people and ensure security of financial assets.
Fourthly, we are attempting to practice macro-prudential management over financial
infrastructure. Financial infrastructure, mostly including clearing, payment and trusteeship
systems, also requires macro-prudential mentality in regulation.
The monetary policy includes quantity and price control, and it should be aligned with
macroprudential policy in the regulatory process. As the monetary policy tools and framework are not
enough to ensure stability, macro-prudential policies can be implemented simultaneously to
maintain financial stability and prevent systematic financial risks. The two-pillar regulatory
framework of monetary and macro-prudential policies can provide additional guarantees when
the PBC considers and addresses the overall situation. The National Financial Work Conference
has proposed that the Financial Stability and Development Committee under the State Council
should be established to enhance the PBC's responsibilities concerning macro-prudential
management and systematic risk prevention.
The second part of my lecture is about how monetary policy supports the real economy. I want to
talk about the macro-economic situation and the response of monetary policy. Some basic
judgments are necessary, for example, we need to have a profound understanding of the "new
normal" of the economic development. At present, China's working-age population is decreasing,
and labor shortages begin emerging in some industries. The proportion of the service sector in
the economy is becoming increasingly larger, growing to exceed 50%. Under this circumstance,
China's economy has been transitioning from a phase of rapid growth to a stage of high-quality
development. Hence the economy will not grow at double-digit rates as it used to, which is
associated with our population structure. Currently, our economy is moving toward high-quality
development. China is the second largest economy in the world, with its GDP exceeding USD 12
trillion, which is a large base. Consumption is the major driver of economic growth. Meanwhile,
we have been acting on the understanding that "lucid waters and lush mountains are invaluable
assets" to enhance environmental protection, as evidence by the increasingly harsh
environmental standards imposed on many industries. All these show the necessity to pursue
high-quality economic development. The growth rate may be a bit lower than before, but we will
be able to achieve sustainable development as long as we can ensure high-quality development,
full employment and "lucid waters and lush mountains." By saying these things, hopefully I can
make you understand that while thinking about the monetary policy, we need to take into account
the basic feature of economic development: China's economy is moving towards its goal of
highquality development.
China's economic growth is close to the potential output, which means that the former is actually
approaching the latter. Hence it is safe to say that resource mobilization and economic
mobilization in China are relatively efficient, and our unemployment rate is not high and few
resources are left idle. Meanwhile, China's economic growth remains resilient. Over the past 12
quarters, the economic growth rate has ranged between 6.7% and 6.9%. The overcapacity
problem has been evidently alleviated, and a basic balance has been achieved between the
supply and the demand. As you can see, there is a blue line and a red line in this figure. The blue
line represents the y-o-y growth of manufacturing investment, and the red line stands for the
y-oy growth of the GDP. When the y-o-y growth of manufacturing investment is higher than that of
the GDP, the production capacity is growing. You can see that the blue line lies below the red line
for some time, and this shows that during that period, overcapacity can be alleviated as the
growth of manufacturing investment is relatively slow. This can also be reflected by enterprises'
profit gains: when enterprises secure satisfactory profits, they tend to invest more; and when
they are experiencing profit downturns, they will invest at a slower pace. Private-sector
investment is particularly sensitive.
Overall, China's economic growth is strong, stable and resilient. Recently, the downward
pressure on the economy has mounted, and the growth of off-balance-sheet financing has
slowed down significantly. The blue line and the red line in the figure represent the growth rates
of entrusted loans and trust loans, respectively. As we can see, entrusted loans and trust loans
grew significantly in 2016 and 2017, but the bar chart indicates that both loans have registered a
negative growth since the beginning of this year - which means their increments are
decreasing. The green line stands for the y-o-y growth of infrastructure investment, and it can be
seen that the decreasing growth of off-balance-sheet financing is highly correlated with the
declining growth of infrastructure investment. Infrastructure investment may be partially financed
by entrusted loans and trust loans. Therefore, if financing is cut, the construction of these
projects and programs will slow down.
In response to the changes in economic operation, we have undertaken forward-looking
preemptive adjustments and fine-tuning of the monetary policy this year. The PBC reduced the
required reserve ratio (RRR) four times, which freed RMB 3.65 trillion capital in total, and
unleashed RMB 1.76 trillion of liquidity in the market via the MLF. All these measures were taken
to provide stronger support for the real economy and ease the investment contraction as a result
of economic cycle. Meanwhile, regulatory policies and some other management requirements,
such as the purge of local government debt, can also give rise to investment contraction.
Through RRR cuts and MLF, we can supply liquidity, offset cyclical investment contraction and
ensure the stability of economic operation.
Recently, the difficulties that private enterprises are faced with in securing financing become
more prominent. Here I'd like to present the statistics of credit, bonds and equity. For example,
the loans obtained by private enterprises from the credit market this year has climbed more than
5% from 2017, which is relatively slow. In terms of bonds, this year also saw a decrease in bond
financing of private enterprises, which showcases enterprises' difficulty in securing bond
financing. Equity financing also registered a decline. Meanwhile, some private enterprises have
become bond defaulters. In the first eight months of 2018, there were 22 enterprise bond
defaults, 18 of which were made by private enterprises, involving more than RMB 50 billion.
These statistics show that it is difficult for private enterprises to access financing.
To deal with this problem, the PBC has introduced a policy mix of "three arrows" targeting at
smoothing the three major financing channels I mentioned just now. The first arrow is to enhance
credit support for private enterprises. We work to support commercial banks in issuing loans to
small and micro businesses (SMBs) and private enterprises by increasing the quota of central
bank lending and central bank discount and adjusting the parameters in the MPA system.
The second arrow is aimed at relieving the difficulty faced with private enterprises in issuing
bonds. The tool can serve as a guarantee to enable private enterprises to issue bonds.
Moreover, the negative effects of the three financing channels, i.e. credit, bonds and equity, may
reinforce each other. Why are commercial banks unwilling to purchase bonds issued by private
enterprises? That is because they are worried about possible bond defaults. Commercial banks
will be held accountable if a private enterprise defaults on the bonds they have purchased.
Therefore, people in commercial banks are concerned about the potential risks of private
enterprises. However, if private enterprises cannot issue bonds, they will lose access to liquidity,
which will then lead to credit problems and further undermine commercial banks' willingness to
issue loans. Why? Because commercial banks are aware that such enterprises have run out of
money and have difficulty in loan repayments. As a result, they dare not to lend money to these
enterprises. Hence if enterprises cannot issue bonds, they will not be able to secure loans. To
make matters worse, banks that have issued loans may even accelerate the collection of
payments once they find a private enterprise at fault. As we know, failed bond issuance will
usually be made known to the public. If a listed company fails to issue bonds, the news will be a
blow to its share price. Since many private enterprises use shares as collaterals to borrow
money from banks, it will be harder for them to secure loans when their share prices plunge.
Meanwhile, in this case, commercial banks will ask them to increase collaterals. Therefore, it can
be concluded that the negative effects of the three financing channels can affect and reinforce
each other.
Among the three channels, bonds and equity are more transparent than credit. In terms of loan
issuance, commercial banks and private enterprises need to sign one-to-one agreements, while,
by contrast, the bond and share issuance information of private enterprises is known to the entire
market. So we choose bonds to be the breakthourgh in a bid to address this issue. What we do
is to provide bonds with insurance, so as to help private enterprises issue bonds smoothly. Then
the successful bond issuance becomes a piece of good news. After knowing that bonds have
been issued, commercial banks will understand that the enterprises have secured money and
stop urging them to pay back loans. When the stock market receives the message of bond
issuance, the share price of such enterprises will probably take a favorable turn. This is the
reason why we have decided to choose bond issuance as the breakthrough in easing the
financing difficulty of private enterprises.
The second arrow is the support instrument for bond financing by private enterprises, which is
similar to the credit risk mitigation (CRM) instrument. If you major in finance, you will know a
buzzword called CDS (Credit Default Swap), which refers to the insurance against credit default.
In the 2008 Lehman crisis, the reason why AIG, an American insurance company, collapsed was
that it had issued too many CDSs, and the US Department of the Treasury and the Fed had to
bail it out. Consequently, on the financial market, people may turn pale at the mention of the
CDS. Will issuing too many CDSs lead to new crisis? In terms of this instrument we introduced,
companies issuing CDSs are fairly reliable. At the same time, the design of the entire support
instrument is completely market-oriented, and companies would issue the CDSs and create the
instrument jointly with lead underwriters including commercial banks and securities companies.
Bond buyers can choose whether to buy the CDSs at their own discretion. But with the
insurance, the bonds are exempt from credit risks, which is conducive to bond issuance.
Recently we have successfully issued several dozens of private enterprise bonds with the
volume reaching tens of billions of yuan. Since November this year, the bond issuance of private
enterprises has been restarted. The support instrument for bond financing has raised the credit
of private enterprises and relieved market anxiety over potential defaults by private enterprises.
Some state-owned commercial banks used to be unwilling to buy bonds of private enterprises as
they were anxious about a possible default. Now they can buy with the insurance. For example,
the yield of a private enterprise bond is 7%, and 1% of it is the premium. Then, an investor who
buys this bond can obtain 6% return on the bond and pay 1% for the premium. If the investor is
audacious enough and do not need the insurance, that is also okay. In this case, all of the 7%
yield belongs to the investor as the instrument we designed is optional. You can choose to buy or
not to buy. Whether the bond is issued at the rate of 6% or 7% is completely determined by the
market according to the roadshow bidding and book building. In the past month or so, the lowest
premium was only 40 base points, or 0.4 percentage point, which means that this enterprise had
a high credit level, so its premium was relatively low. In the meanwhile, the premium of some
enterprise was 200 base points, implying relatively high risk of the enterprise. Yet, this enterprise
was willing to issue bonds. Why was that? For instance, the bond is issued at an interest rate of
7.5%, of which 2% is the premium. As a matter of fact, the person who buys this insurance can
still get a return of 5.5%, which is quite satisfactory for commercial banks.
Therefore, the design of this instrument is market-oriented. When designing the policy, we must
take into consideration the decisive role of the market in resource allocation and put power under
control. When does power most probably incur problems? One is when you can decide who can
issue bonds and who cannot. In fact, we cannot determine who can or cannot issue bonds since
the decision should be made by the market. The same case goes with the question of who can
or cannot successfully issue bonds. We have adhered to this principle in the design of this
instrument by requiring that the competent authorities must not be involved in the selection of the
company list. This is aimed at limiting the power. There is no such process as review or approval
and no competent authorities determining who can or cannot issue bonds.
The second is when we price the bond issuance and CRM instruments. What should the interest
rate be? Is it 6%, 7% or 8%? From the perspective of issuers, the lower the interest rate the
better, since they need to pay for interest. Quite the opposite, investors who buy bonds want
higher interest rates so as to secure more returns in this way. But the risk is also higher when
the interest rate goes up. So investors should not only look at the interest rate as once there is
any default, it will be impossible to get their principal back.
Then what is the appropriate level of the interest rate on bonds and the premium? Who should be
the decision maker? The answer is the market. Therefore, relevant authorities should not set the
interest rate or premium. We all know that there should be a lead underwriter to issue bonds, and
it can be a commercial bank or a securities company. After figuring out the financial condition of
the bond-issuing company, the lead underwriter illustrates it to investors through roadshows, and
invites bids and builds up the book before deciding the interest rate on bonds and the premium.
The third arrow is to study and set up the support instrument for equity financing by private
enterprises, in a bid to alleviate equity pledge risks and stabilize and promote equity financing by
private enterprises.
Now I am going to talk about how to support SMBs and private enterprises. There are many
examples at hand, and they are all about how to help these enterprises obtain loans. Let me start
by presenting a macro quantity-related concept. We have conducted a survey on SMB loans in
line with the statistical standards of inclusive finance. By the end of this October, over 16 million
enterprises had been granted loans, and this is a rather big number. You can see media reports
saying that the Chinese economy is pretty vigorous, and mass entrepreneurship and innovation
are prospering. China has a population close to 1.4 billion, but do you know how many
enterprises there are in China? I mean those that have officially registered at the industrial and
commercial administration. The rough number of China's enterprises (including some public
institutions) is 100 million. Currently this number might have exceeded 100 million since it has
been growing very rapidly over the past few years.
Why do I mention this? It is fairly easy to register a company and now the cost is pretty low, but it
is quite difficult for the company to raise funds. The major financing source of start-ups is
relatives as borrowing money from banks or the capital market is very difficult. Moreover, there is
a strict selection process for bank loans. At present, there are a total of 1.35 million SMBs in
China that have secured loans, 11.03 million self-employed businesses with operating loans, and
4.11 million SMB owners with operating loans. These are all among the 100 million companies
mentioned just now. The credit record of companies with loans can be looked up in the credit
reporting system of the PBC. SMBs and self-employed businesses are at a relatively
disadvantaged position. In view of their loan conditions, we should say that the financial support
for them is quite strong.
The average lifespan of China's SMBs is three years. Some achieve success and become big
companies while others disappear soon. The average lifespan of SMBs in the US is eight years,
and that in Japan is twelve years. When can China's SMBs get bank loans for the first time? On
average, four years and four months after their establishment - that is to say, they have to
survive the death phase before getting loans. If they can get their first loans, they have a 75% +
chance to get the second loans. This is the law of finance. What finance does is to guard against
risks by examining whether you have collaterals or not and how big the risk of granting loans to
you is. So we can see such a distribution structure.
Now let us go back to the three numbers I mentioned just now. Why do self-employed
businesses and SMB owners have more loans than SMBs? It is determined by risks. The
registered companies now are companies of limited liability that can go bankrupt. When SMBs
apply for loans, banks need to check whether they have collaterals. Otherwise, banks cannot get
back the principal once such enterprises go broken. This is the reason why, among so many
SMBs in China, only 1.35 million SMBs can secure bank loans as legal persons. Then why are
there so many self-employed businesses that have been granted operating loans? This is
because although they are companies as well, they apply for bank loans in the name of
individuals. If the money is not paid back, their houses and assets bear joint liability, which in
nature is unlimited liability. The situation for SMB owners is similar, as they ask for loans in their
own names and may have used their houses as collaterals. You can learn about the implications
of preventing financial risks. From the perspective of macro economy, as long as a newly
established company can create jobs and produce products, it is good to the society - just as
the saying goes, it doesn't matter if a cat is black or white so long as it catches mice. No matter
the loans are SMB loans, self-employed business loans or SME owner loans, enterprises can
increase employment and boost economic growth as long as the they get loans. Therefore, what
I care about are the loans of this 16 million plus companies, and we should pay attention to the
perspective of inclusive finance in this sense.
With respect to changes in the external environment, the real economy has been impacted by
some external shocks. These shocks might be trade frictions or other market turbulances, which
have indeed exerted some impacts. In this process, expectation guidance should be enhanced.
And we should particularly be alert that risks can transmit across different markets, like the risk
transmission among the bond market, the foreign exchange market and the stock market. In the
meantime, the monetary policy and macro-prudential policy should be utilized in maintaining
market stability.
The monetary policy pays special attention to market liquidity, and one indicator is DR007. This
year, the terminal DR007 dropped from 2.8% in the first half of the year to 2.6%, and China's
10year treasury bond yield also fell from around 4% at the beginning of this year to around 3.3% at
present. This is the effect of the prudent and neutral monetary policy, reflecting its support for the
real economy. It is safe to say that the financing and interest rate conditions are more relaxed,
which can partly ease the problem of enterprises being unable to access loans or having to pay
high interest to secure loans.
Looking at aggregate indicators, we just released the growth rates of the M2 money supply and
aggregate financing. Currently, M2 grows at a rate of 8%, and aggregate financing around 10%,
matching the g