Hu Xiaolian: Exchange rate regime reform and monetary policy
effectiveness
Article by Ms Hu Xiaolian, Deputy Governor of the People's Bank of China, Beijing,
26 July 2010.
* * *
The Chinese economy is growing rapidly, and is becoming increasingly market-based and
more open. As a result, China needs to deal with a much more complicated economic
situation. In this context, the ability to conduct macroeconomic management is critical for
ensuring sound, rapid and sustainable growth, and the effectiveness of monetary policy has
also taken on greater importance. At the current stage of development, China needs to
employ monetary policy to accommodate four broad objectives, i.e., price stability, growth,
full employment and balanced BOP account. Exchange rate policy has played a role in
achieving these macroeconomic objectives. It also has an impact on China's
competitiveness, trade relations and resources allocation. Therefore, improving the managed
floating exchange rate regime and gradually enhancing exchange rate flexibility will help
make monetary policy more flexible and effective, and strengthen the ability to conduct
macroeconomic management.
I. Monetary policy is an important means of macroeconomic management in
China
Monetary policy is one of the important means through which China manages the economy.
Its effect is transmitted through the financial system, the core of a modern economy. The
effect of monetary policy is not limited to one sector or one area. More broadly, it is felt in
every part of the economy and affects individual economic behaviors at the micro-level. In
this sense, monetary policy carries more system-wide implications and is more systemically
important than exchange rate target. Monetary policy flexibility and effectiveness are
particularly important under China's unique circumstances. As a big developing country
undergoing reform and transition, China has to deal with complicated and rapidly changing
economic situation, and its macroeconomic policies are therefore designed to meet multiple
objectives, such as reform and development. More specifically, monetary policy also has
various objectives, including managing inflation, supporting growth, promoting a balanced
BOP account, boosting employment and facilitating financial reform. This fact highlights the
importance of making flexible and effective monetary policies.
The Chinese economy was put under critical test since the global financial crisis began to
unfold in the second half of 2008. To deal with the extremely complicated situation both at
home and abroad, the Chinese government implemented a proactive fiscal policy and
relatively easy monetary policy, and adopted a comprehensive policy package. The economy
was among the first to recover in the world. In response to the rapidly changing situation, the
Chinese government decided to focus on making substantial progress in shifting the
development pattern, and make sure that progress in this front is in line with the objective of
supporting sound and rapid economic development, so that the two facilitate and reinforce
each other. Recently, in parallel with rapid recovery, China observed a rapid increase in
foreign exchange inflows and a substantial rise in liquidity, which remains abundant despite
of vigorous sterilization efforts. This leads to potential risks of heightening inflation
expectation and asset speculation. In this context, economic policy makers need to carefully
balance the relations between supporting sound and rapid growth, restructuring the
economy, and managing inflationary expectation.
Historical experiences from many countries show that inflation and inflation management is
not only an important topic in the study of economics, but also a key issue that affects social
and political stability. Inflation, as put by Milton Friedman, the Nobel laureate in economics, is
a dangerous disease that can be fatal and destroy the whole society if unchecked. In China,
it is the low-income groups, especially over 40 million urban low-income groups and nearly
100 million migrant workers that will be hit the hardest by inflation. Any mismanagement in
this issue would undermine social justice and stability. For the central bank, this means it
should take preserving the value of domestic currency as the primary responsibility and
prevent risks of high inflation. As monetary policy proves to be the most important and
effective tool in managing inflation, the central bank should enhance the effectiveness of
monetary policy to ensure price stability and, by doing so, promote economic growth.
II. Monetary policy effectiveness has faced challenges in recent years
The independence and effectiveness of China's monetary policy has met with serious
challenges from rapid expansion of RMB supply as a result of foreign exchange purchase.
Prior to 1993, China ran current account surplus and capital and financial account surplus on
an alternate basis. The situation changed in 1994 when China began to have twin surplus,
and intensified following China's accession to the WTO in 2001, as current account surplus
widened markedly and became the major contributor to BOP surplus. In the context of
relatively stable exchange rate, the expansion of BOP surplus and inflow of foreign exchange
forced the PBC to passively inject base money via foreign exchange purchase.
In recent years, the PBC has strengthened the capability of macroeconomic management
according to the overall arrangements of the central government in line with the country's
development strategy. In response to changes in economic and financial circumstances and
foreign exchange flows both at home and abroad, management of the banking sector
liquidity has become an important part in the PBC's monetary policy conduct. Instruments
such as open market operations and reserve requirement ratio have been adopted to
sterilize the growth of RMB supply as a result of foreign exchange purchase, and to absorb
excessive liquidity in the banking system. Nevertheless, the root cause of the liquidity
problem has not been solved. The RMB equivalent to foreign exchange purchase has
become the major source of base money supply while central bank lending to financial
institutions accounts for a smaller share. This undermines the independence of monetary
policy and makes money supply a more endogenous factor. In recent years, though CPI has
remained basically stable at a fairly low level, broad price levels such as PPI and asset
prices such as housing prices have increased significantly. Moreover, the issuance of central
bank bills and the frequent adjustments of reserve requirement ratio in the banking system
have also affected the operational behaviour of commercial banks and even the efficiency of
the financial system. The sterilization cost for the central bank has also been on a rise.
III. A more flexible exchange regime helps enhance the effectiveness of monetary
policy
According to the argument of Impossible Trinity, capital and financial account convertibility,
independent monetary policy and exchange rate stability cannot be achieved at the same
time. It is feasible for a small and open economy to pursue exchange rate objectives at the
expense of monetary policy independence. The Hong Kong SAR is such an example by
adopting a currency board system, where the Hong Kong dollar is strictly pegged to the U.S.
dollar and the Hong Kong Monetary Authority follows the Federal Reserve in its adjustment
of Hong Kong dollar interest rates. As for Singapore, exchange rate instruments, rather than
interest rates, are used more frequently in macroeconomic management, as exchange rate is
taken as the intermediate monetary policy target. China is not a small economy. With a
population of 1.3 billion, China cannot afford to lose monetary policy independence and
subject itself to economic policies of other countries. Adopting a more flexible exchange rate
regime serves China's long-term interests as the benefits of long-term price stability and
economic restructuring far exceed the cost in reorganizing certain industries and removing
outdated capacities.
At present, a more flexible exchange rate regime will help curb inflation and asset bubbles.
When domestic inflationary pressures are heightened, a stronger domestic currency will help
bring down the price of imports. The role played by exchange rate in easing imported
inflationary pressures is particularly important for a country like China that has a robust
demand to import primary products due to unfavorable resource endowment.
Economic restructuring and growth pattern upgrade, as urgent tasks of strategic importance,
cannot be accomplished without persevering efforts. When doing so, it is desirable for China
to seek more balanced trade development. Price tools such as exchange rate can be
adopted to adjust trade and BOP imbalances. This will help ease pressure of inflows of
foreign exchange and rapid build-up of reserves, promote sound and sustainable
development, and realize stable and orderly growth of money supply.
According to international experiences, a flexible exchange rate regime helps mitigate
impacts of external shocks and enhance macroeconomic resilience. Financial crises in the
1990s have shown that a rigid exchange rate regime is vulnerable to speculation and may
even trigger self-fulfilling currency crisis.
Stronger exchange rate flexibility also helps improve the transmission mechanism of
monetary policy. Since 2005, the RMB exchange rate regime reform that has progressed in a
self-initiated, gradual and controllable manner has enhanced market players' awareness to
adapt to exchange rate movements and made them more responsive to market changes.
The money market and foreign exchange market have developed both in breadth and in
depth. Adapting to more flexible exchange rate, financial institutions have strengthened risk
management, improved financial services and come up with more product innovation. These
have helped improve the transmission of monetary policy at the micro and market levels and
played a positive role in enhancing the effectiveness of monetary policy.