This book seeks to explain the transformation of Chinese monetary policy in the years before 2008: specifically, why it became increasingly reliant on direct banking controls in the 2000s in spite of intentions to rely more on market instruments after 1998.
In the mid-2010s, the Peopleās Bank of China (PBC) was announcing moves towards āmarket based policyā. A milestone was reached in October 2015 when the PBC removed the ceiling on bank demand and short-term deposit interest ratesāthe last remaining limit on bank rates. Deputy Governor Yi Gang presented this liberalisation as providing ābasic conditions for transforming the monetary policy frameworkā¦ facilitating the transition towards price-based instrumentsā (Yi 2015). Policy would rely more on targeting short- and medium-term interest rates in the interbank market and deregulation of retail rates was necessary to improve transmission out into credit markets. Policy was reaching a ānew normalā, which would be more like the Westās normal (Deng and Chen 2016; Shevlin 2017; Liu et al. 2017, pp. 1ā2; Wang and Mao 2016; Allen et al. 2018, pp. 445ā446).
Open market operations had been part of the toolkit in the previous decade, but policy had largely depended on direct controls over commercial banks in tightening policy between 2002 and 2008. Authorities administered deposit and loan interest rates, frequently adjusted reserve requirements, imposed lending limits and issued directives. It would be easy to take a Whig view of the shift to liberalisation: Chinese policy is ānormalisingā as authorities shrug off the statist legacy of central planning and move towards an international policy consensus. This fits a familiar story about Chinese economic reform, of tension between ideology and economic rationality: reformers promote rational market-based policy; they are sometimes in the ascendant within the Party and bureaucracy, and sometimes not, but the arc of history bends towards reform.
In this book, we take a different view. The bank-control-based policy framework of the 2000s was not an archaic remnant of planning, but deliberately built in response to financial and macroeconomic conditions, under the influence of the Western ānew macroeconomic consensusā. To understand the transformation of Chinese policy in the 2000s, we need to understand the institutional and market structure of the countryās financial system. Chinese policymakers were pragmatic above all. We understand the evolution of their strategy better by looking in some detail at the nature of the system in which they acted.
The notion that policy change has been driven by an ideological shift from ācontrolsā to āmarketsā is misleading. First, the control/market distinction is too blunt. Chinese authorities have tried to increase their reliance on market instruments, primarily because these promised tighter and more flexible policy influence over the financial system.1 But their effectiveness depended on certain institutional features of interbank markets, which had to be deliberately promoted by the state, as well as the continued and sometimes intensified use of controls. Controls were not an alternative to market-based policy, but an essential condition of them. This is the case in the West as much as in China, but we often take for granted the regulatory structure underpinning ānormalā banking and financial markets.
Second, policymakers could not simply choose to rely on market instruments. Flexible and effective open market operations depend on (1) adequately deep interbank markets; and (2) the dependence of banks on those markets for their liquidity management. These are things we often simply assume in discussing monetary policy, but they cannot be assumed in Chinaās case. Interbank markets had to be actively fostered by policymakers in the period we discuss.
We focus on the decade leading up to the turning point of 2008. This period has been overshadowed by what came later: the enormous stimulus in response to the international financial crisis of 2008, the reforms of the 2010s and the reckoning with āshadow bankingā. But the decade between the Asian financial crisis and the global crisis of 2008 is critical to understanding the shape of Chinese monetary policy today.
The āold normalā Chinese monetary policy framework of the 2000s was already the result of a radical transformation under the influence of Western norms. Ideologically, the reforms of the late 1990s involved an enthusiastic adoption of many aspects of international consensus macroeconomic thinking, especially the prioritisation of price stability. But under the macroeconomic conditions of the 2000s, and given the institutional structure of the Chinese financial system, the pursuit of price stability actually led policy to rely more heavily on direct bank controls, reversing an earlier intention to abandon credit targets and rely on market-oriented instruments in the interbank market. This was not because Chinese policymakers had ideological objections to the international macroeconomic consensus, but because certain features of the Chinese interbank market left it unable to play its role as the main venue of policy. The interbank market was new and underdeveloped, and the central bank had trouble draining a structural surplus of reserves which left the banking system unconstrained by liquidity.
The turn to tighter direct bank controls at mid-decade had a further consequence, which has left a lasting mark on the Chinese financial system: it fed the growth of āshadow bankingā practices which evaded lending controls in various ways. In 2002, bank lending accounted for 95.5% of net new financing to firms and households. By 2008, its share had fallen to 73%.2 With more financing routing around controls, bank regulation could not remain the lynchpin of policy restraint forever. The outbreak of financial crisis in the United States and Europe in 2008 led Chinese policy to reverse into looseness anyway, leaving this question for the future. But in retrospect, we can see the pre-2008 decade as critical, as controls both helped to foster an interbank market in which policy could be effective, and also promoted the growth of instruments and practices that avoided those controls.
Two norms marked the international ānew consensusā on monetary policy that developed in the 1980s and 1990s (Arestis 2007; Arestis and Sawyer 2008; Bofinger 2001): (1) the proper target of monetary policy is low and stable inflation; and (2) the target should be pursued with market-based instruments, specifically by targeting a key short-term interest rate through open market operations and standing facilities. Chinese policy joined this consensus on ends, but departed from it on means.
The PBC had once been tasked with a number of goalsāincluding management of the monetary aspects of central planningābut in the course of the 1990s Party and law increasingly committed it to put currency stability first. Inflation in the 1980s had fed the unrest culminating in the debacle in Tiananmen Square (Naughton 2007, pp. 98ā99), and a further wave of high inflation in the mid-1990s strengthened the position of those in the bureaucracy pushing for monetary discipline. The 1995 Central Bank Law stated the aim of monetary policy as āto maintain the stability of the value of currency and thereby promote economic growthā. That p...