The Monetary System Reforms into a price-based System
Currently,China is putting in place measures to transform its monetary systemto embrace an indirect approach based on open market operations.Direct control measures dominate the current monetary system makingit inefficient. In its current state, the monetary policy is equal toa transitional system (HeDong et al., 24).Quantity-based control measures are the most prominent under thetransitional system. The monetary control measures include benchmarklending, credit, and money growth targets, deposit rates and windowguidance. These transitional control measures are expected to giveway to an indirect system, which is based on open market activities.Additionally, the measures are providing a foundation for thedevelopment of an active bond market (HeDong et al., 27).
Theliberalization of interest rates is a critical aspect of the monetaryreform in China. One aspect of the monetary reform is the lifting ofadministrative guidelines imposed by the Chinese authorities. Thishas led to the ratification of deposit rate ceilings as well aslending rate floors (Shih,438).The main reason for the liberalization of interest rates is toenhance the efficiency of capital allocation as well the developmentof better risk pricing. These efficiencies are meant to enhanceeffective monetary policy transmissions because of the presence ofclear monetary channels. The control of retail interest rates wascounter effective since it created an obstacle for the Central Bankto effect its policies through open market operations. Additionally,the controls hindered financial analysts from using market interestrates to serve as the benchmark for pricing other financial assets(HeDong et al., 32).
ThePBoC intends to enhance the effectiveness of the monetary policytransmission by developing deeper bond markets. The deep bond marketswill enable policy short-term interest rates to be effective. In thisregard, the PBoC is encouraging the uptake of treasury bonds,corporate bonds and commercial bank papers (Shih,103).In June 2012, the PBoC created a high-yield bond market, whichtargeted mainly the domestic enterprises. The market allows smallfirms not listed in the stock market to participate in the bondactivities. The aim of this move is to reduce the dominance ofgovernment bodies/institutions in the bond market. The Chineseauthorities have liberalized interbank rates and interest rates inthese markets. This has allowed the rates to move flexibly, henceclearing the market for borrowing and lending reserves. In thischangeover period, the PBoC relies on price-based tools. Inparticular, it aims to utilize market-based tools by conducting openmarket operations. Additionally, it aims to establish the ShanghaiInterbank Offered Rate (SHIBOR) as the baseline/benchmark for allasset pricings (ChengHoon, et al., 85).
Themonetary reform aims to foster inclusive and stable economic growth,safeguard the country’s financial stability and facilitate internalrebalancing. In recent years, the People’s Bank of China hasreplaced credit rationing with money growth as the main monetarypolicy intermediate target. It sets the targets for year-on-yearmoney supply and bank credit growth rates that are deemed consistentwith the policy objectives of the regulator (Honglinand Wang, 44). The regulator adjusts its policy settings over the course of theyear to reflect intermediate targets as well as changes inmacroeconomic variables. The Chinese authorities have undertakensignificant reforms in transforming the monetary system into aprice-based system. The current control measures provide the rightfoundation for the country to transition into a price-based systemwithin the targeted time (Honglinand Wang, 107).The use of quantity-based instruments to target money growth hasspearheaded the evolution of the Chinese monetary policy.
Comparisons of the Financial Instruments in China and the Developed World
ThePeople’s Bank of China employs a price-based indirect instrumentsand quantity-based direct instruments. The price based indirectinstruments include reserve requirements, discount and rediscountrate, open market operations and PBoC lending and deposit rates. Onthe other hand, quantity based direct instruments include capitalcontrols, window guidance and Direct PBoC lending (ChengHoon, et al., 72).The PBoC landing works based on market-oriented activities suchsimilar to other developed central banks. Under this instrument, thedeposit facility, and the marginal refinancing constitute the lowerand upper limits of market rates. The PBoC manages two benchmarkrates i.e. the lending rate (1-year) and the rediscount rate, whichstands as the standard rate for central bank lending.
ThePBoC uses the discount and rediscount rate to influence thecommercial paper market. On the other hand, it uses the reserverequirements to control the financial sector liquidity. The country’sreserve requirements have three main features. First, excess andminimum reserves bear interests. Secondly, excess reserves are o f ahigher ratio in the financial system and lastly, differentinstitutions have different reserve ratio requirements. The otherinstrument is the open market operations. These include central bankbills, national bonds, and financial bonds (ChengHoon, et al., 54).
Quantity-baseddirect instruments are used to influence the allocation of credit inthe country’s financial system. These instruments include thedirect PBoC lending and the window guidance (HeDong et al., 99). The window guidance utilizes benevolent compulsion to persuadeChinese banks as well as related financial institutions stick to theprovided guidelines. The PBoC direct lending works as an indirectsubsidy for credit corporations in rural China, a lender of lastresort, a lender to asset management companies as well as a lender tothe local governments.
Incontrast, the developed countries use three major instruments tocontrol their monetary policy. In these countries, the objectives ofthe monetary policy are to facilitate full employment, pricesteadiness and reasonable interest rates in the long-term (ChengHoon et al. 46).Through the implementation of effective monetary policy, thegovernments of these countries can ensure price stability thus,supporting conditions necessary for long-term growth and maximumemployment. The three major instruments of monetary policy in thesecountries are open market operations, reserve requirements, anddiscount rate.
Openmarket operations (OMOs) are used as the primary tools of influencingmoney supply in developed countries. It comprises of sale andpurchase of financial instruments by the government (ChengHoon et al. 48.The second instrument is the reserve requirement. In this case, thebanks operating in these countries are required to keep a certainamount of funds in reserve to manage unexpected demand. Thesereserves as kept in their cash vaults or as deposits with theircentral banks. The last tool used in developed countries is thediscount rate. Banks pay back the reserves they borrow directly fromthe central banks at this rate. These reserves are often treated asprimary credit (ChengHoon et al. 49.The central banks of these countries set these rates and review themfrequently to accommodate changes in the market. From this rate, thebanks set the rates at which they advance loans to borrowers.Therefore, discount rate acts as a benchmark rate because it sets thelimit that banks can charge for credit.
Fromthe above, the differences between the instruments of monetary policyused by China and the developed countries are outright.
Opinion: How far is China from a price-based monetary system?
Inmy opinion, China is very close to a price-based monetary system. Inthe past two decades, the country has deepened its financial reforms,which have created the need to institute more market-oriented policyframeworks. The PBoC ceased the direct control if of credit and moneyand stopped implementing its monetary policy through credit plans (HeDong and Honglin Wang 928).The PBoC has since followed this foundation to spearhead furthermarket-oriented reforms. The move towards the adoption ofmarket-oriented reforms started in 1998 after the PBoC adopted anindirect policy management framework. The country has had almost twodecades to enhance the effectiveness of instruments such as thereserve requirement ratio, central bank lending, and open marketoperations (Franklinand Rogoff 18).The PBoC has had important lessons since 1998, and I believe it knowsthe best way to utilize price-based instruments in the monetarysystem.
ThePBoC has continued to gradually develop price-based monetary toolse.g. interest rates. Currently, the PBoC sets an array of benchmarkinterest rates, including deposit rates, rates on required as well asexcess reserves, rediscounting rates and the lending rates (HeDong and Honglin Wang 930). Although the interest rate policy is still under development in thecountry, the presence of these series of rates indicates a cleardetermination from the PBoC to move towards a price-based monetarysystem. The country lacks short-term rates that anchor the policyexpectations in the market however, there is a big room forimprovement in future. Currently, the PBoC uses the benchmark loanand deposit rates to as the major policy interest rates in thecountry (Shih440).I believe the PBoC is close to establishing short-term rates thatwill drive the market expectations in a reliable manner.
Additionally,the liberalization of the financial system has added more pressuretowards the need to adopt a price-based policy system. Themarket-based interest rate reforms begun with the bond and moneymarket rates, which became largely liberalized towards 1998 (Franklinand Rogoff 33).However, the price-based system seems to be maturing fasterespecially when considering the quick liberalization of the bankingretail rate. The PBoC allows commercial banks to adjust the interestrates on loans offered to their customers, restricted by a limitedband, which is pegged to the PBoC’s benchmark lending and depositrates. The liberalization of the banking retail rates is anotherclear indication that the country is moving closer to the fulladoption of a price-based monetary system. From 2010, the PBoC hasreduced the extent of interventions in the forex market (Shih438).This has seen the regulator allow further exchange rate flexibility,which is a clear indication that the country is moving closer to aprice-based system. I believe that the highlighted arguments areenough evidence indicating that we are close to seeing a price-basedsystem in China.
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