How Does Monetary Policy Work in China?

China has the second largest economy in the world, with its GDP predicted to reach 20.6 trillion by 2024, or 80% of U.S. GDP. That’s no small number, and of course, money movements depend upon monetary policy decisions made by the nation. But how is monetary policy enacted in China? And why should this interest you?

First thing’s first, if you’re a business outsourcing your labor to China or are dabbling in Hong Kong offshores, it may interest you to know the flow of money movements in the region. Now that I’ve addressed this initial point, let’s dig into the nitty gritty (which I will simplify as much as possible).

Let’s talk about the definition of Money Supply before anything else. In the U.S., we break the money supply into 3 categories: M0, M1 and M2, which I will define below:

  • M0 is actual money that is in circulation (the most liquid)

  • M1 is M0 plus checking accounts

  • M2 is M1 plus savings accounts, mutual fund accounts and timed deposits

M1 and M2 are important because they give insight to investors as to how money is being allocated across savings and deposit accounts, as well as demand accounts. But even though we can see where the money flows, M2 is not capable of exhibiting how the funds are used. Because of this the People’s Bank of China measures M2 differently with a variable called “aggregate financing”, which measures the total amount of funds provided by China’s at-home financial market to the private sector of the real economy. What aggregate financing shows is how purchasing power is distributed in Chinese society, whereas M2 simply shows the overall purchasing power of society.

Next, as in most economies, China leveraages 4 different monetary policy mechanisms: required reserve ratio (RRR), liquidity management facilities, interest rates and central banks loans. The RRR for large banks hovers at around 12.5%, for medium banks around 10.5% and for small banks around 6.5%. Within the RRR, preferential treatment is given to medium-to-large banks that may be granted a decrease in the RRR by 0.5-1.5%, as well as a decrease in 1% for country-sering banks with an emphasis on local loans to businesses. It’s important to note that the current goal of the People’s Bank of China (PBOC) is to promote the growth of credit to SMEs and private firms.

Now moving on to the more elaborate part: liquidity management facilities. There are four different types:

  • Open Market Operations (most common): this is simply 7-day reverse repurchase notes which inject short-term liquidity into the financial markets

  • Standing Lending Facility (SLF): introduced in 2013, this injects liquidity into the financial markets from 1-3 months

  • Medium-term Lending Facility (MLF): introduced in 2014, this is a more significant source of liquidity for 3 months - 1 year

  • Pledged Supplementary Lending (PSL): introduced in 2014, this provides financing against collateral to policy banks for 3 - 5 years and is intended for executing large projects like urban development

  • Targeted Medium-term Lending Facility (TMLF): introduce most recently in 2018, this provides banks with liquidity and grants a sizeable portion of loans to SMEs within 1 - 3 years

With this in mind, I can introduce interest rates and then tie in the liquidity management facilities as well. China has 2 traditional Interest Rates (IR): the 1-year benchmark lending rate and the 1-year benchmark deposit rate. The former will soon become obsolete because the PBOC is trying to liberalize interest rates, but the deposit rate is likely to remain. The 1-year benchmark deposit rate is important for regulating the cost of funding for commercial banks.

There are also two other “new” rates that are central to Monetary Policy in China. First is the 1-year MLF rate, which is set by the PBOC when it injects liquidity through the MLF stated above. Right now, the PBOC is trying to connect the dots between the MLF & Loan Prime Rate (LPR) which is offered to commercial banks' best customers. The LPR is equal to the average of the monthly quotes that are submitted by 18 banks after taking into consideration the MLF. Based on the LPR, commercial banks can determine customer-specific interest rate and risk premiums. Therefore, the MLF anchors medium term interest rates via the LPR.

To Conclude:

Chinese Monetary Policy is very specific in how it is delivered. From this article, we’ve gathered that China measures M2 differently, has an elaborate liquidity management facilities schema, and intends to liberalize interest rates in the future.


Adopted from Guanghua School of Management

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