## Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China (Conference organized by the People’s Bank of China and the International Monetary Fund, April 28, 2017) ## Source details **Canonical URL:** [Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China (Conference organized by the People’s Bank of China and the International Monetary Fund, April 28, 2017)](https://www.imf.org/-/media/files/news/seminars/2017/fifth-pbc-conference/ebook2017.pdf) ## Other formats - [Markdown version](/-/media/files/news/seminars/2017/fifth-pbc-conference/ebook2017.pdf.md) - [Structured JSON version](/-/media/files/news/seminars/2017/fifth-pbc-conference/ebook2017.pdf.json) --- ### Conference purpose and context - The People’s Bank of China and the IMF held a joint conference on April 28, 2017 to discuss how to strengthen financial and exchange rate frameworks. - The conference aimed to identify practical policy solutions and evaluate benefits and costs of different approaches, drawing on international experience and relevance for China. - The event convened experts, policymakers, and staff from domestic and international institutions. ### Key reform progress and structural changes in China - China has completed formal interest rate liberalization, established a deposit insurance scheme, and advanced reform of the exchange rate regime. - The renminbi (RMB) was included in the IMF’s Special Drawing Rights (SDR) basket. - China is strengthening institutional foundations underpinning market functioning and governance, with continuous calibration of policy frameworks as the economy transitions. ### Exchange rate frameworks — recent steps and transition choices - Recent operational steps: - Reform of the central parity system in August 2015 to let the market play a bigger role in determining the RMB exchange rate. - Publication of a RMB exchange rate index by the China Foreign Exchange Trading System (CFETS) in December 2015. - February 2016 central parity formula: previous closing rate + movements of a basket of currencies + counter-cyclical factor. - May 2017: adding a counter-cyclical factor into the RMB/USD central parity regime. - Three interrelated transition questions highlighted: - What kind of float should China adopt? - How should China get there? - How should authorities intervene and ensure market functioning? - Empirical and operational findings: - From 1995 through 2014, China managed its exchange rate in terms of the U.S. dollar with alternating extreme stability and controlled appreciation; beginning in 2015 China allowed depreciation against the dollar. - The JP Morgan real effective exchange rate (REER) for China depreciated since late 2015, reversing a sharp spike in 2014–15 and returning toward the 2010–13 trendline. - A reasonable objective proposed for China’s exchange rate policy: stabilize the current account (CA) near 0, allowing cyclical deviations of up to +/- 3 percent of GDP. - Reference rate strategy proposed (Williamson framework): when current account > 3 percent of GDP, FX purchases not allowed; symmetrical rules apply for deficits below -3 percent of GDP; rules ideally specified relative to projections up to two years ahead. - Reserve adequacy and operational rules: - Two common benchmarks: three months’ imports and 100 percent of short-term external debt in foreign currency. - Short-term external debt for China is just below $1 trillion. - Operational guidance suggested: resist downward REER pressure by selling FX reserves as long as reserves exceed about $1 trillion and CA is projected to remain in surplus; as reserves approach $1 trillion, use a combination of REER depreciation and reserve sales; below $1 trillion allow REER to depreciate freely. - Empirical evidence and experience: - Sterilized FX intervention can be powerful with capital account restrictions but retains effects when capital accounts are open (Gagnon and others 2017); Switzerland intervened massively with an open capital account. - Latin American practice includes rules-based and transparent interventions; examples report announced programs and sizable operations (Chile, Brazil, Mexico). ### Foreign exchange intervention, expectations, and capital controls - Intervention and expectations: - Short-term central bank intervention often aims to stabilize the spot rate, but stabilizing exchange rate expectations is more important. - Empirical studies suggest intervention can deteriorate exchange rate expectations; central bank selling of FX may increase depreciation expectations by reducing reserves and approaching psychological thresholds. - Ma Jun’s model using China data (2010.01–2017.03) reports intervention coefficients such as -0.19**, -0.108**, -0.182***, -0.10* with t-statistics (-3.37), (-2.01), (-3.22), (-1.80); Adj R-squared values include 0.135, 0.396, 0.161, 0.418 (as presented). - Capital controls: - Can improve the balance of payments in the short run by limiting outflows but tend to worsen balance of payments in the medium/long run by curbing future inflows. - Controls are hard to reverse and can severely reduce investor expected returns (example investor calculation: [10%] probability of capital control * 100% loss in principal + 1% return after FX hedging = [-9%] return). - Operational recommendations on FX stance: - Reduce FX intervention more quickly and substantially increase exchange rate flexibility. - Relax controls on FX outflows and expand channels for capital inflows (e.g., opening bond market access). - Devote more resources to removing barriers to inflows (e.g., streamline CIBM account opening, bond connect, ISDA access, repo access) than to controlling outflows. - Follow a smoothing principle: smooth excessive short-term volatility rather than resist long-term trends. ### Monetary policy, interest-rate regime, and steps toward inflation targeting - Transition implications: - Moving to greater FX flexibility can remove a nominal anchor; recommended to clarify a small number of policy objectives (ideally pure inflation targeting or explicit inflation + output objective). - Challenges include lack of credible unemployment/output gap measures and unstable relationships between money/interest rates and inflation. - Operational structure and instruments: - Multiple PBoC instruments exist: repo and reverse repo at many maturities; SLF, MLF, PSL; market rates such as Shibor. - Practical corridor observed: 7-day reverse repo rate (floor), 7-day SLF rate (ceiling), 7-day PBOC repo rate (middle). - Policy recommendations: - Link benchmark rates to interbank liquidity instruments or de-emphasize benchmark lending rates. - Encourage banks to price credit more flexibly and open PBOC repo access to all banks. - Consider overnight repos as a policy rate and be proactive in providing liquidity; publish more timely liquidity operation data. ### Financial sector transformation, structural imbalances, and insurance - Structural contradictions and priorities (Luo Sheng): - Financing is difficult and expensive; financial institutions can “hold the ball” too long raising financing costs. - Financial sector has drawn resources away from the real economy; product homogeneity and blurred boundaries increase inter-sector competition. - Internet finance has substituted for some traditional finance in payments and consumer finance; big-data/AI could accelerate change but many offerings lack genuine innovation. - Insurance sector specifics: - As of year-end 2016, insurance industry assets totaled 1.5 trillion yuan, that is 5.3 percent of the financial sector. - Liability models: no-cash-value (property/accident/health) vs. cash-value (life/retirement/investment-type). - Asset-liability mismatches: long-liability needs vs. scarcity of long-duration fixed-income assets (gap for assets with maturities > 15 years reported as 5.4 trillion yuan in the discussion). - Regulatory prescriptions: “two penetrations” (equity and investing penetration) and “two dares” (prosecute criminal activity; accept bankruptcy where warranted). ### Financial system development priorities and inclusiveness - Progress and medium-term priorities (Miquel Dijkman): - Major advances: large equity and bond markets, improved financial inclusion, interest-rate liberalization, banking commercialization, safety nets, exchange-rate reform, RMB in SDR. - New role required: allocate resources for greener, more inclusive, more innovative, productivity-led growth; strengthen allocative function; build diverse financial system with active capital markets and NBFIs; improve inclusion for households and SMEs. - Key metrics and trends: - Domestic private debt market increased from 34 to 47 percent of GDP (2010→2015). - Nonfinancial corporation debt share rose from 26 to 43 percent of total debt outstanding (2010→2015). - By end-2015, sum of equity, public and private debt market capitalizations reached 144 percent of GDP. - Traditional NBFI assets = 31 percent of GDP in 2015 (up from 19 percent in 2010); WMP and trust company assets accounted for 34 and 24 percent of GDP respectively in 2015. ### Macroprudential frameworks, institutional design, and tools - Key institutional design elements (UK example and international lessons): - Macroprudential authorities need a clear mandate, accountability, central bank involvement, cross-regulator representation, and a range of powers and tools. - Tools include countercyclical capital buffers, sectoral capital buffers, LTV/DSTI limits applied functionally across providers, liquidity requirements (LCR, NSFR), and perimeter expansion to nonbanks. - Address inaction bias: benefits of early action are uncertain and accrue later while costs are immediate; legal backing and political insulation help. - Cross-border and capital account considerations: - Capital account liberalization can reduce domestic leakage but may increase cross-border transmission; coordination and reciprocity (e.g., Basel III CCyB reciprocity) may be needed. - Macroprudential tools can be currency-differentiated; examples: Korea, Iceland, Sweden applied LCR/NSFR differentiation; Hungary, Poland, Russia tightened FX exposures. - Country cases and operational experience: - Thailand: commercial banks core (about half of total financial assets); NBFIs growing rapidly; coordination mechanisms include Financial Stability Subcommittee, semi-annual MPC/FIPC meetings, and Financial Stability Unit (FSU) established in 2016. - Latin America: many central banks used sterilized, often rule-based interventions; transparency and pre-announced programs produced market responses; empirical studies report measurable, sometimes sizeable short-run effects of interventions. ### Transition design, FX intervention rules, and financial stability - Transition principles: - Financial stability is both a precondition for and a beneficiary of smooth transitions to greater FX flexibility. - Design FX intervention rules to dampen volatility (second moments) rather than fix levels (first moments); rules should lean against excessive short-term moves but allow market determination on average. - Desirable rule attributes: - Realism: recognize central bank reserve constraints. - Supportive: align with price stability mandates and foster market development by allowing two-way risks. - Robustness: adapt parameters over time without major overhauls; include a mid-point reset (moving average), continuous intervention frontier, and daily intervention limits if reserves are constrained. - Empirical suggestions: - Countries with weaker financial stability recorded larger post-adjustment depreciations, higher inflation, and slower credibility building after transitions in selected Latin American cases. - Well-designed interventions and clear communication mitigate market over-reaction and leverage confidence effects. ### Financial stability constraints, leverage, and rebalancing - Systemic vulnerabilities and policy priorities: - Rapid credit growth, high leverage, and limited direct financing share constrain efficient resource allocation and raise systemic risk. - BIS data (end-2016Q3) cited: total outstanding debt of China’s nonfinancial sector "210% of GDP"; nonfinancial corporate sector "166% of GDP"; household sector "43% of GDP"; government sector "46% of GDP". - Foreign-currency corporate external debt figures referenced: "96.8 and 41.4 billion USD respectively, or about 20% total corporate external forex debt" (as presented). - Rebalancing policy levers: - Encourage consumption via social safety nets: research cited finds public spending on health and education raises consumption by at least 50 cents and up to a dollar per dollar spent. - Priority actions: tighten monetary stance to stabilize or lower aggregate leverage ratios; increase share of direct financing (equity and bond markets); restructure regulatory framework and macroprudential coordination; withdraw implicit government guarantees and enable exit of zombie firms/banks. - PBoC macroprudential milestones: - 2004: differential required reserves and credit policies introduced. - 2009: comprehensive study of macroprudential policies began. - 2011: differential reserve adjustment system introduced. - 2015: upgrade to a macroprudential assessment (MPA) system covering FX liquidity and cross-border capital flows. - Current focus includes SIFIs, financial infrastructure, and financial sector statistics. ### Representative country lessons and policy implications - Chile (Rodrigo Vergara): - Chile moved through pegs, bands, and adopted a free float; experience shows free float can act as an effective shock absorber over long periods, but central banks retain right to intervene in “exceptional circumstances.” - ERPT has declined over time; currency mismatches fell after adopting the float. - Lawrence H. Summers and Arminio Fraga remarks: - Both recommend opportunistic movement toward free-floating regimes, cautious capital market liberalization, and preserving scope for intermittent interventions in extreme volatility or low liquidity. - Prioritize greater exchange rate flexibility over capital market liberalization; de-emphasize fixed/intermediate bands that can reproduce peg-like vulnerabilities. - IMF and other contributors: - Emphasize realistic sequencing: strengthen domestic financial supervision and market infrastructure before large-scale capital account liberalization. - Transparency, clear communication, and improved institutional capacity at regulator headquarter levels are recurring recommendations. - Staffing statistics presented suggest many Chinese agencies have relatively small headquarter staffs compared with international peers; policy implication: strengthen central/headquarter staffing, compensation, and retention to manage rising complexity. ### Aggregate conference conclusions and policy recommendations - Core policy preferences: - China should move toward greater exchange rate flexibility, advancing toward a free float over time while retaining limited, rule-based interventions to smooth volatility. - Foreign exchange intervention should focus on stabilizing the current account balance, with monetary and fiscal policy remaining focused on inflation and employment. - Adopt a reference rate strategy with a norm of zero for the current account and clear operational rules tied to reserve levels (illustrative $1 trillion minimum reserve threshold discussed). - Capital account liberalization should proceed slowly and only after strengthening domestic financial supervision, macroprudential frameworks, and market infrastructure. - Macroprudential and structural priorities: - Strengthen regulation, supervision, and coordination across PBoC and the three financial regulators; expand the regulatory perimeter to capture nonbank risks. - Reduce implicit government guarantees and hard quantitative growth targets that drive local government investment and real estate bias. - Deepen and liberalize onshore bond and derivatives markets, reduce hedging costs (examples: remove reserve requirements on FX forwards), and unify onshore/offshore market access as part of gradual internationalization. - Increase transparency and frequency of communication on policy actions and reform objectives. - Operational imperatives: - Improve contingency planning and resolution frameworks for failing financial institutions. - Extend stress testing to include dynamic and contagion analyses. - Raise headquarters staffing and compensation at key regulators (PBC, CBRC, CSRC, CIRC) and introduce mechanisms (e.g., temporary private-sector rotations) to enhance skills and market knowledge. *Source: Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China (Fifth PBC–IMF Joint Conference materials compiled in ebook2017).* ### Introduction ............................................................................................. i ### Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China — Introduction ### Conference purpose and context - The People’s Bank of China and the IMF held a joint conference on April 28, 2017 to discuss how to strengthen financial and exchange rate frameworks. - The conference focused on identifying practical policy solutions and evaluating benefits and costs of different approaches, drawing on international experience and relevance for China. - The event brought together experts, policymakers, and staff from domestic and international institutions. ### Key reform progress and structural changes in China - China has completed formal interest rate liberalization, established a deposit insurance scheme, and advanced reform of the exchange rate regime. - The RMB was included in the IMF’s Special Drawing Rights (SDR) basket, recognizing China’s overall reform progress. - China is strengthening policy frameworks—the institutional foundations that underpin market functioning and governance—to maximize market benefits while minimizing vulnerabilities. - China’s economy remains in transition and policy frameworks need continuous calibration. ### Strengthening the exchange rate and supportive policy frameworks - Recent steps in exchange rate liberalization include: - Reform of the central parity system in August 2015 to let the market play a bigger role in determining the RMB exchange rate. - Publication of a RMB exchange rate index by the China Foreign Exchange Trading System (CFETS) in December 2015 to increase reference to currency baskets. - As China moves toward a float, three interrelated questions were highlighted: - What kind of float should China adopt? - How should China get there? - How should authorities intervene in the market and ensure proper market functioning? - The conference emphasized China’s unique position—size and RMB’s special status in the SDR basket—when applying international experience. ### Strengthening financial sector and macro-prudential policy frameworks - The conference examined drivers of China’s rapidly changing financial landscape, future opportunities (including development of derivatives markets), and key challenges. - Insights from Financial Sector Assessments of key G20 countries were used to discuss lessons for China and good practices for developing macroprudential policy frameworks. ### Opening remarks by CHEN Yulu (Deputy Governor, People’s Bank of China) - Exchange rate developments and reserves: - Since the 2008 Global Financial Crisis, the Euro, Japanese yen and UK pound have fallen against the U.S. dollar by 25 percent, 6 percent, and 32 percent, respectively. - The Chinese Yuan has depreciated only 1 percent over the same period. - The real effective exchange rate (REER) and nominal effective exchange rate (NEER) have appreciated 29 percent and 23 percent, respectively. - Foreign exchange reserves dropped to about $3 trillion from a peak of $4 trillion in 2014, and remain the highest in the world. - Recent market dynamics: - Cross-border capital outflows significantly slowed in the first quarter, and supply and demand in the foreign exchange market have moved closer to equilibrium. - Improvements in the Chinese economy—stronger domestic growth momentum, recovery in growth and efficiency, stronger consumption contribution, rapid development of new technologies and services, and accelerated industrial upgrading—have supported market confidence. - A more stable U.S. dollar exchange rate and improved international financial market conditions contributed to RMB stability in the first quarter. - Policy stance on capital controls and foreign exchange management: - Long-time and large-scale capital controls are not effective in dealing with outflow pressures. - Since experiencing capital outflows, Chinese authorities have not introduced new measures on money exchange and cross-border payments; instead, banks are required to follow existing foreign exchange management rules and background scrutiny has been strengthened. - China’s laws and regulations on foreign exchange management have not changed. - Next steps in exchange rate policy: - The People’s Bank of China will continue to move toward a market-based exchange rate regime and improve the central parity system of "closing exchange rate+exchange rate changes of basket currencies". - The aim is to make exchange rate policy more rules-based, transparent, and market-based so the exchange rate better reflects market supply and demand, supports two-way movements, and acts as an automatic stabilizer of the balance of payments. - Macroprudential framework development and milestones: - The People’s Bank of China has actively explored a macroprudential policy framework tailored to China’s circumstances. - 2004: introduction of differential required reserves and credit policies embodying macroprudential thinking. - 2009: began comprehensive study of macroprudential policies. - 2011: introduction of a differential reserve adjustment system. - 2015: upgrade to a macroprudential assessment system covering monitoring of foreign exchange liquidity and cross-border capital flows. - The authorities are developing a two-pillar policy framework combining and coordinating monetary policy and macroprudential policy. - Going forward, focus will be on systemically important financial institutions (SIFIs), financial infrastructure, and financial sector statistics to prevent systemic crisis. ### Session orientations and expectations - Session I: Strengthening exchange rate and supportive policy frameworks—assesses exchange rate frameworks, intervention, transitions to floating, and market functioning. - Session II: Strengthening financial sector and macro-prudential policy frameworks—examines drivers of China’s financial transformation, development opportunities (including futures and derivatives markets), regulatory frameworks, and macroprudential policy design. - The conference sought active participation, open discussion, and contribution of practical ideas for policy design and implementation. *Conference organized by the People’s Bank of China and the International Monetary Fund (April 28, 2017).* ### PART I: EXCHANGE RATE FRAMEWORKS ### PART I: EXCHANGE RATE FRAMEWORKS ### Reducing Intervention in the Foreign Exchange Market (MA Jun, Chief Economist, Research Bureau, People’s Bank of China) - Short-term objective of central bank foreign exchange intervention is to stabilize the spot rate; a more important objective should be to stabilize exchange rate expectations. - Empirical studies across countries suggest central bank intervention is likely to lead to a deterioration in exchange rate expectations; selling foreign exchange by central banks could lead to greater depreciation expectations. - Mechanism: as a central bank intervenes and reduces its foreign reserves, market expectations strengthen that a sudden sharp depreciation will occur in the future. - Capital controls: - Can improve the balance of payments in the short run by limiting capital outflows. - Are likely to lead to a deterioration in the balance of payments in the medium and long terms because capital outflow controls curb future capital inflows. - After recent foreign exchange reforms in China over the past two years, public and investor acceptance of exchange rate volatility has significantly improved, providing important room for the People’s Bank of China (PBC) to reduce intervention. - Policy proposal: - Reduce foreign exchange intervention more quickly. - Substantially increase exchange rate flexibility. - Relax control over foreign exchange outflows. - Advance reforms to expand channels for capital inflows, such as opening-up of China’s bond market. ### Foreign Exchange Intervention in Latin America (Alejandro Werner, Director, Western Hemisphere Department, International Monetary Fund) - Since the early 1990s, large Latin American economies have progressively transitioned to inflation targeting, which requires exchange rate flexibility; nevertheless, authorities still closely monitor exchange rates due to pass-through to inflation and other risks. - Risks motivating intervention: - Excessive appreciation can lead to loss of competitiveness and costly sectoral adjustments. - Excessive volatility, particularly large abrupt depreciations, can threaten financial stability through currency mismatches on balance sheets. - Trends and resilience: - Exchange rate pass-through has been declining as central banks have built credibility. - Financial resilience improved as borrowers shifted toward safer liability structures (e.g., away from foreign currency debt for unhedged borrowers). - Reserve accumulation and use: - Countries accumulated significant international reserves during periods of large capital inflows, providing precautionary external buffers and moderating appreciation pressures. - Some countries deployed reserves to cope with depreciation when capital inflows declined or reversed. - Taxonomy of intervention dimensions: - Rules-based versus discretionary. - Spot market operations versus swaps and other derivatives. - Sterilized versus unsterilized intervention. - Public/transparent versus secretive intervention. - Regional practice: - Largest Latin American economies (inflation targeters) have used sterilized interventions. - Both spot and derivative-based interventions are common; derivatives can be equally effective if markets function well and convertibility risk is limited. - A long tradition of rules-based and transparent interventions exists (examples include option strikes tied to the 20-day moving average; minimum price auctions triggering sales when one-day depreciation exceeded a threshold). - Notable announced programs and volumes: - Chile in 2011 pre-announced purchases of 12 billion dollars through daily spot purchases of 50 million dollars. - Central Bank of Brazil in 2013 announced daily currency swap sales of 500 million dollars plus weekly 1-billion-dollar spot sales; the stock of swaps sold eventually reached over 30 percent of reserves. - Mexico in 2015 announced daily spot sales of 200 million dollars, and in February 2017 announced it would sell up to 20 billion dollars through swap operations. - Transparency: - Even discretionary interventions have typically been communicated clearly, including operation mechanisms. - Empirical evidence on effectiveness: - Early work on advanced economies found little evidence of effectiveness, reflecting small intervention size relative to deep markets. - More recent literature on emerging markets finds more supportive evidence; intervention seems to have some traction in Latin America. - Announcements of intervention rules have sometimes produced significant market responses; one study (Chamon, Garcia, and Souza) estimates the exchange rate appreciated by over 10 percent as a result of the Brazilian foreign exchange swap program. - Caution: the exchange rate’s nature makes it hard to assess whether intervention effects are permanent or transitory. - Open questions for policy: - Role of foreign exchange intervention under a floating regime remains unclear despite its central role under fixed regimes. - Appropriate intervention strategy over the global financial cycle: - Whether to deploy reserves symmetrically as capital flows decline or to retain reserves for precautionary motives under deteriorating global conditions. - Real-time assessment difficulties about which shocks are permanent versus transitory. - Communication strategy is crucial to mitigate market over-reaction and to leverage confidence effects; communications should highlight intervention’s complementary role to interest rate policy where price stability is the primary objective. - Interim guidance: - While academic answers remain incomplete, policy makers can draw lessons from the diverse Latin American experience with foreign exchange intervention. *Content summarized from contributions in PART I: EXCHANGE RATE FRAMEWORKS.* ### INTRODUCTION ### INTRODUCTION ### Exchange rate history and measurement - From 1995 through 2014, China managed its exchange rate in terms of the U.S. dollar, alternating between periods of extreme stability and of controlled but slightly variable appreciation. - Beginning in 2015, China allowed its currency to depreciate against the dollar; this may reflect a switch in focus to a broader measure of the exchange rate. - The JP Morgan real effective exchange rate (REER) for China has depreciated since late 2015, which may be viewed as reversing a sharp spike in 2014–15 and returning to the upward trendline that had emerged in 2010–13. - The REER is a better measure of the exchange rate for economic policy than the bilateral dollar rate, though stabilizing the REER need not be the best policy objective. ### Focus on imbalances: a reference rate approach - China’s REER exhibits a clear appreciation trend over the past 20 years; continued appreciation is likely as long as China’s productivity growth is faster than that in the rest of the world. - Measures to open the Chinese economy, including reducing barriers to imports, could temporarily reverse the REER appreciation trend. - The People’s Bank of China should focus on stabilizing the current account balance as the ultimate goal of exchange rate policy, while keeping monetary policy focused on stabilizing inflation and employment. - A reasonable goal for China is a current account near 0, with temporary deviations allowed (for mainly cyclical reasons) of no more than +/- 3 percent of GDP. - The current account determines whether a country is a net lender or borrower; given China’s stage of development and high private saving, a zero current account balance may be a reasonable norm. - Current account imbalances have political repercussions; persistent large deficits (for example, the U.S. deficit) can have domestic political impacts. - The effect of the REER on China’s current account is clear with a normal two-year lag: - A rise in the REER from 1995 through 2002 was associated with a small and stable current account. - The decline in the REER from 2002 through 2005 led to record current account surpluses in 2005–07. - Appreciation since 2005 has returned the current account below 3 percent of GDP. - Recent IMF research finds little evidence that integrated global supply chains have reduced the effect of exchange rates on trade imbalances. - As an issuer of one of the world’s reserve currencies, China should allow its exchange rate to float freely, but may still use a reference rate strategy to guide intervention. - The reference rate strategy (Williamson 2007, 2016): - Long-term target balance: 0, with cyclical deviations of as much as +/- 3 percent of GDP allowed. - When current account > 3 percent of GDP: buying foreign exchange is not allowed; selling is encouraged. - When current account between 0 and 3 percent of GDP: purchases discouraged but not prohibited; selling encouraged, less strongly as the current account approaches 0. - Symmetrical rules apply when the current account is below 0. - Rules are specified in relation to the contemporaneous current account but ideally should use projections up to two years ahead. - A reference rate system implies no restrictions on the exchange rate; it provides guideposts for when and in what direction to conduct foreign exchange intervention, always leaning against excessive current account imbalances. - Clear communication of the reference rate strategy to financial markets is likely to dampen excessive exchange rate volatility and mitigate capital flow swings. - Recent research documents an important effect of foreign exchange intervention on the current account. ### Transition to the new framework (reserve adequacy and operational rules) - Determining a minimum level of foreign exchange reserves is necessary to operationalize the reference rate strategy. - Two common benchmarks for reserve adequacy: three months’ equivalent of imports and 100 percent of short-term external debt in foreign currency. - An alternative reserves definition, net official assets, adds non-reserve foreign assets of the central bank and foreign assets held by the sovereign wealth fund and subtracts public and publicly guaranteed external debt. - Both standard reserves measures are far above common adequacy benchmarks for China; probably the best measure of minimum adequate reserves for China is short-term external debt, which is just below $1 trillion. - Operational guidance proposed: - China should resist downward pressure on the REER by selling foreign exchange reserves as long as reserves exceed about $1 trillion and the current account is projected to remain in surplus. - As reserves approach $1 trillion, use a combination of REER depreciation and reserve sales. - Below $1 trillion, the REER should be allowed to depreciate freely. - Upward pressure on the REER should not be resisted unless the current account is likely to become negative within two years or reserves are below $1 trillion. - In the long term China should open its capital markets, but move slowly; priority should be placed on improving financial supervision and regulation and liberalizing domestic markets. - One step that should not be reversed is the opening of China’s bond market to foreign investors while the renminbi is part of the IMF’s Special Drawing Rights basket. - Evidence and examples: sterilized foreign exchange intervention is more powerful with capital account restrictions but retains important effects even when capital accounts are open (Gagnon and others 2017); Switzerland intervened massively despite a fully open capital account. ### The current situation and macroeconomic risks - In the context of current global imbalances, China is the only major economy whose currency policy is consistent with a reference rate strategy; the euro area, Japan, the United Kingdom, and the United States are not intervening. - The euro area’s surplus was 3.4 percent of GDP in 2016; sales of foreign exchange would be strongly encouraged to support the euro in that range. - The United Kingdom and the United States, with current account deficits, would be encouraged to buy foreign exchange to weaken their currencies. - Very high rates of saving and investment in China pose major risks: - A collapse of investment could cause a recession in China and widen China’s current account surplus. - Spillovers to the rest of the world would be greater if the recession involved an abrupt depreciation of the renminbi. - Rebalancing in China is proceeding too slowly; to reduce excessive and unsustainable saving and investment, consumption should be encouraged to grow faster. - Research shows public spending on social safety nets (in health and education) has an enormous positive effect on consumption—at least 50 cents and as much as a dollar per dollar spent—even when fully financed by tax increases. - Expanding household consumption by improving the social safety net would: - Reduce the buildup of risky investment in China, - Raise household living standards in China, and - Reduce its trade surplus with the rest of the world. ### Conclusion and policy recommendations - China should focus external policy (foreign exchange intervention) on stabilizing the current account balance, while keeping monetary policy focused on stabilizing inflation and employment, with fiscal policy assistance. - Structural reforms to reduce excessive saving are essential. - Liberalization of international capital flows is desirable in the long term but should not take precedence over domestic financial reforms. - A reference rate strategy with a norm of zero for the current account balance is a good framework: - China would not buy foreign exchange reserves when its current account balance exceeds 3 percent of GDP. - China would not sell reserves when its current account falls below -3 percent of GDP. - China would be encouraged to sell reserves when its current account is above 0 and buy them when the balance is below 0. - Although not targeted at exchange rate stabilization per se, a reference rate strategy is likely to deliver a meaningful reduction in exchange rate volatility. *Source: Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China (Introduction).* ### REFERENCES ### REFERENCES ### Bibliographic references - Bergsten, C. Fred, and Joseph E. Gagnon. 2017. Currency Conflict and Trade Policy: A New Strategy for the United States. Washington: Peterson Institute for International Economics. - Cline, William R. 2016. “Estimates of Fundamental Equilibrium Exchange Rates, November 2016.” PIIE Policy Brief 16–22. Washington: Peterson Institute for International Economic. - Cline, William, and John Williamson. 2008. “New Estimates of Fundamental Equilibrium Exchange Rates.” PIIE Policy Brief 08–7. Washington: Peterson Institute for International Economics. - Gagnon, Joseph E. 2013. “The Elephant Hiding in the Room: Currency Intervention and Trade Imbalances.” PIIE Working Paper 13–2. Washington: Peterson Institute for International Economics. - Gagnon, Joseph, Tamim Bayoumi, Juan M. Londono, Christian Saborowski, and Horacio Sapriza. 2017. “Direct and Spillover Effects of Unconventional Monetary and Exchange Rate Policies.” Open Economies Review 28: 191–232. - IMF (International Monetary Fund). 2012. External Balance Assessment (EBA): Technical Background of the Pilot Methodology (August 3). Washington. - IMF (International Monetary Fund). 2015. Assessing Reserve Adequacy—Specific Proposals. April. Washington. - Leigh, Daniel, Weicheng Lian, Marcos Poplawski-Ribeiro, Rachel Szymanski, Viktor Tsyrennikov, and Hong Yang. 2017. “Exchange Rates and Trade: A Disconnect?” IMF Working Paper No. WP/17/58. Washington: International Monetary Fund. - Williamson, John. 2007. “Reference Rates and the International Monetary System.” Policy Analysis in International Economics 82. Washington: Peterson Institute for International Economics. - Williamson, John. 2016. International Monetary Reform: A Specific Set of Proposals. London: Routledge. ### Figures and data highlights - Figure 1: Trend appreciation of China’s exchange rate, January 1995 to March 2017. - Axes and labels shown: CNY/USD (range 4.5, 5, 5.5, 6, 6.5, 7, 7.5, 8, 8.5) and Index, 2010=100 (range 70, 80, 90, 100, 110, 120, 130); series: Real Effective Exchange Rate, Nominal Bilateral. - Source: Haver Analytics. - Figure 2: Current account imbalances widening again, 1995 to 2016. - Vertical scale in USD billions with markers -1,000; -500; 0; 500; 1,000. - Series and years indicated: United States, China, Japan, Euro Area across 1995, 2005, 2015. - Sources: IMF World Economic Outlook database and Haver Analytics for 2016 observation. - Figure 3: A reference rate strategy for China, 1995 to 2016. - Current account balance shown in Percent of GDP with ticks -6, -3, 0, 3, 6, 9, 12 over 1995, 2000, 2005, 2010, 2015. - Exchange regime annotations include: FX purchases not allowed; FX sales encouraged; FX sales encouraged, purchases discouraged; FX purchases encouraged, sales discouraged; FX sales not allowed; FX purchases encouraged. - Sources: IMF World Economic Outlook database, Haver Analytics, and author’s illustration. - Figure 4: China reserve adequacy, 1995 to 2016. - Vertical scale in USD billions with ticks 0, 1000, 2000, 3000, 4000. - Series: Net Official Assets, Foreign Exchange Reserves, Three Months Imports, Short-term External Debt across 1995, 2000, 2005, 2010, 2015. - Sources: IMF Balance of Payments database, World Bank External Debt database, and Bergsten and Gagnon (2017). ### Remarks on strengthening exchange rate regime and supporting framework (Lawrence H. Summers) - Overarching position: - China should continue to move opportunistically toward a free-floating exchange rate regime, but during transition should not completely rule out intermittent interventions to prevent excessive volatility. - Capital market liberalization should proceed cautiously. - Rationale against fixed or quasi-fixed regimes: - Fixed or quasi-fixed exchange rate regimes have played a central role in almost every major financial crisis; examples cited include Mexico’s forced devaluation in 1994, the Asian Financial Crisis in Thailand, Indonesia, and Korea in 1997–98, and the Russian and Brazilian crises in 1998. - Pegged regimes are much easier to enter than to exit; if pressures surge, exchange rates are unable to absorb shocks and authorities face credibility loss. - Successful long-duration pegs can cause other serious problems, exemplified by sharp fluctuations of real estate prices in Hong Kong SAR and large-scale troubles in the Eurozone. - The longer a fixed exchange rate regime is maintained, the more traumatic its eventual end; for a large country like China, pegging effectively invites disaster. - Even sizeable reserves can dwindle distressingly quickly—the experience of the last 18 months is highlighted. - End-state and strategic direction: - The appropriate end-state must be a floating exchange rate regime, consistent with practices of other countries in the SDR basket. - Intermediate regime forms (floating within a band) risk reproducing problems associated with a peg by keeping authorities near the edge of the trading band. - A floating exchange rate helps mitigate trade and political tensions arising from China’s high savings and strong growth. - Key considerations for transition: - Prioritize greater exchange rate flexibility over capital market liberalization. - Under the current managed foreign exchange regime, risks include severe loss of credibility, distortions of monetary policy, and significant loss of foreign exchange reserves. - A clear, two-way expectation in RMB would discourage short-term speculative flows; currently the still-limited sense of two-way expectations in RMB is worrying given capital control measures and the pace of reserve depletion. - Authorities should loosen up exchange rate management. - Be opportunistic on the timing of the transition. - The risk of market overshooting is greater in practice than in theory; opportunistic transition is recommended over a forced move. - Openness in capital markets is encouraged but not an imperative. - Progress toward openness should not be an imperative; the degree of control should be based on whether controls create substantial distortions and/or encourage corruption (for example, through over-invoicing). - Priority should be removing controls that are circumvented or unenforceable. - Intermittent foreign exchange interventions should not be completely ruled out. - For an emerging economy like China with less-than-perfect capital mobility, intermittent surprise interventions can be modestly efficacious in supporting stability. - Chinese authorities should announce that on occasions there will be interventions to support exchange rate stability. - During the transition, exchange rate policy can influence monetary policy indirectly. - The exchange rate level should not be an independent element in China’s monetary policy reaction function, which already balances growth, price stability, and financial stability. - Exchange rate levels should feed through inflation and real-sector activity that influence the monetary policy stance. - Additional contextual notes: - The remarks were prepared based on the transcript at the PBC-IMF 5th Annual Conference on Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China on April 28, 2017. - Lawrence H. Summers is identified as the Charles W. Eliot University Professor and President Emeritus, Harvard University. *Source: REFERENCES and accompanying figures and remarks from the PBC-IMF conference materials cited in the content unit.* ### PART II: EXCHANGE RATE AND SUPPORTING ### PART II: EXCHANGE RATE AND SUPPORTING MONETARY POLICY FRAMEWORKS ### Exchange rate regime changes are commonly difficult - The IMF classifies de facto exchange rate regimes under ten possibilities, ranging from hard pegs to pure floats. - Each year, about 10% of the IMF’s member countries have changed their exchange rate regimes. - Transitions from fixed or closely managed regimes to flexible regimes often occur during periods of stress or crisis; the Asian Financial Crisis in 1997/98 is cited as an example. - China’s authorities are committed to gradual evolution toward greater exchange rate flexibility, appropriate for a large economy that is unlikely to face shocks aligned with the United States. - As China’s financial system grows and international engagement expands, a flexible exchange rate will provide insulation from external shocks but requires: - Development of supporting foreign exchange and money markets. - Evolution of the monetary policy framework toward greater policymaker autonomy and clarity of objectives. - Historical transition observations: - Australia moved from a hard peg to a pure free float through a NEER targeting regime in place for about a decade. - Hong Kong SAR eventually pegged to the U.S. dollar after a disorderly float. - Singapore managed its exchange rate with reference to a basket of currencies. - Recent renminbi evolution (narrative chronology preserved): - Fixed exchange rate since the mid-1990s. - Crawling peg from mid-2005. - Essentially fixed from mid-2008 to mid-2010. - More flexible thereafter, with more intervention in 2013–14 as the currency appreciated. - The August 2015 devaluation (very small) triggered a change in market dynamics. - Market interpretation of the past 18 months: authorities struggled to stabilize the U.S. dollar exchange rate. - Alternative interpretation: transition from a managed float of USD/CNY to greater emphasis on a trade-weighted value (NEER-focused), including: - A phase of gradual depreciation against a trade-weighted basket until about the middle of 2016. - Since mid-2016, an objective to maintain stability of the currency in trade-weighted terms. - The presence of implicit permissible variability (trade-weighted variability) in addition to explicit volatility bands around the U.S. dollar. - Two additional observations: - Capital flows forced regime changes in later transitions; with larger international private capital flows today, transitions may occur more rapidly unless capital controls are maintained and frequently tightened. - Large economies are less likely to sustain NEER pegs than small ones; the CNY fixing process can amplify market moves because movements in the CNY fixing cause other major currencies to move in the same direction. ### Practical steps to inflation targeting - A move from a fixed exchange rate to greater flexibility can remove a nominal anchor and introduce inflation risk. - In China’s case, the fixed exchange rate regime had been sustained primarily through capital controls and administrative measures (credit quotas, window guidance), not by aligning interest rates with the U.S. Federal Reserve. - Implication: loss of exchange rate stability need not necessarily damage credibility if the peg was not the central nominal anchor. - Recommended monetary policy framework changes: - Clarify a small number of policy objectives; ideally a pure inflation-targeting framework or at minimum a framework with inflation and some output-related objective. - Clarify how objectives are defined and which instruments will be used. - Challenges to institutional change: - Lack of credible measures of unemployment or the output gap. - Lack of a stable relationship between money (or interest rates) and inflation. - International precedents: - India recently and Indonesia about 16 years ago adopted inflation targets despite unstable mappings from money supply or interest rates to inflation. - Over time, central bank actions (raising rates when inflation is above target and cutting when below) help accumulate credibility. - Observation: exchange rate pass-through to inflation has been weaker recently than in early years under inflation targeting. ### Steps towards a supportive interest rate regime - Monetary policy needs clearer transparency regarding instruments and decisions if oriented toward inflation as nominal anchor. - China introduced multiple alternative policy instruments beyond benchmark lending and deposit rates, leading to potential market confusion. Instruments cited include: - Repo and reverse repo rates at myriad maturities. - Short-term lending facility (SLF), medium-term lending facility (MLF), and pledged supplementary lending (PSL). - Market rates such as Shibor, market repo rates, government and corporate bond yields. - Identified practical corridor (in practice): - 7-day reverse repo rate as the floor. - 7-day SLF rate as the ceiling. - 7-day PBOC repo rate in the middle. - Market behavior: - Since October (year unspecified in excerpt), other money market rates have risen much more than these “policy rates,” and investors increasingly look to the 7-day instruments for policy signals. - Policy recommendations: - Link benchmark rates to the interest rates used to manage interbank liquidity or de-emphasize/abandon benchmark rates. - Encourage banks to price credit more flexibly to reflect wholesale market-determined cost of funds and credit risk. - Open PBOC repo facility access to all banks (currently only primary dealers have access). - Conduct overnight repos and reverse repos, but consider whether overnight should be the official policy rate. - Be more proactive in providing liquidity to smooth short-term fluctuations in rates around the target. - Provide more timely data on liquidity operations to improve transparency. ### Steps towards a supportive foreign exchange market - Moving toward a free float requires a properly functioning onshore and offshore market for the currency; yuan internationalization is both a stated objective and likely inevitable. - Greater flexibility increases exchange rate risk; current buffers in China: - Foreign debt about 13% of GDP. - Domestic foreign currency loans about 7% of GDP. - Market hedging conditions: - Onshore forward turnover has not risen much; total turnover in April 2016 was barely higher than in 2013. Recent increases were concentrated in overnight forwards, likely reflecting banks’ response to PBOC spot intervention. - A 20 percent reserve requirement on U.S. dollar forward positions (20 percent on the notional principal of long dollar options) is estimated to add 20–30 basis points to the cost of hedging. - Recommendation: remove these reserve requirements because they increase hedging costs and discourage hedging. - Recommendation: expand the definition of legitimate “underlyings” so that all foreign currency exposures legitimately undertaken, including foreign currency borrowing, are eligible for hedging. - Offshore-onshore fragmentation: - Lack of liquidity in the CNH market means offshore markets can present different (more bearish) views on the renminbi’s future path. - Attracting foreign investors into onshore bond markets is hampered if offshore liquidity is insufficient and investors are compelled to hedge onshore. - Recommendation: (Re-)unify onshore and offshore foreign exchange markets by allowing onshore and offshore participants to access both markets as part of capital account liberalization. - Money market development: - More liquid onshore money markets, including a unified repo market, would facilitate foreign exchange market liquidity. ### Fear of floating, overshooting, and fear: can exchange rate regime transitions be smooth? (Miao Yanliang) - Historical context: - RMB firmly pegged to the U.S. dollar until July 2005, crawling pegged until August 2015, and since then transitioning towards a clean float. - Exits from pegs often produced excessive currency movements (e.g., ERM 1992–93, Asian financial crisis 1997–98), but successful gradual orderly exits exist (Chile, Israel, Poland). - Four factors conducive to smooth exits: 1. Little foreign exchange debt and currency mismatches so debtors do not front-run currency movements. 2. Consistent macroeconomic frameworks underpinning exchange rate policy; poor fundamentals and twin deficits often precede crises. 3. A large war chest of foreign exchange reserves to maintain confidence and defend against attacks; caveat that reserves cannot exceed the central bank’s own balance sheet (M2). 4. Capital flows management (CFM) and macroprudential measures to alleviate flow pressures. - China’s standing against these criteria: - External debt to GDP: 12 percent. - Currency mismatch: not severe. - Current account surplus narrowed to 2 percent of GDP. - Fiscal deficit kept to 3 percent of GDP. - Reserves stabilized at around $3 trillion since the beginning of 2017. - RMB has depreciated by around 11 percent against the dollar since August 2015. - Adjusted for productivity, RMB no longer seems much overvalued among emerging market peers. - Policy-room conclusion: - China has the policy room to choose its transition path (gradual vs. fast), supported by ample reserves and capital flows management that can be used opportunistically. - Open questions highlighted: - Is gradual transition optimal versus a faster move? - What is the end game—clean float, managed float, or some intermediate regime—and how will exchange rate choices integrate into the macroeconomic framework? - How will major counterparties (e.g., the United States) cope with the transition given the de facto monetary union under the peg? ### Transitions and financial stability (Tommaso Mancini-Griffoli) - Financial stability is important both to smooth transitions and as a beneficiary of well-managed transitions; causality runs both ways. - Standard “haves” for modern monetary policy: - Clear mandate and accountability. - A medium-term inflation objective. - An internally consistent framework and operational independence. - Developed markets and financial sectors to rely on interest rates as an operational target. - Standard “dos”: - Forward-looking and risk-based monetary policy. - Effective operations and internal processes with open debate. - Clear communications. - Financial stability reduces the three common fears of floating: - Economies with lower financial stability risks at transition tend to have smaller post-adjustment depreciations. - They experience lower inflation rates. - They more quickly establish credibility (stable and well-anchored inflation expectations). - Mechanism: - Weak financial stability can force monetary policy to prioritize containing risks to financial institutions, creating costly tradeoffs with price stability during transitions. - Depreciation, volatility, and higher interest rates can worsen financial risks when banks or clients have dollarization, high leverage, or unstable funding, possibly triggering capital outflows and undermining the currency. - Empirical suggestive evidence from selected Latin American cases: - Mexico’s and Uruguay’s transitions coincided with banking crises (Uruguay’s just prior, Mexico’s just after) and experienced greater depreciation, higher inflation, and lower credibility compared with Brazil, Chile, and Colombia. - Caution: inference from 5 case studies is limited, but the pattern is consistent with financial-stability-related vulnerabilities influencing transition outcomes. *Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China, PART II.* ### conclusions are at best suggestive, though they point to the fact that ### ebook2017 - conclusions are at best suggestive, though they point to the fact that ### Financial stability constrains monetary policy - Conclusions are suggestive that financial stability risks constrain monetary policy and its ability to freely pursue domestic price stability objectives. - Among emerging market economies having transitioned to inflation targeting, countries with greater financial stability risks seem to exhibit less monetary policy independence. - In these countries, monetary policy is more correlated to foreign monetary policy, over and above what can be explained by correlations in business cycles; in extreme cases monetary policy becomes pro-cyclical, as documented by Vegh and Vuletin (2013). - A simple regression presented in the material indicates that countries with riskier financial systems (measured according to internal vulnerabilities) hiked policy rates more and intervened more following the 2013 “taper tantrum” (a risk premium or monetary policy shock taken to be orthogonal to the United States’ or other countries’ growth and inflation prospects). ### Heterogeneity in country experiences and preparedness - It is harder to explain heterogeneity in country experiences purely based on countries’ preparedness (degree of central bank independence, clarity of mandate, operational capacity, institutional quality, and market development), though these factors favor smooth transitions (see Asici, Ivanova and Wyplosz 2008; and Gelos and Ustyugova 2017). - Initial evidence across a wider sample of countries in more stable times still supports the role of financial stability as a determinant of monetary policy independence. ### Two-way causality between transitions and financial stability - Financial stability supports successful transitions from fixed or managed exchange rate regimes to more credible and independent monetary policy frameworks. - Exchange rate regimes and financial stability are closely intertwined: greater foreign exchange mismatches on bank balance sheets increase policymakers’ incentives to minimize FX volatility, which in turn encourages banks to take on currency risk. - Thinner market development (for hedging instruments) when a peg is expected to remain in place reinforces policymakers’ reluctance to allow FX flexibility, prolonging pegs until they break and banks incur large losses. - Greater foreign exchange flexibility can help break self-perpetuating cycles and thereby support financial stability; causality runs from transitions to financial stability as well. ### Design and role of FX intervention rules for smooth transitions - To smoothly transition away from pegged or highly managed exchange rate regimes, rely on an intervention rule aiming to dampen second moments (volatility), not first moments (level of the exchange rate). - Such rules lean against excessive short-term moves without fighting exchange rate trends; on average the exchange rate is market determined. - Reasons to have a rule: - Limiting volatility creates a “safe” environment for households and firms to learn to deal with FX risk and for markets to develop hedging instruments. - A rule guides markets and reinforces the shift in the nominal anchor. - A rule provides instructions to central bank traders, preventing reversion to interventionist reflexes. - A rule helps shield central banks from political pressures. - Desirable design features for rules: - Realism: rules must recognize and adapt to the amount of FX reserves available at the central bank. - Supportive: rules must support central banks’ frameworks and price stability mandates by limiting interventions, and foster market development by allowing two-way risks. - Robustness: rules should be robust to shocks and the evolution of market development and monetary policy credibility; parameters affecting interventions should be adjustable over time without major overhauls or temporary suspension. - Example rule features (as illustrated in the presentation): - A mid-point reset every morning based on a moving average of past close rates. - An intervention frontier specifying how much can be spent on interventions as the spot rate evolves. - A continuous frontier so interventions always give into market pressures while leaning against them; interventions never aim to draw and defend a line in the sand and thus should not attract market speculation. - If central banks have limited reserves, the rule can specify a maximum daily intervention limit; because the mid-point adapts daily, the intervention limit is unlikely to be hit on multiple consecutive days. ### Summary recommendations - Emphasize the importance of a stable financial system to support transitions toward greater exchange rate flexibility. - Recognize that well-managed transitions can help strengthen financial stability. - Adopt clear, realistic, supportive, and robust intervention rules to guide FX interventions, support market development, and protect central bank credibility. *Presentation and related analysis in: Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China* ### PART I: CHINA’S RAPIDLY CHANGING FINANCIAL ### PART I: CHINA’S RAPIDLY CHANGING FINANCIAL SYSTEM: DRIVERS AND FUTURE DEVELOPMENT ### Structural problems in China’s financial system (LUO Sheng) - Financial problems reflect the economy and society; financial-system development is driven by problem-solving dynamism. - Key structural contradictions exist across several relationships in China’s financial system. - Relationship between finance and the real economy - Three public-perception “straw men”: the internet economy; the real estate sector (once real economy, now seen as alien); the financial sector “dressed up in western clothes.” - Principal problems facing finance vis-à-vis the real economy: - Financing is difficult and expensive. - In fund circulation, financial institutions “hold the ball” too long → excessively high financing costs, lower efficiency, and superimposed risk. - Financial system preempts profit margins and draws social resources (talent, capital) away from the real economy → neglect of real economy, flagging competitiveness, harder development. - Causes of finance–real economy imbalance: - Real economy transitioning from old to new. - Risk-weighting in pricing due to rigid debt redemption and weak property-rights protection. - Historical “capital is king” advantage from long-term capital scarcity, license controls, and state ownership of finance. - Asset price climb (credit circulation) attracted capital into speculative financial assets and real estate, increasing leverage and hidden dangers. - Policy prescription (state role): transition from short-term temporary policies to long-term fundamental policies, substantive reform, bilateral deregulation, and channeling fund flows to promote fair competition and market orientation. - Relationships among industries in the financial system - Alternative classification: three systems by investment targets/purposes: - Equity financing system (stock market, mutual funds). - Debt financing system (credit market, bond market, trusts). - Risk-management tools system (derivatives, interbank lending). - Banks are infrastructural and dominant due to monetary-account franchise, statutory fund movement channels, branch networks, and customer advantages. - Insurance has cross-market characteristics and a growing, evolving role. - Regulatory paradox: perceptions of “excessive and strict regulation” versus claims of post-2012 “over-liberalization.” Conclusion: areas needing regulation are poorly regulated, areas needing control are not controlled, and areas to be developed remain undeveloped. - Financial services sector value added as a share of GDP exceeds that of highly developed markets (e.g., United States), yet financing remains difficult and expensive — reflecting serious structural imbalance. - Supply and demand relationship - China entering an age of wealth management; household demand for wealth management will become rigid. - Household investing expectations remain unstable after decades of rapid income and asset-price changes → heavy allocation to short-term financial assets. - Product homogeneity and blurred boundaries across industries increase intersector competition (“playing the edges”). - Social factors have impeded development of contractual mentality and risk awareness; rigid payment expectations and difficulty in normalizing financial-institution bankruptcy create large social-cost dilemmas. - Traditional finance vs. internet finance - Internet finance has substituted for insufficient traditional finance in payments and consumer finance; in some respects China is at the international forefront. - Big-data (and future AI) could enable internet finance to match or exceed traditional finance in risk pricing and control, potentially accelerating “intelligent finance” squeeze-out of traditional finance. - Many internet-finance offerings lack genuine innovation and some amount to fraud; regulators should adopt a proactive, open, and tolerant attitude toward genuine internet finance. ### Positioning of insurance in China’s financial system (LUO Sheng) - State orientation: insurance is a key industry and basic risk-management means, forming components of health care, retirement security, and financial systems. - Dual attributes of insurance: - Security (risk-management) attribute — basic attribute. - Financial (investment) attribute — derivative attribute, increasingly pronounced with product innovation and accumulated insurance funds. - Historical policy evolution: restrictions on use of insurance funds were lifted, allowing access to capital markets; underwriting and investing have become the “two wheels” of insurance operations. - Warning against extremes: - “Asset-driven” model (viewing premiums purely as financing means and pursuing high-risk/high-return investing) abandons insurance’s core attribute and must be checked. - Conversely, limiting insurance solely to risk management is inconsistent with state orientation and global industry experience. - Key statistic (insurance scale) - As of year-end 2016, insurance industry assets totaled 1.5 trillion yuan, that is 5.3 percent of the financial sector. ### Insurance liability and investing models (LUO Sheng) - Liability model: two major product types - No-cash-value (consumer-type): property, accident, some health — concentrates on risk-management attribute. - Cash-value (investment-type): traditional life, retirement, investment-type life — reflect insurance’s financial attribute; interest-rate determination follows investment return principles. - Market evolution: fragmentation and network channels allow separation of security-type and investment-type products; customers gain more affordable options and greater right to know. - Mismatch in float sources: - International example: Warren Buffett’s insurance float mainly from property insurance (unearned premium reserves). - In China, many imitate Buffett using life insurance premiums (investment-type) — fundamentally different and a source of recent market risks. - Open questions for policy/industry: - Should investment-type insurance be an option for household short-term wealth management? If restricted, should ratio limits be set and should limits vary across companies? - Why do universal-life-like products perform steadily abroad but face turbulence in China, and what regulatory responses are needed? - Investing model lessons and consensus - Insurance funds in China have the broadest permitted investment scope among fund types; they are “broadband funds” subject to certain ratio restrictions. - Observed deviations: focus on short-term gains, overanxious perfectionism, improper motives by some firms → industry losses. - Agreed priorities: - Robustness of insurance investing (comprehensive balance and assurance) should have higher priority. - Uphold financial investing principles; strict policies, rules and systems are needed for insurance capital conduct in capital markets. - Strictly limit use of insurance funds (particularly investment-premium funds) for corporate acquisitions except for essential industry-chain integration. - Limit derivative investments to hedging based on spot transactions. ### Future development challenges for the insurance industry (LUO Sheng) - Overview: risks and challenges arise from internal market/regulatory issues and from broader economic, financial, and social problems. - Asset-liability matching challenges - Complexity and diversification of liabilities and broad asset-allocation scope increase demand on asset-liability management; many problems persist. - Maturity mismatch: - Long-term funds used for short-term needs; scarcity of long-duration fixed-income assets → liability maturities exceed asset maturities in life insurance. - The gap for assets with maturities of more than 15 years alone is 5.4 trillion yuan. - Short-term funds used for long-term needs → high-cash-value product sales, investment in low-liquidity assets → greater liquidity risk. - Yield mismatch: - Insurance funds are counter-cyclical: easier premium collection when yields fall, but investing becomes harder; rapid premium growth meets fewer high-quality high-yield assets → potential spread losses and cancellation pressure. - Operational restructuring difficulty: - Policy favors longer-term products and tighter controls on medium/short-term products to push restructuring, but path dependence and limited operational capacity make rapid restructuring risky. - Corporate governance challenges - Market reforms increase the importance of corporate governance; core problem: taming capital and preventing shareholder abuses (false funding, self-cycling, using insurers as “ATMs”). - Internal fraud and shareholder manipulation are primary global causes of governance failure; China’s markets face this problem particularly seriously. - Effective governance depends on social/cultural environment, legal system, and market fundamentals — making reform long-term and systematic. Challenge: identify breakthrough points for real company reform. - Insurance regulatory challenges - Historical mission is heavy; recent regulatory thinking emphasizes regulation as intrinsic to regulators’ remit. - Regulatory objectives: liberalize the front end and ease restrictions while effectively controlling the back end and cracking down on market chaos. - Need for a more localized and flexible regulatory rule set and targeted regulatory means to resolve China-specific insurance market problems. - Regulatory trade-offs: - Avoiding a “hard landing” and mass shareholder/capital retreat that could destabilize the market. - Preventing systematic mistrust of private capital, excessive pursuit of security, or differential treatment of state vs. private capital that would hurt market vitality. - Current constraints: limited regulatory professionalism, human resources shortages, and constrained enforcement tools. - Recommended regulatory focus (LUO Sheng): - Implement “two penetrations”: - Equity penetration: penetrating reviews of related-party relationships and shareholder share capital to prevent inappropriate control. - Investing penetration: ensure insurance investing is true, secure, and placed into the real economy (not misappropriated or funneled to shareholders). - Accomplish “two dares”: - Dare to hand cases over for prosecution when criminal activity is suspected. - Dare to embrace bankruptcy for institutions with severe risk problems to achieve “small enough to fail,” allowing market and regulatory hands to address problems. ### Strengthening and developing China’s financial system (Miquel Dijkman) - Progress to date (past decade) - Major strides: continued expansion in size and depth; Chinese equity and bond markets among the largest in the world. - Major progress in financial inclusion: vast majority of Chinese citizens now enjoy access to formal financial services. - Key reforms: interest-rate liberalization; banking commercialization; introduction of financial safety nets; exchange-rate reform; inclusion of the Renminbi into the SDR. - Overarching policy objective: reduce dependence on credit and transition to more sustainable consumption- and service-driven growth. - New role required of the financial system - Historically channeled high savings at low cost to strategic sectors (large corporates). - New priorities: greener, more inclusive, more innovative, productivity-based growth; increase market’s role in resource allocation. - Critical objectives: - Strengthen the financial sector’s allocative function. - Build a more diverse financial system with more active capital markets and NBFIs. - Build a more inclusive financial system addressing underserved households and SMEs. - Strengthening allocative function - Bank lending shifts (2010–15): share of utility, infrastructure and manufacturing lending declined from 55 to 45 percent; construction and real estate stable around 17 percent. - Nonperforming loans (NPL) ratio edged up in agriculture, mining, manufacturing, and trade since global headwinds post-2011. - Structural shift in banking: large state-owned commercial banks balance sheets ≈ 114 percent of GDP in both 2010 and 2015; combined asset size of other banking institutions (excluding policy banks) rose from 99 to 148 percent of GDP (2010→2015). - Lending patterns: larger banks lend relatively more to households and less to corporates; small banks show the opposite trend and hold higher proportions of on-balance-sheet investment assets allocated to corporates and local government financing vehicles. - Policy actions recommended: - Harden budget constraints vis-à-vis ailing borrowers. - Reduce perceptions of implicit state guarantees to alleviate moral hazard and enable commercial risk pricing. - Pursue corporate restructuring and prepare for orderly firm exits; under adverse scenarios, decisive NPL-resolution strategy may be necessary. - Building a more diverse financial system - Capital markets and NBFIs priority for development (equity, bond, commodities, derivatives; insurance, pension funds, mutual funds). - Size indicators (2010–15): - Domestic private debt market increased from 34 to 47 percent of GDP. - Share of nonfinancial corporation debt among total debt outstanding rose from 26 to 43 percent. - By end-2015, sum of equity, public and private debt market capitalizations reached 144 percent of GDP. - NBFI asset growth: - Traditional NBFI assets = 31 percent of GDP in 2015 (up from 19 percent in 2010). - WMP (wealth management product) and trust company assets accounted for 34 and 24 percent of GDP respectively in 2015. - Challenges: private pension funds and mutual funds have not kept pace; WMPs and trust companies may lack long-term orientation attributed to institutional investors. - Maturing capital markets need a stronger institutional investor base and improved enabling environment (stronger gatekeeper functions and public/private rights). - Building a more inclusive financial system - Financial inclusion is a key priority for rebalancing; provision of credit, deposit, payment, insurance, and risk-management services to households and SMEs is important. - Measured by account metrics, China has made major strides in individual financial access relative to peers. - SMEs continue to face tight financing constraints for investment and working capital. - Recommended shift: move from government-promoted outreach to a market-based approach that creates an enabling environment for providers to serve underserved groups commercially sustainably. *From: Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China (conference presentations compiled in ebook2017).* ### PART II: REGULATORY FRAMEWORKS AND MACRO‐ ### PART II: REGULATORY FRAMEWORKS AND MACRO‑PRUDENTIAL POLICIES ### Key attributes of macroprudential policy: the example of the United Kingdom - Mandate and objectives - The Financial Policy Committee (FPC) is the macroprudential authority charged with identification, monitoring, and acting to remove or reduce systemic risks to protect and enhance the resilience of the UK financial system. - Financial stability is defined as the financial system's ability to continue to deliver essential services at reasonable prices, including credit intermediation, even after a severe shock. - The FPC has a secondary objective to support government policies, including for growth and employment, provided this does not interfere with the primary objective of financial stability. - Institutional composition and skills - The central bank must be deeply involved because it brings the macroeconomic perspective and market understanding from monetary policy formulation and implementation; the FPC sits in the Bank of England, which supplies the staff and almost half the policymakers. - The macroprudential committee should include representatives from other regulatory authorities, including the head of the conduct authority and the microprudential regulator of banks and insurance companies. - The presence of several outsiders with expertise in financial institutions and markets and in policymaking helps bring fresh perspectives and resist groupthink. - Policymakers must focus on tail risks, externalities, amplification mechanisms, and spillovers that markets cannot price by themselves. - Authority and tools - The FPC has powers of direction and can adjust some regulations itself without needing the assent of microprudential regulators or the government; this power encompasses some parts of the capital regime for banks and several aspects of real estate lending. - The FPC can make recommendations to anyone on anything related to financial stability and has used recommendations to request deeper information, recommend microprudential preparedness for tail risks, and suggest adjustments in capital requirements. - Two key authorities to protect financial stability are stress tests and orderly liquidation: - Stress tests should be countercyclical: shocks should get larger the more ebullient markets are and the more leveraged the lending. - Orderly liquidation of systemically important institutions allows failure without taxpayer support and involves the possibility that creditors will bear losses, enhancing market discipline. ### Regulatory framework and macroprudential policy in Thailand - Financial system structure and interconnections - Commercial banks remain at the core, accounting for about half of the total financial sector’s assets. - Nonbank financial institutions (NBFIs) such as mutual funds, insurance companies, and savings cooperatives have grown in the double digits in the past three years, with implications for financial stability. - Banks and NBFIs are interconnected through inter-group (arms-length) links and intra-group (financial conglomerate) links, so risks from NBFIs can affect the banking sector and overall stability. - Institutional arrangements and coordination - Several agencies supervise financial institutions, financial markets, and payment services: Bank of Thailand (BoT), Office of Insurance Commission (OIC), and Securities and Exchange Commission (SEC), with responsibilities bestowed by the Ministry of Finance. - The Bank of Thailand has long presumed responsibility for financial stability even though no laws grant it an explicit mandate; it leads efforts to strengthen the national financial stability framework. - Internal and interagency coordination mechanisms include a Financial Stability Subcommittee, semi-annual joint meetings between the Monetary Policy Committee (MPC) and Financial Institutions Policy Committee (FIPC), and the Financial Stability Unit (FSU) established in 2016 to coordinate financial stability work. - Remaining challenges - Coordination difficulties because financial stability is not a central mandate of all regulators; institutional and inter-agency arrangements are being discussed for improvement. - Data and tools gaps: the need for reliable and high-frequency data and analytical tools to identify systemic risks; the BoT is working to lessen the data gap and enhance technical capacity by exploring alternative data sources and exploiting new technology such as big data analytics, and developing systemic risk analysis toolkits such as scenario planning and macro stress testing. - Human resource capacity: financial stability is multi-disciplinary, requiring a mix of skillsets to manage macro-financial linkages, systemic risk assessment, and macroprudential policymaking. - Conclusion - The Bank of Thailand and other regulatory agencies are continuously strengthening institutional arrangements for a macroprudential policy framework that can ensure overall financial stability. ### Macroprudential policy — lessons from international experience - Fundamental challenges - Macroprudential policy faces "inaction bias" (first examined in Nier (2011)): because policy manages tail risks, benefits of action accrue in the future and are hard to measure, while costs are visible and felt immediately, reducing willingness to take early and forceful action. This bias can be compounded by lobbying, capture by the financial industry, or political pressures. - The financial system evolves dynamically, changing the level, source, and distribution of systemic risk. Evolution can be driven by financial technological innovation, regulatory constraints, and distortions from other policies such as fiscal distortions that favor debt, opening "policy gaps" and increasing the need for cross‑field coordination. - Institutional foundations for effectiveness - Willingness to act: - Fostered by a clear assignment of the mandate to a body or committee, a strong role for the central bank in macroprudential policy, and objectives and accountability mechanisms established in law. - Ability to act: - Requires powers and tools with sufficient range and reach, including powers to collect information, calibrate tools, and designate systemically important financial institutions or services. - Cooperation mechanisms: - Go beyond councils; for cooperation, microprudential agencies and securities regulators should be given a financial stability objective (as in Australia and the United Kingdom). - Addressing domestic leakage and expanding the perimeter - Collect and share information via back-up powers to collect information directly from firms and establishment of (credit) registers and common data platforms. - Expand the regulatory perimeter beyond banks to substantial nonbank intermediaries; e.g., the U.K. FPC can recommend perimeter expansion to the Treasury. - Adopt a functional approach to regulation to capture product- and service-based risks; for example, enforce Loan-to-Value (LTV) and Debt-Service-to-Interest (DSTI) restrictions on all providers of credit (as in Hungary, Korea, and the Netherlands). - Capital account liberalization and cross-border considerations - Further capital account liberalization can be useful over the medium term for efficient allocation of savings and investments and may reduce domestic leakage by freeing savings, but it can also stimulate cross-border credit and reduce the effectiveness of domestic macroprudential tools. - Cross-border credit increases may call for cross-border or regional coordination of macroprudential action, including "reciprocity" agreements (e.g., Basel III Countercyclical Capital Buffer reciprocity among Basel Committee members; regional agreements in the European Union for tools beyond the Countercyclical Capital Buffer). - Managing new risks from capital flows - Liberalization can lead to larger and more volatile capital flows and new risks such as increases in wholesale funding (including in foreign exchange) and incentives for households and corporates to borrow in foreign exchange, especially when domestic interest rates are higher than those of major carry currencies (such as the U.S. dollar, yen, or Swiss francs). - Targeted macroprudential tools can address these risks, including liquidity requirements (LCR, NSFR) potentially differentiated by currency (as introduced in Korea, Iceland, and Sweden), and higher capital requirements or tighter loan restrictions on foreign exchange exposures (as in Hungary, Poland, and Russia). *Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China — PART II: REGULATORY FRAMEWORKS AND MACRO‑PRUDENTIAL POLICIES* ### REFERENCES ### REFERENCES ### Bibliographic citations - IMF. 2013. “Key Aspects of Macroprudential Policy.” IMF, Washington, DC. - IMF. 2014. “Staff Guidance Note on Macroprudential Policy.” IMF, Washington, DC. - IMF. 2017. “Increasing Resilience to Large and Volatile Capital Flows: The Role of Macroprudential Policies.” IMF, Washington, DC. - IMF-FSB-BIS. 2016. “Elements of Effective Macroprudential Policies: Lessons from International Experience.” Paper from the IMF, Financial Stability Board, and Bank for International Settlements, Washington, DC. - Nier, Erlend. 2011. “Macroprudential Policy: Taxonomy and Challenges.” National Institute Economic Review No. 216, 2011, London. ### Major themes and findings from Alfred Schipke’s chapter "A Rapidly Changing Economic and Financial Structure: Does China Need a Public Administration Reform?" - Structural transformation: - China shifted from agriculture to manufacturing and more recently to services; in purchasing power parity terms, China is now the largest economy in the world. - The financial system has grown more rapidly than the real economy, becoming more complex and interconnected. - Government role and public sector: - The government has been deeply involved in the economy through state-owned enterprises, local governments, and strong guidance; the public sector has declined as a share of the economy but remains very large. - The chapter argues the country needs—in many areas—a larger public sector at the center/headquarters to handle emerging tasks. - Sources of strain on headquarter ministries and agencies: - Reform push following the 3rd Party Plenum in 2013 and the 13th Five-Year Plan (2016–2020) requires development of vast reform blueprints and workplans. - Rapidly developing, complex, and interconnected financial system requires constant assessment of new risks, widening regulatory perimeter, and stronger supervision. - Increasing global footprint and “Going Global” strategy require adaptation of frameworks and participation in global forums and bilateral dialogues. - Staffing and resource constraints: - Central government ministries and regulatory agencies have extremely small staffing at headquarters that have remained largely unchanged despite rising demands. - China’s relatively flat civil service salary structure, combined with rapid wage growth in sectors such as financial services, makes attracting and retaining highly qualified public-sector employees more difficult. - A public administration reform that increases resources at the center/headquarters is argued to be warranted and urgent as the state shifts from transactional roles to facilitator roles focusing on strengthening policy frameworks. ### Institutional examples and specific statistics - State Administration of Taxation (SAT): - The whole tax system employs some 750,000 people, but only 750 people work at Beijing’s headquarters. - The chapter notes that, instead of the 0.1 percent ratio observed in China, a comparison with other good tax authorities would suggest that 3–10 percent should be employed at the center, or 7,500 to 22,500 people. - Some 5.5 million enterprises were founded in 2016 alone, contributing to compliance and revenue-protection challenges for SAT. - Ministry of Finance (MOF): - The local government bond market reached RMB10.6 trillion in 2016. - The MOF center employs only some 1,000 staff. - Financial sector regulators and system development: - The largest banks in the world are now Chinese; China’s equity market is the second largest; the bond market is the third largest in the world. - Rapid financial deepening included liberalization, rapid credit growth, a sharp increase in nonbank financial institutions, emergence of more complex financial products, and new markets such as derivatives. - Product speed examples: Alibaba’s Yuebao money market fund grew from zero to 85 million customers within one year; P2P platforms have mushroomed over the past couple of years. - Increased complexity and global importance call for more coordination among regulators domestically and internationally and better, timely communication. - IMF/World Bank 2011 Financial Sector Assessment Program recommended strengthening of staffing. - Headquarter staffing (table values reproduced exactly as shown): - People's Bank of China (PBC): Headquarter 717; Headquarter/total (in percent) 0.7; System-wide 105,980. - Ministry of Finance (MOF): Headquarter 1,023; Headquarter/total (in percent) 0.2; System-wide 488,192. - State Administration of Taxation (SAT): Headquarter 750; Headquarter/total (in percent) 0.1; System-wide 750,000. - China Banking Regulatory Commission (CBRC): Headquarter 662; Headquarter/total (in percent) 2.8; System-wide 23,683. - China Securities Regulatory Commission (CSRC): Headquarter 730; Headquarter/total (in percent) 23.6; System-wide 3,097. - China Insurance Regulatory Commission (CIRC): Headquarter 390; Headquarter/total (in percent) 13.9; System-wide 2,802. - Treasury (China): Headquarter 2,120; Headquarter/total (in percent) 2.52; System-wide 84,050. - Federal Reserve (Fed): Headquarter 2,700; Headquarter/total (in percent) 12.45; System-wide 21,686. - Treasury (United States): Headquarter 2,144; Headquarter/total (in percent) 28.23; System-wide 7,596. - Reserve Bank of Australia (RBA): Headquarter 1,232; Headquarter/total (in percent) 91.46; System-wide 1,347. - Treasury (Australia): n.a. Headquarter/total (in percent) n.a.; System-wide 1,238. - Bank of England (BOE): Headquarter n.a.; Headquarter/total (in percent) n.a.; System-wide 3,680. - Federal Ministry of Finance (Germany): Headquarter 1,864; Headquarter/total (in percent) n.a.; System-wide n.a. - Bundesbank: Headquarter 4,623; Headquarter/total (in percent) 47.98; System-wide 9,636. - Table source: Annual reports of respective agencies, Overseas development institute report. - Organizational constraints: - Shifting of resources between departments within agencies is very constrained; the chapter recommends public administration reform to ensure adequate and well-paid staff, especially at headquarter agencies. ### Policy implications and recommendations (as presented) - Strengthen central/headquarter staffing: - Increase the number of qualified, well-paid staff at center/headquarters of key ministries and regulatory agencies to better design reforms, identify emerging risks, and develop rules and regulation. - Modernize and revamp tax administration: - SAT needs continuous modernization efforts to protect the revenue base amid the expansion of global operations by Chinese firms and fast enterprise creation domestically. - Enhance regulatory capacity and coordination: - Financial regulators should expand capacity to assess new risks, widen the regulatory perimeter as needed, and strengthen regulation and supervision overall. - Improve coordination and timely communication among domestic regulators and with international counterparts to manage China’s increasing global financial footprint. - Adjust compensation and career incentives: - Reform civil service salary structures or other incentives to attract and retain highly qualified staff in the public sector, given fast-growing wages in the private financial sector. *Source: REFERENCES and Alfred Schipke, "A Rapidly Changing Economic and Financial Structure: Does China Need a Public Administration Reform?", Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China.* ### 4. Excluding printing and minting companies. ### 4. Excluding printing and minting companies. ### Chilean exchange rate regime evolution and historical episodes - Rodrigo Vergara (Former Governor, Central Bank of Chile) recounts Chile’s movement from a peg to a semi-peg and eventually to a free-floating exchange rate system, covering almost every exchange rate regime over the last four decades. - 1980s: Chile had a fixed exchange rate to the U.S. dollar; the peg was abandoned during the debt crisis and a crawling exchange rate band was adopted in 1984 with an initial band of ±0.5 percent that was gradually widened. - Early 1990s: The band was widened to ±5 percent; central parity fixing was changed from the U.S. dollar to a basket of currencies; capital controls on outflows were lifted and controls on inflows were imposed via a reserve requirement targeting all inflows, especially short-term inflows. - Inflation and central bank independence context: inflation was 10–20 percent annually in the first half of the 1990s; the Central Bank became independent in December 1989 with an explicit mission to reduce inflation. - Late 1990s crises and policy response: the Asian crisis and the Russian crisis led to sharp depreciation; the central bank hiked interest rates by more than 500 basis points, and GDP fell 0.4 percent in 1999, marking a recession. - Transition to free float: the band was widened to ±8 percent and then to ±12 percent; at the end of 1999 the band was abandoned, the exchange rate floated freely, and all capital controls were removed. - Tenure and practice since float adoption: it has been close to 18 years under a free-floating exchange rate regime with no capital controls, though the central bank reserves the right to intervene under “exceptional circumstances.” ### Foreign exchange interventions and reserve management - Definition of “exceptional circumstances”: when the exchange rate is off its equilibrium level by a significant margin for significant time; the central bank uses models to estimate the equilibrium real exchange rate. - Justifications for intervention also include accumulation of reserves when the currency is clearly over-appreciated and international reserves have declined after a long period without intervention. - Recorded interventions since the free float: - Four periods of exchange rate intervention since adoption of the free float. - Early 2000s: two small, short-lived sales of foreign exchange in response to depreciation linked to external events (crisis in Brazil). - 2007–early 2008: massive capital inflows produced major appreciation; the central bank announced a sterilized purchase program of foreign exchange for a given amount for the whole year, divided evenly for each working day; the program was discontinued as the global financial crisis erupted and capital flowed out. - 2011: a second purchase program during massive capital inflows, completed at the end of the year. - During Vergara’s tenure as governor, the Central Bank of Chile did not intervene in the foreign exchange market. ### Capital controls, effectiveness, and financial trade-offs - Capital controls applied historically: - Early period: capital controls on outflows were imposed when coming out of crisis. - Later: controls on inflows via reserve requirements were used to stem appreciation pressures. - Effectiveness: most evidence shows capital controls were fairly effective at the beginning but lost effectiveness over time as markets found ways to circumvent restrictions. - Central bank balance sheet consequences: sterilized interventions implied significant losses to the central bank; the Central Bank of Chile has had negative capital for a long time in part because of sterilized interventions during this period and in the 2000s. ### Policy lessons and considerations for flexible exchange rates - Exchange rate as shock absorber: Vergara finds that over close to 18 years the free float has acted as an effective and efficient shock absorber for Chile. - Hedging and market development: - Flexible regimes imply greater exchange rate volatility than pegs or bands; agents need access to deep markets for hedging. - It is important that conditions be set to develop deep derivative markets when moving to a float. - Currency mismatches and “fear of floating”: - Large currency mismatches in corporate or household sectors create vulnerability to depreciation and can precipitate financial crises. - Monitor currency mismatches and inform the corporate sector of risks from open foreign-currency positions under a flexible exchange rate. - Chile’s experience indicates currency mismatches are largely endogenous and have fallen significantly since the free float was implemented. - Exchange rate pass-through (ERPT): - ERPT is the effect on inflation of changes in the exchange rate and is particularly relevant for resource-dependent countries facing volatile commodity prices and terms of trade shocks. - Evidence shows ERPT has declined in most economies over recent decades; ERPT is larger in emerging markets than in advanced economies, and among emerging markets it is higher in commodity exporters than in non-commodity exporters. - Vergara considers ERPT should not be a major obstacle for China to move to a more flexible exchange rate system. - Financial stability and transition: - Financial stability is crucial for a successful transition from a semi-peg to a flexible exchange rate. - Vergara concurs with prior conference presentations emphasizing the importance of financial stability during such transitions. *Remarks by Rodrigo Vergara, “EXCHANGE RATE POLICY: REMARKS BASED ON THE CHILEAN EXPERIENCE,” from Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China.* ### 2015. Jackson Hole, Wyoming. ### 2015. Jackson Hole, Wyoming. ### REMARKS ON STRENGTHENING FINANCIAL AND EXCHANGE RATE FRAMEWORKS — Arminio Fraga - China’s monetary and exchange rate regime has been evolving: after a decade pegged to the U.S. dollar ended in 2005, the People’s Bank of China has been gradually moving toward a more flexible system that responds to economic fundamentals and, more recently, takes as reference a basket of the more relevant currencies. This strategic move has been supported by many institutional and operational improvements that have paved the way for the inclusion of the renminbi among component currencies of the IMF Special Drawing Rights (SDRs). - The adoption of a more flexible exchange rate regime is justified because China does not belong to the optimal currency area of another region or country. - Over time it makes sense for China to move to an even more flexible regime, probably a free floating exchange rate. - The current focus on a basket has proven to be an effective transition regime; however, China would benefit from de-emphasizing the basket and moving to a fairly free float. - Intervention under a freer float: - Intervention should take place mostly in extreme circumstances of high market volatility and, especially, low market liquidity. - Intervention could also take place as part of any future effort at exchange-rate coordination among the larger currency blocks, something not on the table at the moment. - Capital controls: - As economies and financial markets become more sophisticated, capital controls lose efficacy. - Over time the only controls that make sense are those related to either a more prudential nature (such as temporary taxes on short-term inflows) or related to transparency and anti-money-laundering efforts. - Strengthening complementary frameworks required for a floating rate: - Monetary: moving away from a managed exchange rate will require a clearer nominal anchor, such as a target for inflation, preferably one that preserves some flexibility to help smooth the business cycle. Direct credit controls as a monetary tool entail relevant efficiency costs. - Fiscal: long-term challenges include implications of dramatic demographic changes, unsustainable financing of local governments through land sales, and potential losses stemming from state-owned enterprises (SOEs) and the financial sector. - Financial sector: core issue is accelerated credit growth and its disconnect with economic growth; the large credit/GDP ratio is a flashing sign of danger when compared to historic records of banking and financial crises. - Policy stance on risk and reform: - Switch from short-term, demand-driven growth targets to more flexible, longer-term, supply-side driven targets to reduce over-investment, excessive credit growth, and asset bubbles. - A gradual policy response to remove implicit guarantees must be carefully designed to avoid triggering sharp credit contractions. - An effective strategy includes a global assessment of flows (losses) and stocks (balance sheets) based on conservative growth and stress scenarios. ### TOWARDS LESS FOREIGN EXCHANGE INTERVENTION — Ma Jun - Exchange rate regime and transparency: - The People’s Bank of China’s adoption in early 2016 of a formula-based daily fixing system made significant progress toward transparency and substantially reduced the market expectation of one-off depreciation of the renminbi (RMB). - Consensus among conference participants: China should move toward greater exchange rate flexibility by reducing foreign exchange intervention and refraining from additional measures to control capital flows. - The basket system should be viewed as an intermediate step in China’s transition toward—rather than the final goal of—a flexible exchange rate regime. - Effectiveness of intervention and capital controls: - Foreign exchange intervention tends to be ineffective in affecting exchange rate expectations and may even worsen exchange rate expectations. Empirical studies by the Bank for International Settlements and Ma Jun show that foreign exchange intervention has led to deterioration in exchange rate expectations, using data from Brazil, China, Korea, Malaysia, and Peru (for example, central bank selling of foreign exchange worsens depreciation expectations). - Capital controls tend to be less effective than perceived. Even if capital controls effectively limit hard currency outflows, they may increase RMB outflows and substantially reduce future inflows. - Market acceptance and policy implications: - Social and market acceptance of two-way volatility of the CNY/USD exchange rate has increased substantially in the past two years; fully understanding this growing market acceptance could help convince policy makers to avoid excessive foreign exchange intervention and unnecessary capital controls. - PBOC has substantial scope to improve transparency of monetary and exchange rate policies; the market is confused about why the central bank needs so many different policy rates and it is unclear who is setting these. - Protecting and developing the foreign exchange hedging market and reducing hedging costs will support acceptance of two-way volatility of the RMB exchange rate. - Macroprudential and regulatory recommendations: - De-emphasize the GDP growth target to reduce tensions between growth and financial stability. - Avoid sending signals of implicit guarantees to market participants, including FX and stock markets. - Expedite reforms to allow loss-making state-owned enterprises to exit and reduce borrowing by inefficient enterprises. - Introduce property taxes in more cities to replace land revenue as a major source of fiscal income to reduce local government incentives to boost property inflation and property-related leverage. - Devote more regulatory resources to cover shadow banking activities. - Significantly increase staffing at the headquarters of financial regulators (including the PBC, China Banking Regulatory Commission, China Securities Regulatory Commission and China Insurance Regulatory Commission), boost their compensation, and introduce a "revolving door" mechanism to ensure necessary skills and financial market knowledges. - Extend stress testing from static analysis on individual institutions to "dynamic analysis" by including contagion effects and assessing impact of “shocks” on the entire financial system. - Develop contingency plans to deal with sudden market crashes and ensure orderly resolution of failing financial institutions. - Improve communications of prudential policies and coordination among regulators; use forward guidance to influence market participant behavior and avoid "shocking" the market. - Improve coordination among regulatory agencies at both ministerial and working levels by setting up interdepartmental working groups. - Study and prepare for new risks from financial innovation and capital account liberalization, such as excessive use of wholesale funding and excessive foreign exchange borrowing. ### CONTAINING SYSTEMIC FINANCIAL RISKS IN CHINA — Huang Yiping - Policy emphasis and background: - From late 2017, China’s leaders have repeatedly emphasized the importance of controlling systemic financial risk. - The Government Work Report delivered by Premier Li Keqiang in early March highlighted the need to steadily advance financial regulatory system reform, systematically resolve risk factors, consolidate financial order, and build a firewall against financial risks. - Recent sources of financial stress: - Starting about three years prior to these remarks, financial risks emerged across sectors: equity and wealth management product markets, then property and foreign exchange markets. - Example: Shanghai A-share Index rose from 3,258 on January 5, 2015 to 5,174 by June 15, 2015, but then dropped to 3,052 by September 30, 2015; equity investors leveraged trust and banking sectors during the upswing. - Since 2009 the property market experienced three cycles, peaking in July 2011, December 2013, and September 2016; each cycle produced sharper and more broad-based price jumps, raising concerns about consolidation risks for the banking sector. - Currency pressures and policy responses: - The August 11, 2015 reform of setting daily central parity triggered strong market anticipation of a weaker RMB; the central bank tightened capital account controls and used foreign exchange reserves to intervene, yet the renminbi depreciated in the subsequent two years. - These episodes raised concern that China’s financial risks had become systemic, given the high contagion between banking crises and currency crises. - Structural changes increasing systemic vulnerability: - China avoided a serious financial crisis historically due to two factors: undisrupted, rapid economic growth and implicit/explicit government guarantees backing borrowing by local governments, SOEs, and financial institutions. - Both factors are changing: - Growth decelerated from 10.6 percent in 2010 to 6.7 percent in 2016, leading to deterioration of corporate balance sheets and increases in bad assets. - Macroeconomic evolution produced the "risky trinity": rising leverage ratios, falling productivity, and narrowing policy flexibility—meaning greater financial risks and reduced government capacity to respond. - Liquidity and scale indicators: - Abundant liquidity exacerbates vulnerabilities: broad money supply, M2, was 208 percent of GDP at the end of [text truncated in source]. *Source: Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China (2015, Jackson Hole, Wyoming).* ### 2016. By comparison, that proportion was only around 80 percent in the ### Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China ### Money supply, financial intermediation, and risk dynamics - In 2016, the proportion of money supply held was contrasted with "around 80 percent in the United States." - China’s financial intermediation is dominated by the banking sector, linked to a large M2. - There appeared to be a built-in acceleration mechanism for money supply: - When the economy was doing well, money supply needed to accelerate to facilitate expansion of economic activities. - When the economy was not doing well, money supply also needed to accelerate to stabilize the economy and market; the latter was linked to the government guarantee. - Historical pattern: M2 growth was consistently faster than narrow money supply growth (M1) until mid-2015. - In mid-2015, M1 growth "suddenly took off and grew significantly faster than M2," implying depositors shortened terms on bank deposits and sought higher returns elsewhere. - The combination of a large volume of investible funds and limited investment opportunities caused rotating financial risks: - Rapid flows of money into where investment opportunities existed produced booms and bubbles. - Booming and cooling across equity, property, and foreign exchange markets reflected investors searching desperately for investment opportunities. - This feature is characterized as persistent: "not going to go away easily." ### Findings on systemic vulnerabilities - Large M2 alone had not necessarily caused trouble historically, but shifts in deposit behavior increased market risk. - Government implicit guarantees contributed to stabilization pressures and moral hazard. - Limited direct financing (equity and bond markets) share in total financial intermediation constrains efficient use of financial resources. - Existence of zombie firms and banks increases systemic risk. ### Policy recommendations to contain systemic financial risks - Authorities should address at least three areas: 1. Monetary policy and leverage - The central bank should maintain relatively tight monetary policy conditions to gradually stabilize or even lower the aggregate leverage ratio. - Achieve this through more efficient use of money supply (financial resources). - Increase the share of direct financing (equity and bond markets) in total financial intermediation. 2. Regulatory framework and macroprudential policy - Restructure the regulatory framework; macroprudential policy is a first step toward averting systemic financial crisis. - Urgent coordination and collaboration among the central bank and three financial regulators to eliminate gaps (potential sources of risk) in the regulatory system. - Regulators should focus more on maintaining financial order rather than nurturing development of the financial industry. 3. Withdrawal of government guarantees and market discipline - The government needs to decide firmly to withdraw its unnecessary guarantees. - It is asserted that the government "is no longer able to honor its implicit guarantees." - Zombie firms and banks should exit the market to reduce risks in the system. ### Closing remarks — broad consensus points from the conference - Exchange rate: - "China needs to move toward a more flexible exchange rate, and sooner rather than later." - Capital account liberalization: - "This should be done carefully; currently, preconditions are not in place for an aggressive opening." - Long-term goal: integrate China’s capital market. - Macro-prudential framework — three key issues for success: - Regulation, supervision, and structure need: a clear mandate, ability to detect risk, power to act, and coordination and information sharing. - Fiscal/quasi-fiscal dominance sustains pressure for credit growth; it is important to move away from hard and quantitative growth targets that contribute to local government investment and real estate spending biases. - Eliminate widespread implicit government guarantees that have contributed to moral hazard and fueled strong credit growth. - Transparency and communication: - At China’s level of development and global footprint, transparency and improved communication are critical. - This includes policy and reform objectives, frameworks, developments, and actions, and should be done "a lot more frequently, that is, daily and weekly, for every action." *Source: Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China (IMF conference e‑book).* ### 1982. In 1983, he became one of the youngest individuals in recent ### Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China ### FX intervention and exchange rate expectations (Ma Jun; Research Bureau, The People’s Bank of China) - Empirical evidence suggests FX intervention may worsen exchange rate expectations: - Ma Jun’s empirical model with China data (2010.01–2017.03) shows intervention coefficients: -0.19**, -0.108**, -0.182***, -0.10* (t-statistics shown in parentheses: (-3.37), (-2.01), (-3.22), (-1.80)). - Other coefficients reported: -0.16 and -0.18 (t-statistics (-1.82), (-2.0)); US INDEX coefficients 0.38 and 0.36 (t-statistics (5.50), (5.41)); another variable -0.022 and -0.02 (t-statistics (-1.61), (-1.63)). - Adj R-squared values reported: 0.135, 0.396, 0.161, 0.418. - Mechanism offered: intervention reduces FX reserves, and when reserve levels approach a psychological threshold, changes in reserves have larger impacts on expectations. - Non-linearity noted: the relationship between reserve changes and expectations may be non-linear with larger effects near psychological reserve thresholds. - Ma Jun cites Miyajima and Motoro (2013, BIS paper No 73): a positive and statistically significant b would indicate a positive impact of FX purchase on exchange rate expectation (i.e., FX purchase improves expectation of appreciation). ### Capital controls and investor behavior (Ma Jun) - Short-term effectiveness of capital controls is limited: - Cross-border RMB flows can increase to bypass controls, making controls less effective even in the short term. - Longer-term impact of capital controls: - Capital control tends to worsen exchange rate expectation, thereby worsening the balance of payments over the longer term. - Outflow controls are particularly damaging to credibility and are difficult to reverse; they are seen as a renege on prior promises because funds are already in the country. - Investor example (roadshow experience): - Investor expected return calculation used: [10%] probability of capital control * 100% loss in principal + 1% return after FX hedging = [-9%] return. - Conclusion: Only if the perceived probability of capital control is less than 1% would investors consider investing. ### Social acceptance of exchange rate volatility and implications for intervention (Ma Jun) - Market tolerance for FX volatility has increased: - Two years prior to April 2017 a 0.5% move in CNY/USD made headlines; by April 2017 this was no longer the case. - Annualized daily volatility of CNY/USD is now close to 5%, up from about 2% about two years earlier. - Suggested adjustment to FX intervention strategy: - Principle: smooth out excessive short-term volatility rather than resist long-term trends—avoid “too much” intervention for “too long”. - Ma Jun’s operational suggestions: 1. Devote more resources to removing barriers to inflows (e.g., CIBM market reforms) than to controlling outflows. - Projection: Once China bonds are included in major global bond indices, there would be USD700bn passive inflows to China in the following five years. - Reforms to speed market access: streamline the CIBM account opening process, launch the bond connect program, permit foreign investors to use ISDA and to access repo, etc. 2. At policy making level, better understand increased social/market acceptance for two-way exchange rate volatility. 3. Reduce FX intervention following the smoothing principle above. 4. More aggressively address macro/structural vulnerabilities (leverage, SOE, property bubbles, etc.) while the ongoing cyclical recovery provides an opportunity. ### Latin America experience with exchange rate frameworks and intervention (Alejandro Werner; IMF, Western Hemisphere Department) - Transition and outcomes: - In the early 1990s Latin America transitioned to exchange rate flexibility and inflation targeting within a context of open capital accounts, helping lower inflation, anchor expectations, and lower exchange rate pass-through as central banks gained credibility. - On the back of capital inflows, Latin American countries accumulated international reserves. - Given open capital accounts, central banks intervene when necessary in foreign exchange markets. - Objectives of FX intervention in the region: - Achieve adequate level of international reserves. - Avoid excessive appreciation (competitiveness) and depreciation (price stability). - Minimize excessive exchange rate volatility (financial stability; improve FX market functioning). - Minimize large and abrupt depreciation (financial stability; balance sheet effects and FX mismatches). - Smooth transitions to permanent shocks. - Approaches to coping with inflows and outflows: - When coping with inflows and reserve accumulation: rules-based approaches (Colombia and Mexico) or ad-hoc approaches. - When coping with outflows/depreciation pressures: largest economies often rely on pre-announced rules-based FX sales; announcing intervention is preferable for signaling; transparent rules can alleviate fears that FX intervention sends mixed signals about commitment to inflation target. - Taxonomy of FX intervention dimensions: - Rules vs. discretion; spot vs. swap/derivatives; sterilized vs. unsterilized; transparent vs. secretive. - Examples of interventions: - Brazil: August 2013 announcement of daily sale of US$ 500 million swaps plus US$ 1 billion spot sales on Fridays (later extended). - Mexico: December 2014 announcement of US$200 million spot sales when one-day depreciation exceeded 1.5 percent; July 2015 announcement of daily auctions of US$200 million (later extended); Feb 2017 announcement of up to $20 billion in swaps. - Colombia: October 2015 announcement of US$500 million sale triggered by 7 percent depreciation in the 20-day moving average of the exchange rate (auction of call options). - Empirical evidence on effectiveness in the region and cross-country: - Studies typically find some effect; significant market responses often follow announcement of intervention rules; hard to estimate whether effects are permanent or transitory though some episodes seem fairly persistent. - Cross-country/selected study findings (as reported): - Adler and Tovar (2014): 0.1 of GDP foreign exchange intervention slows domestic currency appreciation by 0.3 percent. - Adler, Blanchard, and Carvalho (2015): 0.25 percent of GDP foreign exchange intervention reduces appreciation on impact by 1.5 percent. - Adler, Lisack, and Mano (2015): 1 percentage point of GDP foreign exchange intervention depreciates nominal and real exchange rates by between 1.7–2.0 percent and between 1.4–1.7 percent, respectively. - Daude, Levy-Yeyati, and Nagengast (2014): 1 percent increase in foreign exchange intervention weakens the domestic currency by 0.18 percent. - Country examples: - Brazil: Barroso (2014) US$ 1 billion buy intervention => 0.45–1.18 percent depreciation; US$ 1 billion selling intervention => 0.46–0.66 percent appreciation; average ~0.5 percent change in domestic currency valuation. Chamon, Garcia, and Sousa (2015) reported appreciation in excess of 10 percent following the 2013 Swap Program Announcement. Kohlscheen and Andrade (2014) US$1 billion FX sale appreciates exchange rate by 0.29 percent. Saborowski (2016) US$ 1 billion intervention moves exchange rate by 1 percent. - Peru: Tahu (2014) foreign exchange sales effective in reducing volatility and depreciation; foreign exchange purchases not effective. - Mexico: Domac and Mendoza (2004) foreign exchange sale of US$ 100 million strengthens the peso by 0.08 percent. Chamon (2015) reported appreciation of about 2½ percent following 2015 FX intervention announcements. - Colombia: Kamil (2008) foreign exchange purchase of US$ 130 million weakens the peso by 1 percent during a monetary policy easing cycle. ### Reserve accumulation and deployment questions (Alejandro Werner) - Policy dilemma under the global financial cycle: - Countries accumulated reserves during capital flow booms—should they deploy reserves symmetrically as flows decline/reverse, or hold on to reserves as precautionary buffers when global conditions are less benign? - Can FX interventions be effectively communicated and internalized by the private sector to mitigate over-reactions? ### A stability-oriented exchange rate policy for China (Joseph E. Gagnon) - What should be stabilized: - China has shifted focus from a stable yuan/dollar rate toward a trade-weighted exchange rate. - Current account imbalances are more important than swings in exchange rates; foreign exchange intervention should target a current account balance near zero. - Monetary and fiscal policy should stabilize inflation and employment. - Observed trends: - Chinese nominal CNY/USD and real effective exchange rate show trend appreciation (January 1995 to March 2017 illustrated). - Current account imbalances of major economies peaked in 2006–08, narrowed in 2009, remained moderate for 5 years, and were widening again by 2016; China is not the main driver—Euro area surplus and US deficit dominate. - Reference rate strategy (Williamson 2007; Gagnon’s illustration): - Target FX intervention to the projected current account (1–2 years ahead). - Rules proposed: When CA above 3 percent of GDP, no FX purchases. When CA below -3 percent of GDP, no FX sales. FX sales encouraged when CA>0 and purchases encouraged when CA<0. - Reserve adequacy and minimum: - China’s foreign exchange reserves greatly exceed standard benchmarks of reserve adequacy. - IMF’s new reserve metric is argued to give inappropriately high weight to money supply in a floating exchange rate regime. - $1 trillion is proposed as a reasonable minimum level of Chinese foreign exchange reserves. - Policy prescription (Gagnon): - Resist depreciation of REER as long as CA>0 and reserves>$1 trillion. - As reserves approach $1 trillion, allow some depreciation. - Do not resist REER appreciation unless CA<0 or reserves<$1 trillion. - Monetary and fiscal policy should focus on domestic stabilization. - Capital account liberalization should wait on financial reforms. - Reference rate strategy can work even with fully open capital markets. - Macro risk highlighted: - Progress on domestic rebalancing is too slow: saving and investment are too high, raising financial risks. - Expanding the social safety net (including hukou reform) supports consumption. - IMF (2012) and Gagnon (2013) evidence: tax-financed health and education spending raise consumption significantly without fiscal deficits; such policies benefit China and the world. *Source: Strengthening Financial and Exchange Rate Frameworks: International Experience and Relevance for China (International Monetary Fund), April 2017.* ### Conclusion ### Conclusion ### Core findings and policy preferences - China values stability. - Stabilizing CA imbalances is more important than stabilizing the exchange rate. - Keep monetary and fiscal policy free to stabilize inflation and employment. - A reference rate strategy uses FX intervention to lean against incipient CA imbalances. - Allow greater exchange rate flexibility over time. - No hurry on capital account liberalization but no need to reverse liberalization for now. ### RMB exchange rate formation and recent operational changes - Since the second half of 2015, China has further enhanced the RMB exchange rate formation mechanism, which is based on market supply and demand and with reference to a basket of currencies. - Key procedural changes: - August 11, 2015: The daily quotes of central parity that market makers report should refer to the previous closing rate. - December 11, 2015: Publishing RMB exchange rate indices, guiding market participants to referring more to a basket of currencies. - February, 2016: Central parity = previous closing rate + movements of a basket of currencies + counter-cyclical factor. - May, 2017: Adding counter-cyclical factor into the RMB/USD central parity regime to counterbalance the procyclicality in the FX market. - Objective of changes: Reflect market supply and demand, maintain RMB exchange rate generally stable against a basket of currencies, counterbalance market procyclicality and reflect economic fundamentals. ### Historical and measured movements of the RMB - From June 2005 to May 2017: - CNY-USD central parity appreciated 17.98%. - BIS RMB REER appreciated 39.20%. - RMB indices and changes (as of Jun. 23, 2017): - CFETS RMB exchange rate index closed at 93.22. - CFETS: 93.22; BIS: 94.20; SDR-based index: 94.51 (headline values shown: 93.22, 94.20, 94.51). - Change since 2013 year end: CFETS 1.02%, BIS 1.57%, SDR 0.44%. - Change since 2011 year end: CFETS 9.15%, BIS 8.88%, SDR 3.52%. - Change since 2006 year end: CFETS 26.30%, BIS 30.84%, SDR 27.36%. - On June 23th, 2017: CNY-USD central was 6.8238, gaining 1.66% from the end of 2016; the market exchange rate closed at 6.8387, gaining 1.62% from the end of 2016; CFETS lost 1.70% from the end of 2016. - Since Donald Trump was elected US president, RMB remained generally stable against USD. - Since the 2008 Financial Crisis, RMB has been acting as a stable strong currency in the International Monetary System. ### Exchange rate operation and volatility - After PBoC improved the quotation of CNY central parity on August 2015, the previous deviation between CNY central parity and the market exchange rate underwent a one-time correction. - Since February 2016, the RMB/USD central parity has been operating in accordance with the “previous closing rate + movements of a basket of currencies” mechanism; flexibility of RMB/USD exchange rate has been increasing. - Since October 2016, USD has generally been strong, while movements of CNY central parity and market rate have been highly consistent. - Volatility patterns: - Since August 2015, market supply and demand played a bigger role and elasticity of FX movements was enhanced. - In most of the period since October 2016, the volatility of RMB/USD exchange rate (central parity) has been higher than that of RMB exchange rate indices. ### Market expectations and FX reserves - At the end of 2016, the CNH-CNY spread reversed from consistent depreciation to appreciation. - In most periods since end-2016, the CNH-CNY spread moved around 200bps. - Market expectation divergence: some financial institutions raised expected exchange rate levels; firms and residents started to sell USD; movements of foreign exchange reserve stabilized and its balance increased back to above 3 trillion USD by the end of February. ### Macroprudential policy (MPP) design and practices - MPP framework components: Goals / Evaluation / Instruments / Implementation & Transmission / Governance structure. - Elements of governance and implementation: Decision Maker (e.g. Financial Policy Committee), Executive Department (e.g. Bureau of Prudential Regulation), Policy Evaluation Department, Financial Institutions. - Timeline and instruments: - Started research on policy measures to enhance macroprudential management in 2009. - In 2011, officially introduced the dynamic adjustment mechanism of the differentiated reserve requirements; initially built the macroprudential policy framework. - “Upgraded” the dynamic adjustment mechanism to MPA system at 2015 year end. - Specific macroprudential measures: - Macro-prudential regulations on real estate loans: counter-cyclical adjustment on the down payment ratio (1–LTV). - Requiring a maximum 50% Debt service-to-income ratio. - Since 2015, PBoC included FX liquidity and cross-border capital flow into the system (mainly focusing on leveraging behavior in capital flow and FX market). - Implements nationally the macroprudential management of external debt. - Requires banks deposit, with the PBC, 20% of their short positions in FX derivatives contracts with their non-bank clients (forwards, options and swaps). - Normalize deposit reserve requirement on offshore financial institution’s onshore deposit. ### Macroprudential management of cross-border capital flow - Target: The leveraging behavior in capital flow and FX market. - Tools referenced: - Quantitative tools. - Pricing instruments. - Operational requirement reiterated: banks must deposit, with the PBC, 20% of their short positions in FX derivatives contracts with their non-bank clients (forwards, options and swaps); normalize deposit reserve requirement on offshore financial institution’s onshore deposit. ### Practical transition steps toward more flexible regimes (research and policy commentary) - Exchange rate regime changes are commonly difficult; transitions may be forced by crises. - Historical observations: - Capital account liberalization forces a faster pace of institutional change than in prior decades; China is unlikely to have the luxury of long transition time if it opens its capital accounts. - Large countries are less likely to sustain NEER pegs than small countries because significant fixing moves can cause other currencies to move in the same direction. - Since 1994, China has moved among pegs and crawling pegs and, in the view presented, to a NEER “targeting” framework since late 2015. - On inflation targeting and interest-rate regime: - Transition from a fixed to a floating exchange rate risks the loss of a nominal anchor; inflation targeting has been adopted by about one-fifth of countries. - Inflation in China has been reasonably stable around 2% for the past five years; question raised: "But is 2% the right target?" - Challenges: lack of a stable relationship between money (or interest rates) and inflation and unreliable data on unemployment and output gaps. - Example: In a country where more than 80% of households own their own homes, is market rent the appropriate measure of housing costs? - Steps toward supportive interest rate regime: - Authorities have introduced alternative interest rate policy instruments: repo and reverse repo rates at myriad maturities, short-term (SLF), medium-term (MLF) and long-term liquidity (PSL) facilities. - Practical representation of corridor: 7-day reverse repo rate (floor), 7-day SLF rate (ceiling), 7-day PBOC repo rate middle. - Recommendations: de-emphasize benchmark lending rates; encourage banks to price credit more flexibly; open PBOC repo facility to all banks; conduct overnight repos; be proactive in providing liquidity and provide more timely data on liquidity operations. - Steps toward supportive foreign exchange market: - Greater exchange rate flexibility implies greater risk; total foreign currency liabilities are just over 10% of GDP. - Forward market turnover has not risen much; much of 2016 increase was in overnight transactions in response to FX intervention. - Recommendations: - Drop the 20% reserve requirement on long dollar forwards (10% on long dollar options). - Allow onshore participants to trade in the offshore market and offshore participants to trade onshore. - Permit forward transactions reflecting legitimate underlying needs but view more non-trade exposures as legitimate. - Encourage central clearinghouses for FX derivatives to contain systemic risk and standardize contracts. - Develop more liquid money markets and less volatile repo rates to facilitate FX market liquidity. *Source: Conclusion, ebook2017* ### Appendix 1: Important Disclosures ### Appendix 1: Important Disclosures ### Disclosures, data sources, and price conventions - Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local exchanges via Reuters, Bloomberg and other vendors. - Other information is sourced from Deutsche Bank, subject companies, and other sources. - Aside from within the report, important conflict disclosures can also be found at https://gm.db.com/equities under the “Disclosures Lookup” and “Legal” tabs. - Investors are strongly encouraged to review the above disclosures before investing. ### Analyst certification and contact - The views expressed accurately reflect the personal views of the undersigned lead analyst about the subject issuers and the securities of those issuers. - The undersigned lead analyst has not and will not receive any compensation for providing a specific recommendation or view in this report. - Lead analyst: Michael Spencer, PhD | (+852 ) 2203 8303 | michael.spencer@db.com - Date: April 21, 2017 ### Additional information on Deutsche Bank research practices - The information and opinions were prepared by Deutsche Bank AG or one of its affiliates (collectively "Deutsche Bank"). - Deutsche Bank makes no representation as to the accuracy or completeness of sourced information. - If a recipient uses Deutsche Bank services in connection with a discussed security, Deutsche Bank may act as principal or agent and may trade in a manner inconsistent with views in the research. - Deutsche Bank and/or its affiliates may hold debt or equity securities of issuers covered. - Analysts are paid in part based on the profitability of Deutsche Bank AG and its affiliates, which includes investment banking, trading and principal trading revenues. - Opinions, estimates and projections constitute the author’s judgment as of the date of the report and are subject to change without notice. - Deutsche Bank has no obligation to update, modify or amend the report if any opinion, forecast or estimate changes or becomes inaccurate. - The report is provided for informational purposes only and does not take into account particular investment objectives, financial situations, or needs of individual clients. - Target prices are based on the analyst’s judgment and are inherently imprecise; target prices set by Deutsche Bank's equity analysts are based on a 12-month forecast period. - Prices and availability of financial instruments are subject to change without notice. ### Risk disclosures (fixed income, derivatives, FX, futures, options) - Macroeconomic fluctuations often account for most risks associated with instruments promising to pay fixed or variable interest rates; longer maturities and larger moves in discount factors increase potential losses. - Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are common adverse macroeconomic shocks for receivers. - Counterparty exposure, issuer creditworthiness, client segmentation, regulation, changes in tax policies, currency convertibility, and settlement issues are important additional risk factors. - Derivative transactions involve numerous risks including market, counterparty default and illiquidity risk. - The risk of loss in futures trading and options can be substantial; losses may exceed the amount initially deposited due to leverage. - Options on swaps (swaptions) bear typical option risks plus risks related to rates movements. - Participants in foreign exchange transactions may incur risks from volatile exchange rates, macro-political events, and possible devaluation or exchange controls. ### Capital flows, CFMs, and macroprudential measures - Capital flow management measures (CFMs) can alter the composition of flows (more FDI, less carry trades) and are part of the standard toolkit. - IMF (2012) gave a green light for using CFMs. - CFMs may carry stigma despite efforts to de-stigmatize them; enforcement of existing rules is often as important as imposing new ones. - Example: Brazil 2009-2011 implemented a 2% Tobin tax aimed mainly at carry trade flows. ### Jurisdictional approvals and specific notes - United States: Approved and/or distributed by Deutsche Bank Securities Incorporated, a member of FINRA, NFA and SIPC. - Germany: Approved and/or distributed by Deutsche Bank AG, authorized under German Banking Law and supervised by the European Central Bank and BaFin. - United Kingdom: Approved and/or distributed by Deutsche Bank AG acting through its London Branch; authorised by the Prudential Regulation Authority and subject to limited regulation by the PRA and FCA. - Hong Kong: Distributed by Deutsche Bank AG, Hong Kong Branch. - India: Prepared by Deutsche Equities India Pvt Ltd; Research Analyst SEBI Registration Number is INH000001741; DEIPL may have received administrative warnings from the SEBI for breaches. - Japan: Approved and/or distributed by Deutsche Securities Inc.(DSI). Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Target prices for Japanese reports are based on a 12-month forecast period. - Korea: Distributed by Deutsche Securities Korea Co. - South Africa: Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). - Singapore: Distributed by Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch (One Raffles Quay #18-00 South Tower Singapore 048583, +65 6423 8001); special investor categorizations apply under Singapore law. - Taiwan: Securities/investments that trade in Taiwan are for reference only; readers should independently evaluate investment risks. ### Additional legal and distribution notes - Additional information relative to securities, other financial products or issuers discussed is available upon request. - The report may not be reproduced, distributed or published without Deutsche Bank's prior written consent. - Copyright © 2017 Deutsche Bank AG ### Summary of findings (Yanliang MIAO, SAFE Investment Center) — selected findings and metrics - Exits from pegs can be long and yet smooth: - Transitions can take long but do not necessarily end up in crises. - Historical examples of gradual and orderly exits include Chile, Poland and Israel. - Recent smooth and gradual realignments of exchange rates include India and Singapore. - Four factors conducive to smooth transitions or realignments: - Little forex debt and currency mismatches. - Consistent macroeconomic framework. - A large war chest of forex reserves. - Flexible use of all tools available. - Conditions for China: - The conditions seem to be there for a smooth and gradual transition in China. - The choice between corner solutions (peg vs. float) may be a false one. - Policy tradeoffs: - Short term tradeoff: exchange rate as an asset price vs. as a relative price. - Longer term tradeoff: macroeconomic policy framework. ### RMB regime transition: starting point, current framework, and goal - Starting point: July 2005 de-pegged from the US dollar and a reference basket introduced. - Right now: managed float with the central parity formed from “previous close + movements of a basket of currencies”. - The goal: clean float. ### Regime duration, motives, and empirical patterns - Average duration of a currency regime lasts less than 10 years. - Optimal regime choice trades off stability (credible anchor) and flexibility (monetary autonomy). - No single regime fits all countries or times (Frankel, 1999). - The hollowing out hypothesis did not fully materialize; more countries are in the middle (managed floats) than in the early 2000s. ### Regime switches and outcomes - Some peg exits ended in currency crises, often under pressure and forced de-peg. - Some overshot initially but stabilized later on. - Others exited smoothly and even appreciated; Eichengreen and Rose (2012) found 51 such cases since the 1960s and called de-peg “the decision to flex”. - Eichengreen and Rose warned that de-pegs sometimes led to a discernible slowdown in economic growth, especially in high investment and rapid export growth economies. ### Historical crisis antecedents and risk factors - De-pegs were often associated with large discrete currency declines (e.g., EMS 1992-93; Asian crises 1997-98). - External debt and currency mismatches predated crises: - Examples: 1994 Mexican Tequila crisis, 1997 Asian crisis, 1998 Russian ruble crisis, 2001-02 Argentine crisis. - Original sin hypothesis: incompleteness in financial markets prevents borrowing in domestic currency. - Poor fundamentals and twin deficits predated crisis: - Fiscal deficit can limit ability to raise seigniorage (first generation models, Krugman, 1979). - Current account deficits increase dependency on foreign financing. ### Reserves, policy tools, and capital controls - Exchange rate pressures can be eased by hiking interest rates or using forex reserves. - Forex reserves act as buffers but cannot substitute for the central bank’s balance sheet (M2). - Capital controls carried stigma historically; IMF (2012) endorsed use of CFMs. - CFMs and macroprudential measures overlap; preference for price- and currency-based measures over quantity/residency-based ones. ### Middle ground between peg and float - Corner solutions may be appropriate for some; interior solutions (middle ground) can provide partial stability and partial independence. - Rey (2013) highlighted trilemma vs. dilemma considerations. - Empirical distribution of regime categories (2008-2014) shows a mix across conventional peg, crawling peg, managed arrangements, floating, and free floating. ### Examples of smooth realignments - Singapore (BBC regime): - Since 1981, policy centered on the exchange rate with basket, band and crawl (BBC) features. - NEER appreciated by around 1% per year since 2013 and depreciated against the dollar. - Positive factors: limited external debt in foreign currencies, fiscal and current account surplus, large foreign reserves, and macroprudential policies. - India (managed float): - Indian rupee depreciated by 4%-5% per year against the dollar in 2014-16 and exhibited greater stability than EM peers. - Positive developments since 2014: decrease in currency and maturity mismatches; continued fiscal consolidation and significant reduction in CAD; rising forex reserve; improving fundamentals: 2016 CPI 4.9%, growth 7.5%; political stability. ### How China stacks against the four criteria (summary) - External debt: less than 15% GDP and little currency mismatch. - Fundamentals: economy slowing but still positive current account and little government debt. - Reserve adequacy: adequate by most metrics. - Valuation: RMB probably overshot in the one-way appreciation during 2005-14. - Market sentiment and credibility of the PBC: challenging but improving. ### Selected numeric facts and metrics cited - Average duration of a currency regime: less than 10 years. - NEER appreciation in Singapore: around 1% per year since 2013. - Indian rupee depreciation: 4%-5% per year against the dollar in 2014-16. - India 2016 CPI: 4.9%. - India 2016 growth: 7.5%. - China external debt: 11.5% of GDP in 2016. - Local currency debt share of China’s total external debt: 34.3% in 2016. - SOLAR idea time horizon: no less than two weeks. - Target prices forecast horizon: 12-month. *Source: "Appendix 1: Important Disclosures", ebook2017 (IMF).* ### 96.8 and 41.4 billion USD respectively, or about 20% total corporate external forex debt. ### China’s external debt, reserves, and exchange rate regime ### External debt and corporate sector - Foreign-currency corporate external debt: "96.8 and 41.4 billion USD respectively, or about 20% total corporate external forex debt." - Distribution of foreign-currency corporate external debt: by industry (end-2015). Source: Miao and Rao (2016). - China’s external debt characterized as "relatively small and healthy." ### Overall debt levels and policy response - China’s overall debt burden is high and concentrated in the nonfinancial corporate sector. - BIS data (end-2016Q3): - Total outstanding debt of China’s nonfinancial sector: "210% of GDP". - Nonfinancial corporate sector: "166% of GDP". - Household sector: "43% of GDP". - Government sector: "46% of GDP". - Authorities’ measures: - Structural economic reforms are emphasized to deleverage over medium to longer terms. - Authorities have taken measures to roll over corporates’ maturing debts and lower their financing costs. ### Balance of payments and fiscal position - Current account (CA) developments: - "2014-2015, CA surplus has been fluctuating around $300 bn per year, or 2.5-3.0% of GDP." - Medium to long run expectation: "China’s current account will likely be more balanced by increasing services deficit." - Fiscal policy: - Fiscal policy has become more active; the overall fiscal deficit has expanded but remained relatively low. - Fiscal deficit widened "from around 2% before 2014 to around 4% in 2016." ### Reserve adequacy - IMF metric (2015) reserve recommendations (Trillion USD, Q4 2016): - With capital controls, recommended range: "US$ 1.8-2.7 trillion" assuming fixed rate and with capital controls. - Without capital controls, recommended range: "US$ 2.9-4.4 trillion." - Actual reserves: - "China’s forex reserves stabilized at around 3.0 trillion US$ since 2017M1." - Note: "Reserves and CFMs are substitutes for each other (Ilzetzki et al, 2017)." - Reserve adequacy component weights and lower bounds (as presented): - Short-term debt: Weight "1.00" Lower Bound "0.3" (various regimes shown: 30% / 0.3% / 0.33% formatting in table). - Other liabilities: Weight "0.79" Lower Bound "0.2" (with alternative lower bounds in table). - Exports: Weight "2.20" Lower Bound "0.25" (with alternatives). - Broad money: "22.34" and alternative weights with lower bounds "5% 1.12.5% 0.6 10%2.25%1.1" as shown in table. - Recommended ranges in table: "1.8 1.1 2.9 1.6" and "2.7 1.6 4.4 2.5" (table formatting preserved as presented). - Source for reserve table: "PBC, Haver, Author’s calculation." ### Exchange rate valuation and regime - RMB real effective exchange rate (REER) appreciation: - "RMB appreciated slowly but steadily by 55 percent in REER term in 2005-14." - Adjusted for productivity: "the RMB seems not much overvalued among EM peers." - Cautionary note: "a large overvaluation plus fast credit expansion call for exchange rate flexibility. Or else, crises likely (Ghosh, Ostry and Qureshi, 2014)." - REER/NEER data: China REER and NEER (2010=100) shown (source: Haver/IMF/WB and SAFE Research, c.f. Berg and Miao (2010)). - RMB volatility: - "China a de facto peg to the dollar until recently." - "RMB volatility rose since August 2015 but still less than that of the Singapore dollar." ### Exchange rate regime communication: facts and myths - Facts: - "It is about regime choice, not exchange rate level." - Short-term tradeoff: "output loss vs. financial stability concerns." - Longer-term tradeoff: "Monetary independence vs. exchange rate stability." - Myths corrected: - "Clean float is the only choice for superpower" — labeled a myth; coordination possible in a bipolar system. - "The weights of CFETS basket are secrets" — actually disclosed on the website. - "The central fixing (parity) are 'fixed' by the PBC" — actually based on prices provided by market players. ### FX intervention rules, transitions to inflation targeting, and financial stability - Transition design principles (from Tommaso Mancini-Griffoli, IMF): - Financial stability is necessary for transitions to inflation targeting (IT). - Transitions affect financial stability; well-designed FX rules can help. - Design objectives for FX use: "Limited" — leans but does not fix; limits but does not eliminate; allows markets to determine rate, on average. - Implementation elements: - Neutral range, lower bound, upper bound, intervention frontier, intervention volumes, intervention limit, mid point — rule illustration for FX intervention. - Transition “must haves” and “dos”: - HAVEs: Mandate & accountability; Operational independence; Medium-term inflation objective; Market development; Internally consistent framework. - DOs: Effective operations, processes & culture; Forward looking, risk-based policy making; Clear communications. - Empirical notes on transitions: - Months for expected inflation to reach target in sample countries: Brazil "(6)", Chile "(1)", Colombia "(25)", Mexico "(64)", Uruguay "(31)". No clear pattern explains success except for financial stability. - During the 2013 taper tantrum, more vulnerable EM countries (higher credit to GDP) "Hiked more" and "Intervened more." ### Macroprudential supervision and tools (CBRC perspective) - Systemic risk analysis: - Use of aggregate data, horizontal peer reviews, macroprudential analysis reports, systemic risk early warning system. - Continuous monitoring of market liquidity and domestic and overseas developments. - Stress testing program and guidelines: - The Guidelines on Stress Testing: "2007." - Stress tests examples: "2010: stress tests on banks’ exposures to the property sector in major cities"; "2014: stress tests to analyze the impact of macroeconomic situations, property market conditions and changes in the financial market on banks"; "2015: stress tests on credit risk, market risk and liquidity risk." - Regular communications with banks: "Quarterly meetings with major banks, attended by Chairmen and CEOs." - Countercyclical tools and standards: - Countercyclical capital requirement since "2009": - "2% capital buffer on top of the minimum capital adequacy requirement for all banks." - "1% capital surcharge for five large banks in China." - June 2012: "Regulations on Capital Adequacy of Commercial Banks." - "Capital conservation buffer requirement: 2.5%" and "Countercyclical capital requirement: 0-2.5%." - Leverage ratio: - June 2011, updated in 2015: "Supervisory Rules on Leverage Ratio." - "Minimum standard: 4%" — "1 percentage point higher than the Basel III requirement." - Provisioning requirements: - "2009: banks were required to increase provisioning coverage ratio to 150%." - July 2011: updated "Supervisory Rules on Loan Loss Provisioning." - "Minimum provisioning coverage ratio requirement: 150%." - "Minimum provisioning/loan ratio requirement: 2.5 %." - Liquidity risk management: closely monitor market liquidity conditions; allow banks to use HQLA during stress. - Dynamic loan-to-value (LTV) requirements and loan-to-income (LTI) requirements: "50% limit since 2004." - G-SIBs and D-SIBs frameworks: - Chinese banks participated in the "Basle G-SIBs QIS since 2009." - "Four large banks have been identified as G-SIBs." - Guidelines on disclosure of G-SIB assessment indicators: "January 2014" — "12 indicators used." - Banks with leverage ratio exposure exceeding "RMB 1.6 trillion" or identified as G-SIB in the previous year subject to disclosure timing rules. - D-SIBs identification: four categories — size, interconnectedness, substitutability and complexity; supervisory judgment applied; allocation to buckets informs capital surcharge decisions. - D-SIBs supervision: enhanced and intensified supervision; increased supervisory frequency and intensity; consolidated banking supervision with cross-sector and cross-border dimensions. - Recovery, resolution, and crisis cooperation: - Recovery and resolution plans (RRPs): require five large banks to formulate RRPs. - Crisis management group (CMG): established for each of the four G-SIBs; members include Ministry of Finance, PBC, CBRC and relevant overseas authorities; meet annually. - Cross-sector and cross-border cooperation: - Financial Crisis Response Group (FCRG) led by the State Council met "once every ten days during 2008-2009." - JMC among the PBC and three regulators established in "2013" and meet quarterly or when necessary. - Supervisory MOUs and Exchange of Letters (EOLs) with financial supervisory authorities in "68 countries and regions." - Regular bilateral regulatory consultations with "US, UK, Canada, Japan, Korea, Singapore, Hong Kong, etc." - Supervisory colleges for internationally active banks and CMGs for G-SIBs. - Challenges identified: - "Systemic vulnerabilities identification" — models not sufficiently robust to predict crises beforehand; qualitative judgments important. - "Use of macroprudential tools" — discretion vs. rules. - "Institutional framework and accountability" — need to make unpopular decisions; difficulty defining accountability of agencies; need to balance independence and accountability. - "Effectiveness" — it remains to be seen how effective macroprudential policies will be in practice. *IMF-PBoC Joint Conference, Beijing, April 28, 2017 (ebook2017).* ### 4. Effective in serving the real economy ### 4. Effective in serving the real economy ### I. Achievements and function of the futures market - Coverage and product scope - Commodity futures cover major industrial sectors including agricultural products, metal, energy and chemical industry. - Sector product counts: - Agriculture and forestry: 23 - Metal: 14 - Energy and chemical industry: 11 - Finance: 6 - Agriculture and forestry product examples include: Sugar, cotton, soybean No. 1, soybean No.2, soybean meal, soybean oil, corn, strong wheat, strong flour, common wheat, early indica rice, rapeseed oil, palm oil, rapeseed, rapeseed meal, egg, japonica rice, fiberboard, plywood, late indica rice, corn starch, natural rubber, soybean meal future, sugar future. - Metal product examples include: Copper, aluminum, zinc, lead, gold, rebar, wire, silver, iron ore, hot rolled coil, ferrosilicon (ferroalloy), manganese silicon (ferroalloy), tin, nickel. - Energy and chemical industry examples include: Fuel oil, coking coal, thermal coal, PTA, LLDPE, PVC, coke, methanol, glass, petroleum pitch, polypropylene. - Finance examples include: CSI 300 stock index futures, SSE 50 stock index futures, CSI 500 stock index futures, 5-year Treasury bond futures, 10-year Treasury futures, SSE 50ETF options. - Market scale and activity - Turnover on China’s futures market was 4.138 billion contracts (excluding 50ETF futures), increasing by 15.71 percent year on year. - Among this total: - Turnover of commodity futures registered 4.119 billion contracts, accounting for 99.6 percent. - Turnover of financial futures reached 18 million contracts, accounting for 0.4 percent. - Legal and regulatory framework - Multitier regulatory framework described: - First tier: Regulation on the Administration of Futures Trading enacted by the State Council, and judicial interpretation pertaining to the futures market. - Second tier: sectoral rules and normative documents issued by the CSRC. - Third tier: rules of futures exchange, including articles of incorporation of futures exchanges, rules and detailed rules. - The Futures Law is not launched yet, but listed into second-category legislative plan of the 12th NPC. - Functional effects of the futures market (roles identified) - Playing an important role for the CSRC to monitor and manage risks on the market. - Effectiveness in serving the real economy: - First: futures pricing enhances market efficiency, and ensures effective and orderly operation of the market. - Second: futures hedges risks, and promote robust growth of enterprises and sound development of industries. - Third: it lowers corporate funding cost and enhances efficiency for resource allocation. - Fourth: futures market helps China integrate into global production and trade system. - Fifth: it provide SOEs with risk management and financing support. - Observed link with real economy profitability - Before 2003: affected by deflation, profitability of real economy sectors is low with small volatility. - After 2003: as affected by economic cycle, sectors insufficiently participated in futures market underwent big swings in profitability. - Since 2009: profitability of non-ferrous metal industry increased steadily, while that of other industries declined substantially. - Openings and market needs - Openings up of commodity futures market. - Huge opportunity for the development of financial futures. - Risk management needs of small and medium-sized products. - Risk management needs of SOEs. ### II. Development opportunities and business models for futures and derivatives - Business model components for risk management subsidiaries of futures companies (functions listed) - Cooperative hedging - Warehouse receipts service: purchase, sales, pledge - Pricing: basing point pricing, future-spot arbitrage, calendar spread arbitrage, cross-product, cross-market - Basis trading - OTC option and swap - Hedging types: Long hedge, Short hedge, Pledge hedging, Agent hedging, Joint hedging - Futures insurance (mentioned) - Key development challenges - Lack of experiences in cross-border regulatory coordination and relative institutional arrangements. - Insufficient market regulation resources. - Insufficient risk management awareness on part of market participants and enterprises, persistent criticism and blames on derivatives. ### III. High-level financial sector development themes (conference / policy context) - Policy context and reforms - The publication notes comprehensive financial sector reforms including: - Liberalization of interest rates: removal of ceilings on deposit rates. - Banking reforms: launch of private bank pilot program, removal of loan-to-deposit cap, introduction of deposit insurance, policy bank reform. - Capital markets: Shanghai – Hong Kong and Shenzhen – Hong Kong Stock Connect Program, expansion of foreigners’ access to the domestic bond market. - RMB internationalization: inclusion of RMB in SDR basket. - Overarching policy objective: to rebalance the Chinese economy towards a more environmentally sustainable, more inclusive, more consumption and service-driven and less credit-dependent economy. - Three high-level developmental challenges for the financial sector - 1: Strengthening the allocative function of the financial sector - Channel scarce resources to their best economic use; refocus lending activity from old to new sectors. - Policies and actions listed include lending decisions based on commercial considerations; hardening of budget constraints vis-à-vis old, unviable economic sectors; decisive and comprehensive strategy for the resolution of NPLs; timely and orderly exit of unviable firms; willingness to engage in true operational restructuring of potentially viable ones. - Observed shifts in bank lending (2010–15): - Significant drop in share of manufacturing and utilities and basic infrastructure. - Biggest increases in wholesale and retail trade and primary industry. - Exposures to manufacturing and utilities/basic infrastructure still account for around 45 percent. - Bank structure dynamics: - Joint-stock and city commercial banks have rapidly increased market share at the expense of large commercial banks. - The big-four (large banks) show faster drop in share of corporate loans and a moderate increase in loans to households; other banks show different trends. - 2: Building a more diverse financial system - China remains a bank-dominated financial system with a comparatively minor role for NBFIs and capital markets. - Importance of developing NBFIs (insurance companies, pension funds, mutual funds) and capital markets to improve risk management, access to long term finance, and relieve banking sector. - Capital market developments: - Steady development of debt and stock market capitalization (2006–15). - Issuance in equity market primarily by a relatively small number of mostly larger firms. - Government and financial institutions account for a significant share of bond market issuance activity. - Institutional investor base: - Growing importance of institutional investors, albeit from a low base. - Overall capitalization levels compare reasonably with other emerging market peers, but the institutional investor base is in the lower ranges. - Asset management and private markets: - Rapid growth particularly in private equity and venture capital sectors—albeit from a low base. - Aggregate private equity value end-2015: just short of $ 14 bln. - Venture capital: steady growth since 2014; aggregate value just short o $12 bln. - Venture capital deal flow: >400 deals per quarter in 2015. - Market maturation needs: - Need to win trust of investors to expand reach to smaller companies; promote long-term orientation; strengthen price formation. - Diversification of the investor base; reduce retail dominance and strengthen gatekeepers (sponsors, auditors, rating agencies) and enforcement. - Private pension funds appear to be particularly underdeveloped. - 3: Building a more inclusive financial system - The financial system’s function evolves as economy transitions away from an investment-led growth model to one focused on services, consumption, and inclusiveness. - Access metrics: - Adults with an account at a formal financial institution: progress noted (2011–2014 comparisons presented). - Firms with line of credit: firms’ access to credit still on the low side. - Recommended public policy evolution: - From “last mile” targets to a broader set of objectives, including a wider range of appropriately designed financial products for underserved groups (payments, credit, savings, insurance). - Shift from government-mandated approaches to more market-based approaches. - Establish preconditions and enabling environment for financial institutions to serve underserved segments commercially sustainably. - Facilitate cost-effective and innovative alternatives to brick-and-mortar branches (e.g. agent-based banking and digital finance). - Improve competition in rural areas; revise restrictions on operations of village and township banks and microcredit companies; improve governance of rural credit cooperatives. ### IV. Macroprudential governance attribute (illustrative example) - Example from the United Kingdom (attributes of macroprudential organizations) - Clear mandate from government: commitment from government to financial stability; instructions to, and empowerment of, committee to accomplish that; standards for committee accountability. - Quoted primary objective (Bank of England Act 1998, as amended in 2012): “The responsibility of the Committee in relation to the achievement by the Bank of its Financial Stability Objective relates primarily to the identification of, monitoring of, and taking of action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system.” Subject to that a secondary objective to: “Support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.” *The chapter "4. Effective in serving the real economy" from ebook2017 (Fifth PBC–IMF Joint Conference material).* ### 2. Skill to identify risks ### 2. Skill to identify risks ### Particular nature of risks to financial stability - Key roles identified: Governor, plus deputy governors (including head of BSP?), executive director for financial stability, strategy, and risk; and representation of other interested authorities (e.g., ECB, ECF? as enumeration appears). - Outside experts and external members can be used for extra legitimacy and expertise (examples: external members, deputy governor, executive director). - Particular nature of risks to financial stability includes: - Tail risks. - Systemic interactions between banks and non-banks, and evolving market structures. - Growing role of non-banks and interconnectedness with banks via financial conglomerates (Bank of Thailand observation). - Data and indicators emphasized for identification: - Tail risks. - From leverage and maturity mismatches in particular market segments or the broad state of the financial cycle. - Asset price levels and lending terms. - Financial sector amplification and private-borrower behavior. ### Authority to take action - Macroprudential bodies (e.g., FPC/FPC-like committees) can give direction to regulators to adjust specific macroprudential tools: - Countercyclical capital buffer. - Sectoral capital buffer. - Terms of residential mortgage lending. - Leverage ratio. - Authorities can make recommendations to any regulator on anything related to financial stability: - To other regulators on comply-or-explain basis. - To Treasury on regulatory perimeter. - Stress testing and assessment tools cited: - IMF: annual cyclical scenario; varying stress levels counting same stressed out‑come; setting the countercyclical capital buffer. - Stress tests used for assessing resilience; quantitative scenario analysis and setting buffer levels. - Orderly resolution of systemically important institutions highlighted via: - Enhanced market discipline while sustaining stability. - Effect on required liquidity and capital. ### Communication and cooperation with microprudential and monetary policy authorities - Need to understand objectives, types of risks, and likely course of action across policy spheres. - Cross-effects from one policy sphere to others require: - Understanding objectives and likely course of action. - Possibility of phasing policies to minimize conflicts while accomplishing objectives. - Examples of cooperation (institutional set-ups and tools): - Stress tests. - Brexit response coordination. - Institutional compositions cited (UK example): MPC, FPC, FPC external members, HMT observers, etc. - Coordination mechanisms described: - Joint MPC and FIPC meetings (semi-annual since June 2012) in Bank of Thailand context. - Financial Stability Subcommittee (quarterly) as internal platform for coordination and policy discussion on systemic risk issues. - Financial Stability Unit (set up in 2016) to centralize cross-department working groups, prepare macroprudential toolkits, and act as secretariat and public communicator (FSR chief editor role). ### Thailand: evolving financial landscape, risks identified, and policy responses (Bank of Thailand) - Structural facts: - Commercial banks remain at the core of Thailand’s financial system. - 65% of total assets of financial institutions (aggregate figure cited in structure slide). - Market shares and growth: - Market shares of banking groups’ affiliates in other financial services (2014–2016 average growth): Mutual funds 19.3, Insurance 12.0, Savings Coop 9.6, SFIs 7.2, Commercial banks 3.4 (labels and values preserved as presented). - Growing role of non-banks and specific pockets of risk: - Unrated corporate bond issuance has grown as a small pocket of risk due to search-for-yield behavior; risk considered contained because of small size and investor concentration. - Policy responses: enhance information disclosure & reporting, due diligence, and impose investment limits in some asset types; BoT and SEC monitor and warn investors. - Number of unrated bond issuers and outstanding volumes increased over 2009–2016 (chart provided; categories A/B/non-investment grade/unrated). - Savings cooperatives: - Rapid expansion raised concerns about "too many involved to fail" and interconnectedness with core banks. - BoT worked with relevant regulators to strengthen regulatory and supervisory framework. - Savings cooperatives’ balance sheet components tracked (Loan, Cash and deposits, Investment, Other assets, Equity funds, Deposits, Borrowings, Other liabilities) over Dec-11 to Nov-16. - Debt overhang from household leverage: - Household debt growth and household debt to GDP highlighted; specific values include household debt growth figures and share to GDP (charts show Housing/Auto/Credit card/Personal loan/Business loan/Others and % YoY with Household debt to GDP (RHS)). - MPC minutes (29 March 2017): “the Committee decided to keep the policy rate unchanged at 1.50 percent in order to maintain accommodative financial conditions ...some committee members viewed that imbalances in the financial system could continue to accumulate under the prolonged low interest rate environment ...seen in the recent increase in lending and borrowing through channels other than commercial banks and SFIs due partly to different regulatory standards.” - Bank- vs market-based finance trends (2011–2016 BnTHB): - Bank-based and market-based aggregates shown with Average growth 2011-2016; specific series values noted (e.g., 14,104; 16,148; 17,393; 18,448; 19,196; 19,588 and 10,679; 13,875; 14,419; 16,618; 16,377; 19,379) preserved as presented. ### Macroprudential policy — lessons from international experience (IMF / Erlend Nier) - Summary takeaways: - Conduct of macroprudential policy is challenging and requires strong institutional foundations. - Macroprudential policy is subject to domestic "leakage" and regulatory gaps. - Key mechanisms: collect and share information; expand scope of intervention across entities; capture risks inherent in products and services. - Institutional foundations required: - Willingness to act: clear mandate assignment, strong role for central bank, objectives and accountability mechanisms established in law. - Ability to act: powers and tools with range and reach sufficient to contain risks (information collection, calibration, designation). - Mechanisms to ensure cooperation in risk assessment and mitigation (financial stability objectives for microprudential agencies and securities regulators). - Challenges: - Inaction Bias: benefits of action accrue in the future and are hard to measure, while costs are immediate and visible; lobbying and political pressures compound bias. - Dynamic evolution of the financial system leads to changing sources and distribution of systemic risk, creating policy gaps and need for cross-field coordination. - Addressing leakages: - Expand scope of macroprudential intervention: back-up powers to collect information (example: U.S. OFR), credit registers and common data platforms (China). - Expand perimeter of regulation beyond banks to substantial non-bank intermediaries; use functional approaches so tools like LTV and DSTI apply across providers (examples: Netherlands, Hungary, Korea). - Liberalization and cross-border considerations: - Further capital account liberalization can reduce domestic leakage but increase cross-border leakage, calling for regional coordination or reciprocity arrangements (Basel III CCyB referenced). - Liberalization can create new risks from larger and more volatile capital flows; toolkit may need expansion to include liquidity requirements differentiated by currency (e.g., LCR, NSFR; examples Sweden, Iceland, Korea) and higher capital or tighter loan restrictions on FX exposures (examples Russia, Poland, Hungary). --- _Source: https://www.imf.org/-/media/files/news/seminars/2017/fifth-pbc-conference/ebook2017.pdf_