## _wp0714

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---

### I. Introduction and summary
- Since 1984 the People’s Bank of China (PBC) has moved to a monetary strategy anchored on intermediate monetary targets and currently announces targets for growth of a broad monetary aggregate (M2) aligned with objectives of maintaining the stability of the value of the currency and promoting growth.
- The PBC has developed instruments similar to advanced central banks (reserve requirements and open market operations (OMOs)), but continues to use administrative measures and moral suasion.
- Interest rate liberalization remains incomplete thirteen years after the November 1993 Third Plenum decision; policy interest rates changes at the PBC generally require State Council validation.
- Remaining frictions:
  - Financial market segmentation and weaknesses in the banking system that weaken the interest rate channel.
  - Reliance on reserve requirements to a greater extent than other major central banks.
  - Administrative guidance of credit growth and sectoral allocation.
- The current approach’s effectiveness is likely to diminish with increased financial sophistication, innovation, and opening to the outside world.
- Paper organization (as stated): Section II: macroeconomic and financial sector attributes; Section III: operational framework; Section IV: empirical reliability of money as intermediate target; Section V: elements to strengthen monetary policy frameworks and policy measures; Section VI: conclusions; Appendix I: four arguments why move to fully-fledged market-based monetary policy is pressing.

### II. Macroeconomic attributes — findings and implications
- Main challenge:
  - Implementation of a tightly managed exchange rate in the face of foreign exchange inflows creates conflicts for monetary policy—particularly limits using interest rates to manage aggregate demand because tightening may induce larger capital inflows.
- Administrative controls:
  - Reserve requirement adjustments and moral suasion have restrained credit and investment growth, maintaining low interest rates; effectiveness likely to decline with financial liberalization and WTO-related opening.
- Broad money (M2) developments:
  - M2 growth during 2000–2005 fluctuated in a 14½ percent–17½ percent annual rate range, with a maximum of 19.6 percent in 2003.
- Money multiplier and reserve operations:
  - Money multiplier instability for M2 complicates controlling the monetary aggregate.
  - OMO became, since 1999, the main instrument to influence reserve money.
  - PBC reversed its policy of lowering the reserve requirement ratio from a peak of 13 percent to 8 percent in November 1999.
  - Starting in 2003 the PBC increased the ratio to the current level of 9.5 percent for large state-owned banks and joint-stock banks and 10 percent for smaller institutions.
  - Cost of sterilization kept low due to capital account restrictions allowing divergence between domestic and international interest rates; central bank securities sold to state-owned banks at rates lower than average return on international reserves.
- Real estate and credit measures:
  - Nationwide housing prices increased by 14.4 percent in 2004 but later decreased to a plateau of around 6 percent following control measures.
  - PBC adjustments: March 2005 elimination of preferential interest rate on housing loans and imposition of a lower limit of 0.9 times the benchmark lending rate with same maturity; raised down payment on consumer housing loans from 20 percent to 30 percent in cities/areas with rapidly rising prices.
  - June 2006 China Banking Regulatory Commission rule: banks may lend only 70 percent of house value to individual buyers, down from 80 percent.
- Constraint:
  - The “impossible trinity” constrains China’s ability to simultaneously maintain a managed exchange rate, endure capital inflows, and pursue an independent money-targeting monetary policy.

### III. Financial sector attributes — findings and implications
- Banking sector dominance and scale:
  - Commercial banks intermediate nearly 75 percent of the capital in the economy.
  - As of end-2002, the ratio of domestic credit to GDP was above 160 percent.
  - Bank credit to nongovernment entities represents more than 100 percent of GDP.
- Relative importance of financial markets (2003 data):
  - Increase in domestic and foreign currency loans by financial institutions equaled 23 percent of GDP.
  - Funds raised through stock markets: 1 percent of GDP.
  - Corporate bond issuance: 0.3 percent of GDP.
  - China’s equity and bond markets are among the smallest in the world (relative basis).
- Banking sector reform and soundness:
  - Important steps: upgrade prudential regulations, assess asset quality and provisioning, strengthen lending practices, improve accounting and disclosure standards.
  - Three of the four dominant state-owned commercial banks restructured and raising capital through IPO issuance; reforms at the Agricultural Bank of China pending.
  - Evidence that dominant state-owned banks have substantially changed behavior toward market orientation is unclear.
- Capital allocation and efficiency:
  - Wholly and partially state-owned companies absorb most funding; private enterprises account for 52 percent of GDP but receive only 27 percent of total credit.
  - High levels of nonperforming loans (NPLs) and contingent liabilities signal misallocation of capital.
  - McKinsey & Company study: investment needed to produce US$1.00 of GDP increased from US$3.30 in the first half of the 1990s to US$4.90 since 2001.

### IV. Operational framework, instruments, and market structure
- Evolution of policy frameworks:
  - Three broad phases: until 1986 centrally-planned; 1986–1993 targets on currency in circulation and banks’ loan portfolio; December 1993 onward State Council defined goals and September 1994 PBC defined M0, M1, and M2.
  - Since 1998 credit ceilings eliminated, leaving money supply as single intermediate target; strategic hierarchy: final target — inflation; intermediate target — M2; operating target — reserve money.
- Interest rate liberalization sequencing and status:
  - November 1993 basic scheme; 2002 and 2003 policy statements advancing market-based rates.
  - Wholesale transactions fully liberalized; retail operations progressively liberalized.
  - October 2004: removal of ceilings on lending rates and of a floor on deposit rates; a floor for lending rates and a ceiling for deposit rates retained, differentiated by maturity.
- Liquidity management tools:
  - Standing facilities (SFs): automatic collateralized lending (ACL) at rediscount rate minus 27 bps (2.97 percent); excess reserves facility (ERR) remunerated (rate history truncated in source).
  - OMO timeline: introduced 1993, discontinued 1997, reintroduced May 1998; repos and PBC bill auctions from 2002 onward; OMOs conducted two (or more) times a week.
  - December 2005: experimental use of foreign exchange swaps (anecdotal).
- Reserve requirements:
  - In place since mid-1980s; reduced from 13 percent to 8 percent in March 1998 and to 6 percent in November 1999.
  - 2003 and 2004: raised to 7 percent and later to 7.5 percent.
  - RRs ratio raised three times in 2006 (June, August and November), and again in Junuary 2007 to current levels of 9.5 percent (10 percent for financial institutions with a weak financial position).
  - RRs are remunerated at 1.89 percent since 1998.
- Market segmentation and innovation:
  - Commercial paper (CP) represents 11 percent of banks’ outstanding loan portfolios; CP outstanding increased 51 percent year-to-year in March 2006 vs 14 percent for banks’ loans.
  - Discounted bills outstanding increased 72 percent year-to-year in March 2006.
  - July 2005 foreign exchange swap liberalization and free current account enabled synthetic RMB borrowing using NDFs; NDF implied rates at times lower than domestic rates, enabling onshore corporates to raise RMB funding at negative rates.
  - Segmentation increases with liberalization, threatening PBC operational effectiveness.
- Money market structure:
  - Interbank market: overnight to four months lending; trading concentrated in one- to seven-day range; seven-day loan rate is CHIBOR benchmark.
  - Interbank bond market: largest bond market where PBC bills are traded (3- to 12-month maturities, some 3-year bills).
  - Bond repo market: short-term borrowing; one-seven day contracts most active; seven-day repo benchmark.
  - Regulatory limits and segmentation persist (e.g., foreign banks borrowing limit of 1.5 times branch capital in RMB interbank market).

### V. Obstacles to using interest rates as operational target
- Structural and institutional obstacles:
  - Incomplete bank restructuring; some banks with high NPLs and little capital.
  - Banks’ pricing of risk limited; firms (particularly SOEs) may still operate under quantitative frameworks where credit channel dominates aggregate demand.
  - Money market segmentation prevents arbitrage and limits transmission from interbank market to other financial markets.
- Excess reserves and liquidity:
  - Excess reserves declined during the 2000s but remain high; repeated increases in reserve requirement ratio in 2006 expected to reduce excess reserves.
  - Remuneration of required reserves is lower than money market rates—potentially distortionary.
  - Reliance on reserve requirements lacks flexibility of OMOs.
- Instrument independence and objectives:
  - Decisions regarding interest rates or reserve requirement ratios require State Council approval—limits PBC flexibility.
  - Multiplicity of objectives assigned to the PBC creates "noise" in policy implementation.

### VI. Empirical evidence on money as an intermediate target
- Historical performance of monetary aggregates (1994–2004):
  - Targeted and actual values coincided:
    - three times for M1, and
    - four times for M2.
  - Strong deviations of more than four percentage points occurred several times for both M1 and M2.
  - Selected annual entries from Table 1 (as in source) for M1 growth and M2 growth (Targets / Actual):
    - 1994: M1 21 / 26.2
    - 1995: M1 21–23 / 16.8 ; M2 24 / 34.5
    - 1996: M1 18 / 18.9 ; M2 25 / 29.5
    - 1997: M1 18 / 16.5 ; M2 23 / 25.3
    - 1998: M1 17 / 11.9 ; M2 16–18 / 17.3
    - 1999: M1 14 / 17.7 ; M2 14–15 / 15.3
    - 2000: M1 15–17 / 16.0 ; M2 14–15 / 14.7
    - 2001: M1 13–14 / 12.7 ; M2 15–16 / 12.3
    - 2002: M1 13 / 16.8 ; M2 13 / 14.4
    - 2003: M1 16 / 18.7 ; M2 16 / 16.8
    - 2004: M1 17 / 13.6 ; M2 17 / 14.6
- Money multiplier and velocity:
  - Money multiplier shows abrupt changes; ADF Test for multiplier:
    - ADF statistic value: -1.059
    - Associated one-sided p-value (for 40 observations): 0.7223
    - Cannot reject the null of a unit root.
  - Income velocity of M2 is non-stationary; irregular deceleration since 1994.
  - Money demand appears stable in the long run as a function of GDP, interest rate and inflation (see Appendix III).
  - Monetization increasing: demand for nominal money more than fully adjusts to prices in the long run.
- Stylized inflation model estimated parameters (1994–2004):
  - *π = 2.0
  - φ = 0.92
  - ω σ = 1.01
  - π σ = 6.52
  - Interpretation: standard deviation of inflation shocks low (1.01 percent); inflation process highly persistent (0.92).
- VAR (1994–2005, quarterly) five-variable evidence:
  - One standard deviation (SD) money innovation:
    - Sudden reaction of prices to money disturbance with persistent long-lived effects on inflation.
    - Money has no long run real effect on output.
  - One SD interest rate innovation:
    - Accumulated response of GDP to an interest rate innovation shows low impact of interest rate changes on macroeconomic variables.
  - Results subject to significant standard errors given limited dataset; interpret with caution.

### VII. Strategic options and policy recommendations (the way forward)
- General considerations:
  - Migration toward frameworks based on informed judgments (monitoring indicators or inflation targeting) requires developed financial markets and central bank research capacity.
  - The short-term interbank interest rate is the appropriate operational target in mature market consensus.
- Anchoring strategies for China moving to a flexible exchange rate:
  - Inflation targeting
  - Monetary targeting
  - An eclectic framework monitoring a broad range of monetary and economic indicators
- Assessment:
  - Full-fledged inflation targeting not viable in the foreseeable future due to lack of PBC operational independence and weaknesses in inflation forecasting and financial markets.
  - Monetary targeting as sole anchor problematic given low inflation and short-run instabilities in money demand.
  - Recommended approach: an eclectic monetary policy framework using growth in money supply and bank credit as intermediate guidelines for determining short-term interest rates while monitoring a broad range of variables.
- Operational recommendations:
  - Define a short-term interest rate as the operational target (preferably announce a short-term bills rate to communicate policy stance).
  - Shift away from tight interest rate controls on deposit and lending operations to allow market-based allocation and shape of yield curve.
  - Monitor banks’ margins at portfolio level (see Box 3) rather than maintain loan-by-loan administered limits.
  - Reduce banks’ excess reserves to levels consistent with minimum settlement balances before relying on short-term interest rate operational target.
  - Consider conducting policy from a structural liquidity deficit position and use transparent rules-based instruments (remunerated at market rates) to induce market intermediation.
  - Grant the PBC full discretion to make interest rate changes so it can use its policy interest rate more actively.
- Practical sequencing and safeguards:
  - Strengthen interbank market functioning and liquidity forecasting capacity.
  - Gradually reduce reliance on administrative measures (window guidance, forced placement) and reserve requirements as primary instruments.
  - If permanent sterilization via reserves persists, remunerate reserves at market rates or increase ERR remuneration to market levels.
  - Support banking sector restructuring to reduce NPLs (noted NPLs at 7.5 percent at end-September 2006; some analysts place NPLs ratio at a much higher level) and improve capital allocation to enhance transmission.
- Transitional institutional reforms:
  - Improve PBC research, modeling, communication, and forecasting capability.
  - Consider announcing a long-run inflation goal as a priority to help anchor expectations without fully adopting IT immediately.

### VIII. Cross-country lessons, boxes, and appendixes (selected implications)
- Box 1: China: Main Monetary Policy Instruments — standing facilities (ACL at rediscount rate minus 27 bps = 2.97 percent; ERR remunerated — historical levels referenced).
- Box 2: Initial Conditions for Inflation Targeting — four groups of initial conditions (mandate/autonomy/transparency; external position stability; financial system development; policy tools and understanding of transmission).
- Box 3: Monitoring Banks’ Margins — country examples and mechanisms to prevent oligopolistic behavior; recommendation to replace administrative rate limits with portfolio-level margin monitoring and use of structural liquidity deficits.
- Appendix V: The Role of Money and Asset Prices in the ECB Monetary Strategy — ECB two-pillar framework, importance of monetary analysis focused on M3, role of asset prices in transmission, and conditions under which "leaning against the wind" can be considered.
- Appendix II: cross-country experiences with capital inflows indicate most countries responded with a combination of steps including, in all cases, greater exchange rate flexibility.

*Source: _wp0714 - References..............................................................................................................*

### References..............................................................................................................

### _wp0714 - References..............................................................................................................

### I. Introduction and summary
- Since 1984 the People’s Bank of China (PBC) has moved to a monetary strategy anchored on intermediate monetary targets and currently announces targets for growth of a broad monetary aggregate (M2) aligned with objectives of maintaining the stability of the value of the currency and promoting growth.
- The PBC has developed instruments similar to advanced central banks (reserve requirements and open market operations (OMOs)), but continues to use administrative measures and moral suasion.
- Interest rate liberalization remains incomplete thirteen years after the November 1993 Third Plenum decision; policy interest rates changes at the PBC generally require State Council validation.
- Remaining frictions:
  - Financial market segmentation and weaknesses in the banking system that weaken the interest rate channel.
  - Reliance on reserve requirements to a greater extent than other major central banks.
  - Administrative guidance of credit growth and sectoral allocation.
- The current approach’s effectiveness is likely to diminish with increased financial sophistication, innovation, and opening to the outside world.
- Paper’s organization (as stated):
  - Section II: China’s macroeconomic and financial sector attributes relevant to intermediate and operating targets.
  - Section III: Current operational framework for monetary policy.
  - Section IV: Empirical research on the reliability of money as an intermediate target.
  - Section V: Elements to strengthen monetary policy frameworks and policy measures to address authorities’ concerns from shifting to fully-fledged monetary policy.
  - Section VI: Conclusions.
  - Appendix I: Four arguments why a move to fully-fledged market-based monetary policy is pressing.

### II. Macroeconomic attributes (summary of findings and implications)
- Main challenge: implementation of a tightly managed exchange rate in the face of foreign exchange inflows creates conflicts for monetary policy—particularly limits using interest rates to manage aggregate demand because tightening may induce larger capital inflows.
- Administrative controls (including reserve requirement adjustments and moral suasion) have been used to restrain credit and investment growth, maintaining low interest rates; effectiveness of these measures is likely to decline with financial liberalization and WTO-related opening.
- Broad money (M2) developments:
  - M2 growth during 2000–2005 fluctuated in a 14½ percent–17½ percent annual rate range, with a maximum of 19.6 percent in 2003.
- Money multiplier instability for M2 complicates controlling the monetary aggregate (further discussed in Section IV).
- PBC actions in response to monetary developments include:
  - Increases in benchmark rates for banks’ loans and deposits (noted events: April and August 2006 raises for loans; August 2006 raise for deposit rate).
  - Sterilization operations, higher reserve requirements, and administrative controls and lending guidance.
- Sterilization and reserve policy:
  - OMO became, since 1999, the main instrument to influence reserve money.
  - The PBC reversed its policy of lowering the reserve requirement ratio from a peak of 13 percent to 8 percent in November 1999.
  - Starting in 2003 the PBC increased the ratio to the current level of 9.5 percent for large state-owned banks and joint-stock banks and 10 percent for smaller institutions.
  - The cost of sterilization has been kept low due to capital account restrictions that allow divergence between domestic and international interest rates; central bank securities sold to state-owned banks at rates lower than average return on international reserves.
- Real estate and credit concerns:
  - Nationwide housing prices increased by 14.4 percent in 2004 but later decreased to a plateau of around 6 percent following control measures.
  - PBC adjustments: March 2005 elimination of preferential interest rate on housing loans and imposition of a lower limit of 0.9 times the benchmark lending rate with same maturity; raised down payment on consumer housing loans from 20 percent to 30 percent in cities/areas with rapidly rising prices.
  - June 2006 China Banking Regulatory Commission rule: banks may lend only 70 percent of house value to individual buyers, down from 80 percent.
- The “impossible trinity” (fixed exchange rate, free capital flows, independent monetary policy) constrains China’s ability to simultaneously maintain a managed exchange rate, endure capital inflows, and pursue an independent money-targeting monetary policy.

### III. Financial sector attributes (summary of findings and implications)
- Banking sector dominance:
  - Commercial banks intermediate nearly 75 percent of the capital in the economy.
  - As of end-2002, the ratio of domestic credit to GDP was above 160 percent in China.
  - Bank credit to nongovernment entities represents more than 100 percent of GDP.
- Relative importance of financial markets:
  - In 2003, increase in domestic and foreign currency loans by financial institutions equaled 23 percent of GDP.
  - Funds raised through stock markets: 1 percent of GDP in 2003.
  - Corporate bond issuance: 0.3 percent of GDP in 2003.
  - China’s equity and bond markets are among the smallest in the world (relative basis).
- Banking sector reform and soundness:
  - Important steps: upgrade prudential regulations, assess asset quality and provisioning, strengthen lending practices, improve accounting and disclosure standards.
  - Three of the four dominant state-owned commercial banks were restructured and are raising capital through IPO issuance; reforms at the Agricultural Bank of China are still pending.
  - Clear evidence that dominant state-owned banks have substantially changed behavior toward market orientation is unclear; further time and incentives are needed.
- Capital allocation and efficiency:
  - Wholly and partially state-owned companies absorb most funding; private enterprises account for 52 percent of GDP but receive only 27 percent of total credit.
  - High levels of nonperforming loans (NPLs) and contingent liabilities signal misallocation of capital.
  - McKinsey & Company study: investment needed to produce US$1.00 of GDP increased from US$3.30 in the first half of the 1990s to US$4.90 since 2001 (40 percent more than required by other Asian emerging market economies in their high-growth periods).

### IV. Operational and policy implications (recommended directions)
- Greater reliance on market forces would increase economic efficiency and growth by:
  - Subjecting commercial banks to price incentives to enhance efficient allocation of large deposit bases.
  - Developing a more market-based money market to strengthen the interest rate monetary policy transmission channel.
  - Supporting development of China’s equity and bond markets.
- Challenges to a market-based approach:
  - Multiple policy objectives assigned to the central bank complicate implementation.
  - PBC does not enjoy full discretion over policy interest rates.
  - Excess reserves and money market segmentation hamper interest rate transmission.
- Policy measures highlighted or discussed in subsequent sections and appendixes (as described in the paper):
  - Strengthening market-based monetary policy instruments and reliance.
  - Addressing banking sector weaknesses to enhance transmission and financial stability.
  - Managing capital inflows and exchange rate policy consistent with the “impossible trinity” trade-offs.
  - Appendix I: Four arguments summarizing why a move to fully-fledged market-based monetary policy is pressing.
  - Appendix II: Policy responses by countries that faced capital inflows, noting that most responded with a combination of steps including, in all cases, greater exchange rate flexibility.

### V. Key figures, tables, boxes, and appendixes referenced in the content unit
- Tables mentioned (titles only as listed):
  - Table 1. China: Targeted and Actual Values for Monetary Aggregates, 1994–2004
  - Table 2. China: Required and Excess Reserves, 2000–2005
  - Table 3. China: Persistence and Variability of Inflation, 1994–2004 (quarterly)
  - Table 4. Stylized Structure of Interest Rates
- Figures mentioned (titles only as listed):
  - Figure 1. China: Selected Macroeconomic Indicators
  - Figure 2. China: Structure of Interest Rates, 2000-2006
  - Figure 3. China: Inflation and Money Growth, 1994–2006
  - Figure 4. China: Inflation and Money Growth (Kernel Graph)
  - Figure 5. China: Money Multiplier
  - Figure 6. China: Responses of Prices and GDP to one SD Money Innovation
  - Figure 7. China: Response of GDP to one SD Interest Rate Innovation
  - Figure 8. Stylized Representation of the Channels of Transmission
- Boxes listed (titles only as listed):
  - Box 1. China: Main Monetary Policy Instruments
  - Box 2. Initial Conditions for Inflation Targeting
  - Box 3. Monitoring Mechanisms of Banks’ Margins: Country Examples
  - Box 4. Cross-Country Experiences with Dealing with a Liquidity Surplus
- Appendixes listed:
  - Appendix I. Why the PBC Should Rely on Market-Based Monetary Policy
  - Appendix II. Monetary Policy with Open Capital Account and Large Capital Inflows
  - Appendix III. Modeling Money Demand in China
  - Appendix IV. Monitoring Financial and Monetary Indicators as Intermediate Targets
  - Appendix V. The Role of Money in the ECB Monetary Strategy

*Source: _wp0714 - References..............................................................................................................*

### 7.5 percent at end-September 2006. Some financial analysts place the NPLs ratio at a much higher level.

### _wp0714 - 7.5 percent at end-September 2006. Some financial analysts place the NPLs ratio at a much higher level.

### Financial sector characteristics and implications
- Nonperforming loans (NPLs) noted at 7.5 percent at end-September 2006. Some financial analysts place the NPLs ratio at a much higher level.
- Implication: ample room to ensure a more efficient allocation of savings (capital) through:
  - greater reliance on interest rates in the conduct of monetary policy (while avoiding destabilizing the banking sector), and
  - further use of market-oriented instruments to manage credit and investment growth.

### Evolution of China’s monetary policy frameworks
- Three broad phases:
  - Until 1986: centrally-planned system with no explicit intermediate monetary targets.
  - 1986–1993: targets on currency in circulation and on banks’ loan portfolio as intermediate targets; dual goals of currency stability and promoting economic development.
  - December 1993 onward: State Council defined goals as maintaining the stability of the value of the currency and thereby promote economic growth.
- Second phase: began September 1994 when the PBC defined M0, M1, and M2; in 1996 money supply formally treated as an intermediary target and targets set during the Ninth Five-Year Plan.
- Third/current phase: started in 1998 when credit ceilings were eliminated, leaving money supply as the single intermediate target.
  - Strategic framework under the current framework: final target — inflation (and thereby growth); intermediate target — M2; operating target — reserve money; with attention to short-term interbank interest rates and exchange rate stability.

### Performance of monetary aggregates (1994–2004)
- Correlation of the intermediate target with real economic activity has not been stable, causing deviations between announced targets and actual values for monetary aggregates.
- During 1994–2004, targeted and actual values coincided only:
  - three times for M1, and
  - four times for M2.
- Strong deviations of more than four percentage points occurred several times for both M1 and M2.
- Judged against lower levels of inflation achieved, evidence suggests a wider range of monetary aggregate growth consistent with current inflation; at relatively lower levels of inflation, M2 loses relevancy.
- Table 1 (selected entries preserved as in source):
  - Year / M1 growth (In percent) Target / Actual / M2 growth (In percent) Target / Actual
  - 1994: 21 / 26.2
  - 1995: 21–23 / 16.8 ; 24 / 34.5
  - 1996: 18 / 18.9 ; 25 / 29.5
  - 1997: 18 / 16.5 ; 23 / 25.3
  - 1998: 17 / 11.9 ; 16–18 / 17.3
  - 1999: 14 / 17.7 ; 14–15 / 15.3
  - 2000: 15–17 / 16.0 ; 14–15 / 14.7
  - 2001: 13–14 / 12.7 ; 15–16 / 12.3
  - 2002: 13 / 16.8 ; 13 / 14.4
  - 2003: 16 / 18.7 ; 16 / 16.8
  - 2004: 17 / 13.6 ; 17 / 14.6
- Source cited within table: Geiger (2006).

### Monetary policy implementation, markets, and institution building
- Mid-1990s priority: develop a nation-wide money market to enhance monetary policy effectiveness and strengthen the foreign exchange market.
- Interest rate liberalization has proceeded slowly; market infrastructure upgraded but money market remains segmented.
- Unification of the exchange rate in January 1994 and acceptance of Article VIII obligations in December 1996 made domestic interest rate flexibility desirable.
- November 1993 Third Plenum decision provided strategic support for financial reforms as a key element of macroeconomic management.

### Interest rate liberalization: sequencing and developments
- Gradualism favored to manage risks of financial sector reform; real interest rates have tended to be positive.
- Milestones and policy directions:
  - November 1993: basic scheme for liberalizing interest rates laid out.
  - 2002: Sixteenth National Congress report reiterated advancing interest rate market reforms.
  - 2003: Third Plenary Session of the Sixteenth Central Committee pointed to establishing a robust mechanism for market-based interest rates.
- Sequencing:
  - First lift restrictions on wholesale transactions, then gradually liberalize retail transactions.
  - Deposit and lending interest rates on foreign currencies liberalized before local currency; loans before deposits; long term and large amounts before short term and small amounts.
  - Beginning in 1996: restrictions on wholesale transactions began to be lifted (bond and interbank market operations).
- Status:
  - Wholesale transactions fully liberalized, as well as interest rates on foreign currency denominated instruments.
  - Retail operations: progressive reduction in administered rates, allowance for pricing within floating margins, and adjustments of bank lending rates to reflect PBC reference changes.
  - October 2004: removal of ceilings on lending rates and of a floor on deposit rates.
  - However: a floor was retained for lending rates, and a ceiling for deposit rates, differentiated by maturity (three, six and 12 months, and two, three, and five years) — intended to protect banks’ intermediation margins.

### Impact of financial innovation and market segmentation
- Financial innovations providing market-based funding alternatives:
  - Commercial paper (CP):
    - CP represents only 11 percent of banks’ outstanding loan portfolios.
    - Outstanding balance of CP increased by 51 percent on a year-to-year period in March 2006, compared to 14 percent for banks’ loans.
    - Primary market subject to PBC guidance; secondary market trading rates are free.
  - Discounted bills:
    - Outstanding balance of discounted bills increased by 72 percent on a year-to-year period in March 2006.
    - Banks’ discount operations are not subject to interest rate controls on banks’ lending operations, enabling below-statutory-rate lending.
  - Foreign exchange swap liberalization (July 2005) and free current account:
    - Allowed corporations with access to foreign exchange to combine NDF rates and spot operations to construct synthetic RMB borrowing, potentially borrowing at interest rates below domestic market and PBC interest rates.
    - NDF implied interest rates have at times been lower than domestic interest rates due to segmentation created by capital account restrictions; when spot access was unavailable NDF did not represent a real funding alternative.
    - At times, widening spread between NDF implied and domestic rates (because of appreciation pressures on the offshore market) allowed onshore corporates to raise RMB funding at negative rates.
- Net effect: steps to liberalize money and foreign exchange markets have also contributed to further segmentation, threatening the effectiveness of the PBC’s operational framework.

### Liquidity management and PBC instruments
- The PBC has developed a set of monetary instruments conforming to best practices, enabling reliance on market-based instruments.
- Open market operations (OMO) via issuance of PBC bills play an important role in sterilizing excess liquidity; reserve requirements support OMOs.
- Cost of sterilization via OMOs was contained because of a positive differential between foreign and domestic money market rates.
- However, policy has entailed a cost for the banking sector when banks’ deposit rates have been kept above money market or PBC bills rates.
- Relationship between PBC bills and short-term interbank repo rates:
  - There is a relatively close relationship between the PBC bills rates and short-term interbank repo rates, indicating PBC rates tend to be “effective” in the money market.
  - Bank deposit and lending rates (also set by the PBC) have been detached from PBC bills rates or money market rates.
- Figure referenced: China: Structure of Interest Rates, 2000-2006, showing series including 12M Deposit rate, 12M Lending rate, Remuneration of required reserves, Remuneration of excess reserves, Interbank Repo Rate 3M month avg, PBC automatic collateralized lending, PBC bills reference yield 3M month avg.

### Main monetary policy instruments (Box 1, excerpt)
- Standing facilities (SFs) operated by the PBC include:
  - (i) automatic collateralized lending (ACL): Banks can obtain liquidity from the PBC at the rediscount rate minus 27 bps if arranged during the trading day (2.97 percent).
  - (ii) excess reserves facility (ERR): automatic deposit facility; banks’ excess reserves are remunerated at a rate that has been lowered in December 2003 from 1.89 to [text truncated in source].

*Italic source attribution: Content derived from _wp0714 - 7.5 percent at end-September 2006. Some financial analysts place the NPLs ratio at a much higher level.*

### 1.62 percent, and to 0.99 percent in March 2005.

### _wp0714 - 1.62 percent, and to 0.99 percent in March 2005.

### Open market operations (OMO)
- OMO timeline and instruments:
  - Introduced in 1993, discontinued in 1997, re-introduced in May 1998.
  - PBC started outright transactions on bonds, later replaced by repurchase transactions (repos).
  - June 2002: PBC started using reverse t-bonds repos to cope with foreign exchange inflows.
  - September 2002: PBC ran out of t-bonds and started to auction its own bills; outstanding repos were converted into PBC bills during a transition period.
  - OMOs are conducted two (or more) times a week.
  - Primary dealer system in OMO started in 1998.
  - December 2005: PBC made experimental use of foreign exchange swaps (emphasized as anecdotal).

- Interaction with standing facilities:
  - Interaction between PBC’s standing facilities and OMOs is not fully consistent with practices in mature markets.
  - In practice, OMOs do not fully steer excess reserves to avoid excess reserves; excess reserves facility (ERR) in China is used to sterilize liquidity on a permanent basis.
  - Implication: if financial institutions were free to price operations, short-term money market rate would be close to the ERR, which is "not a sensible proposition given its current level."

### Reserve requirements (RRs)
- Historical changes:
  - In place since the mid-1980s.
  - Reduced from a peak of 13 percent to 8 percent in March 1998, and to 6 percent in November 1999.
  - 2003 and 2004: PBC raised RRs to 7 percent and later to 7.5 percent.
  - April 2004: PBC adopted a differentiated RRs system—banks with capital adequacy ratios or asset quality below certain standards hold higher required reserves.
  - RRs ratio raised three times in 2006 (June, August and November), and again in Junuary 2007 to current levels of 9.5 percent (10 percent for financial institutions with a weak financial position).

- Remuneration:
  - RRs are remunerated at 1.89 percent since 1998.

### Interest rate controls
- Since October 2004:
  - Ceiling on banks’ lending rates and floor on deposit rates were eliminated.
  - Banks are subject to a device to protect intermediation margins: deposit rates subject to a ceiling, lending rates to a floor.
- PBC benchmark rate changes:
  - April 2006 and August 2006: benchmark rates for banks’ loans changed in response to high money and credit growth.
  - August 2006: benchmark rates for deposits changed once.

### Window guidance and other administrative measures
- Window guidance:
  - Credit plans eliminated in 1998; PBC convenes financial institutions to provide guidance on credit growth and sectoral allocation.
  - Believed to involve lending volume guidelines.
  - Considered relatively successful because the governor of the PBC is a higher-ranking official than those at commercial banks.
  - Institutionalized starting in June 2003 with a published notice aimed at curbing lending to the real estate sector.
  - Usage reported in Quarterly Monetary Policy Reports and on PBC website.

- Other administrative measures:
  - PBC has issued forced PBC bills targeted at commercial banks where loan growth was considered too fast.

### Money market development
- Three main sub-markets:
  - Interbank market: banks lend among themselves from overnight to four months; trading concentrated in one- to seven-day range; seven-day loan rate is CHIBOR market’s benchmark.
  - Interbank bond market: now the largest bond market where PBC bills are traded (3- to 12-month maturities, small number of 3-year bills); MOF and policy and commercial banks issue debt here.
  - Bond repo market: short-term borrowing, tends to be less volatile and more liquid than CHIBOR; since 1997 repo rate set by the market; most active contracts one-seven days; seven-day repo is benchmark.

- Market segmentation and regulatory limits:
  - 1990s regulatory separations between securities and banking business led commercial banks to withdraw from repo trading on stock exchange and operate on interbank market only.
  - Restrictions appear relaxed, but limits remain (e.g., foreign banks can only borrow 1.5 times their branch capital in the RMB interbank market).
  - In Q1 2006 securities and fund management companies’ borrowing in repo and interbank market amounted respectively to about 20 percent and 40 percent of market turnover.
  - At end of March 2006 trading in the OTC foreign exchange market stood around 30 times trading in CFETS.

### Foreign exchange market development
- Post July 21, 2005 reforms to enhance FX market operations:
  - Introduction of a market-maker system and over-the-counter (OTC) transactions in the spot foreign exchange market while maintaining matching system in CFETS; OTC market became backbone of the spot market.
  - Launching RMB and foreign exchange swaps and RMB interest rate swaps on a pilot basis.
  - Allowing access of more market participants; 64 member banks dealing in the inter-bank RMB forward market.
  - Introducing a primary dealer system for PBC foreign exchange transactions to allow gradual exit strategy of PBC from FX market.

- Expected effects:
  - Reforms should enhance PBC capacity to manage exchange rate with greater flexibility.
  - OTC trading and market makers expected to improve price discovery, risk management tool development, reduce credit risk borne by CFETS, and facilitate PBC communication and signaling.

### Obstacles to the Effectiveness of Interest Rates as an Operating Target
- Structural and institutional obstacles:
  - Banking sector issues: incomplete restructuring, some banks with high non-performing loans and little capital.
  - Banks’ operational reforms only starting; pricing of risk is limited.
  - Firms (particularly SOEs) may still operate under quantitative frameworks where credit channel was primary influence on aggregate demand.
  - Market segmentation: 1995 Banking Law created a de facto two-tier commercial banking system (commercial banks subject to prudential ratios and policy lending banks not similarly regulated); separation of commercial banking and securities activities.
  - Money market segmentation prevents arbitrage and limits transmission from interbank market actions to other financial markets.
- High excess reserves:
  - Excess reserves declined during the 2000s but remain high.
  - Repeated increases in reserve requirement ratio in 2006 expected to reduce excess reserves.
  - Remuneration of required reserves is lower than money market rates—potentially distortionary.
  - Reliance on reserve requirements lacks flexibility of OMOs.
- Instrument independence:
  - Decisions regarding interest rates or reserve requirement ratios require State Council approval—limits PBC flexibility.
  - Multiplicity of objectives assigned to the PBC creates "noise" in policy implementation; interest rate changes may not be consistent with prevailing monetary stance.

### Money as an intermediate target: empirical evidence for China
- Survey of previous research:
  - Xie (2004): period 1998-2002 — strong relationship between base money and broader aggregates (M1 and M2); money supply partly endogenous; long-term monetary aggregates determine inflation, not economic growth.
  - PBC 2005 Q1 report: period 1980–2003 — money supply and output often moved in parallel across episodes; examples:
    - 1980s: annual growth of money supply and GDP averaged 24.5 percent and 9.8 percent respectively; inflation reached 7.5 percent.
    - 1990s: average annual growth of money supply and GDP stood at 24.9 percent and 9.7 percent respectively; inflation recorded 7.8 percent.
    - 2000–2004: average annual growth of money supply and GDP were 15.9 percent and 8.9 percent respectively; inflation stood at 1.1 percent.
  - Geiger (2006): period 1994-2002 — money and credit targets frequently missed; weak relationship between intermediate target and interest rate; window guidance critical during 2003–2004 cycle; monetary indicators remain relevant given vague relationship between interest rates and inflation.
  - Green and Chang (2006): January 2003–March 2006 — changes in adjusted inflows explained 78 percent of changes in reserve money (PBC can control reserve money); reserve money and M2 not closely correlated due to unstable multiplier; bank loans predict M2 in short-run but impact fades after five months.

- New empirical evidence (authors’ analysis):
  - Figure 3 and Figure 4 summary:
    - Changes in M1 and M2 not closely aligned with inflation since 1994; association stronger when inflation is high, weaker at lower inflation rates.
  - Money multiplier instability:
    - Money multiplier shows abrupt changes (Figure 5); Augmented Dickey-Fueller (ADF) Test:
      - ADF statistic value: -1.059
      - Associated one-sided p-value (for 40 observations): 0.7223
      - Cannot reject the null hypothesis that multiplier has a unit root.
  - Velocity of money:
    - Income velocity of M2 is non-stationary; shows irregular deceleration since 1994.
    - Money demand appears to be a stable function of GDP, interest rate and inflation in the long run (see Appendix III).
    - Monetization is increasing: demand for nominal money more than fully adjusts to prices in the long run so desired level of real balances increased.
  - Stylized inflation model (equations reproduced from source):
    - Inflation dynamics: tt t ω φ π π φ π ++ − = −1 * )1(  where *π is long-run inflation, φ captures persistence (1<φ), ω is inflation shock with standard deviation ω σ.
    - Variability of inflation: )1( 2 φ σ σ ω π − = .
    - Estimated parameters (1994–2004):
      - *π = 2.0
      - φ = 0.92
      - ω σ = 1.01
      - π σ = 6.52
    - Interpretation: standard deviation of inflation shocks low (1.01 percent); inflation process highly persistent (0.92).

### VAR evidence on monetary policy transmission
- Five-variable VAR (1994–2005, quarterly) including log real GDP, CPI, exchange rate, short-term interest rate, and M2 (and federal funds rates in specification).
- Key impulse response findings:
  - One standard deviation (SD) money innovation:
    - Sudden reaction of prices to money disturbance with persistent long-lived effects on inflation.
    - Money has no long run real effect on output.
  - One SD interest rate innovation:
    - Accumulated response of GDP to an interest rate innovation shows low impact of interest rate changes on macroeconomic variables.
- Notes:
  - Limited dataset implies significant standard errors; results interpreted with caution.
  - Ordering of variables has little effect; Choleski responses similar to unrestricted responses.

### The way forward — general considerations and strategic framework
- Historical context:
  - Since 1970s, advanced central banks moved from credit/interest rate controls to money market operations supported by reserve requirements.
  - In early reform stages, lack of developed markets and price information may force central banks to rely on quantities (money, credit) as indicators or intermediate targets.
- Trade-offs in target choice:
  - Monetary aggregates may be superior operating targets in shallow markets or where central bank analytical capacity is limited.
  - Simple quantity-based frameworks have drawbacks: sensitivity to money demand instability, limited shock-handling, and reliance on assumptions.
  - Migration toward frameworks based on informed judgments (monitoring indicators or inflation targeting) typically requires developed financial markets and central bank research capacity.
- Preconditions for inflation targeting:
  - High level of central bank autonomy and developed inflation forecasting capacity, and a developed financial sector.
- Policy implication:
  - Monetary policy ultimately about setting short-term market interest rates; central bank uses its monopoly in base money creation to regulate liquidity and steer short-term money market interest rates to affect funding costs for banks and the wider economy.

*Source: Excerpts from the provided IMF working paper content.*

### Box 2. Initial Conditions for Inflation Targeting

### Box 2. Initial Conditions for Inflation Targeting

### Initial conditions overview
- Four groups of initial conditions:
  - A mandate to pursue an inflation objective and accountability by the central bank for meeting this objective, autonomy to set monetary instruments accordingly, and transparency in policy formulation and implementation.
  - Ensure the inflation target will not be subordinated to other objectives, and the external position is stable to enable monetary policy to focus on achieving the inflation target.
  - The financial system should be developed and stable enough so that monetary policy is not sidetracked by concerns about the health of financial institutions. Markets should be sufficiently developed to enable reliance on market-based monetary instruments.
  - The central bank needs the proper policy tools to influence inflation on the basis of a reasonable understanding of the links between the stance of policy and inflation.
- Source attribution in the box: Source: Schaechter (2002).

### Transmission of monetary policy to prices and output
- Central bank needs an understanding of channels of transmission from policy interest rates to lending and deposit rates and ultimately to the price level (Figure 8: Stylized Representation of the Transmission Channels).
- Transmission involves monetary policy → Money and Asset Markets → Goods Markets → Output and Prices, with key intermediaries including:
  - Exchange Rate
  - Asset Prices
  - Yield Curve
  - Monetary & Credit Aggregates
  - Aggregated Demand
  - Imported Good Prices
  - Domestic Good Prices
  - Aggregated Output
  - Aggregated Prices
- Given complexity, central banks use simple guiding rules; example: the ECB views inflation in the medium to long term as a monetary phenomenon and monitors monetary developments to assess inflation trends.
- The weight on money growth in setting interest rates is an empirical question; central banks should undertake research on the potential role of money and credit as leading indicators and elements in the transmission mechanism (Freedman (2006)).

### Choice of an operational framework
- Consensus: the short-term interbank interest rate is the appropriate operational target of monetary policy (Bindseil 2004).
- Functions assigned to monetary instruments must accord with market infrastructure and central bank institutional capacity.
- Instrument mix depends on financial reform progress and the depth/liquidity of the money market (linked to bank soundness).
- Early-stage market development instruments: liquidity requirements (reserve requirement and liquid asset ratios) and standing facilities — collectively “rules-based instruments.”
  - Liquidity requirements: useful to permanently absorb liquidity.
  - Standing facilities: fine-tuning function; central bank may limit individual bank access to refinance standing facilities to maintain balance sheet control.
  - Standing facilities and reserve requirements (when maintained on average during the maintenance period) can play a buffer function for payment system operations during unexpected liquidity shocks or weak liquidity forecasting.
- For market-based instruments to be effective:
  - Interbank market must operate smoothly to permit redistribution of reserves and allow the central bank to manage liquidity as a whole.
  - Central bank needs liquidity forecasting capacity to anticipate balance-sheet-driven liquidity surpluses or shortages.
- Transition from administrative measures (window guidance or forced placement of securities) and reduced reliance on reserve requirements to market-based instruments depends on:
  - Strengthening the interbank money market.
  - Developing the central bank’s liquidity forecasting framework.
- Effective liquidity forecasting enables informed timing and sizing of money market operations, better steering of system liquidity, and a wider interest spread between deposit and lending standing facilities to encourage market trading.
- Interest rate structure considerations:
  - Rates on various instruments must be internally consistent.
  - Spread between liquidity-providing and liquidity-absorbing operation rates must be wide enough to incentivize interbank dealing.
  - Table 4: Stylized Structure of Interest Rates (levels from Highest to Lowest):
    - Highest: Lending interest rates in commercial banks
    - Central bank’s refinancing standing facility rate
    - Central banks’ open market operations rate
    - Central bank’s deposit standing facility rate
    - Corridor for money market rates
    - Lowest: Remuneration of retail deposits in commercial banks
  - Source for table: based on Laurens (2005).

### Strengthening China’s strategic framework — possible anchoring strategies
- Three anchoring strategies for China moving to a flexible exchange rate:
  - Inflation targeting
  - Monetary targeting
  - An eclectic framework monitoring a broad range of monetary and economic indicators
- Monetary targeting:
  - Long-run link between money growth and inflation exists, but China’s current low inflation environment and short-run instabilities make money targets difficult to manage as a stand-alone nominal anchor.
- Inflation targeting (IT):
  - Adoption of full-fledged IT does not seem viable for the foreseeable future due to:
    - Lack of central bank operational independence.
    - Weaknesses in producing reliable medium-term inflation forecasts.
    - Greater reliance on interest rates in monetary policy is still widely discussed in China.
- Recommended approach for China at the juncture:
  - An eclectic monetary policy framework using growth in money supply and bank credit as intermediate guidelines for determining short-term interest rates.
  - Evidence: money growth and inflation tend to be highly correlated in the long run, so monetary aggregates can play an operational role to stabilize inflation and help assess asset price booms.
  - Caveat: money and credit aggregates cannot be the sole nominal anchor; structural changes and financial market evolution can create inconsistencies between money growth and stable inflation.
  - The PBC should consider developments in a range of variables (financial and real sector indicators) because monetary aggregates alone may not indicate future inflation.
- Implementation features of the eclectic framework:
  - Emphasize research, modeling, internal communication, regular meetings to discuss conjectural events, preparation of materials to inform policy makers, and elaboration and communication of forecasts and reports.
  - The central bank becomes a sophisticated machinery of information collection and analysis.
  - The PBC may announce a long run inflation goal as a priority for monetary policy (clarifying this is not a move to an IT framework) to help tie down inflation expectations.
- Debate on using interest rates as operating procedure:
  - Test following Walsh (2003): whether the central bank should keep interest rate constant or hold monetary quantity constant to minimize variance of output deviations.
  - Model setup (log terms, simple IS-LM variant):
    - Objective: Min)(2 t yE
    - IS: t t t urBy += 1
    - Money demand: t t t erBy m ++ = 2
    - From (6): 2 B e y m r t t t t −− = (7)
    - Plugging (5) in (7): t t t t u B e y m By + [ − − ] = 1 2 (8)
    - Solving for t y gives equation (9):
      t t t t u BB B e BB B m BB B y 12 2 12 1 12 1 − + − − − = 
    - Objective function (10):
      [] 2 21 2 2 22 1 2 )(BB BB yE ue t − + − = σσ
    - With interest rate as instrument and money market equilibrium, setting interest rate such that 0)(=yE yields (11):
      22 )( uti yEσ =
    - Criterion to choose interest rate as operating procedure (12):
      22 )( uti yEσ <
    - Equivalent condition (13):
      2 2 21 2 2 22 1 )( u ue BB BB σσσ < − + −
    - Further equivalent conditions (14) and (15):
      2 1 21 2 )2( ue B BB σσ − >
      2 1 2 2 ] )2( 1 [ ue B B σσ − >
    - Interpretation: interest rate is preferable as operating target when:
      - Variance of money demand disturbances is larger,
      - LM is steeper,
      - IS curve is flatter.
  - Applying the setup to China yields results implying that an interest rate would be desirable as the operating target for monetary policy conduct in China, culminating in expression (16):
    3303.373830.4 ] )2( 1 [ 2 1 2 2 < − > ue B B σσ
  - Conclusion: monetary policy would benefit from giving the PBC full discretion to make interest changes and to start using a policy interest rate more actively.

### Strengthening China’s operational framework — practical measures
- Multiple PBC objectives complicate reliance on an operational framework centered on interest rates:
  - PBC objectives include maintaining profitability of state-owned banks and creating an environment for market-oriented loan and deposit pricing; PBC monitors banks’ margins.
  - Lack of a well-defined operational target; reliance on window guidance to influence loan portfolio structure and credit allocation.
  - Current structural excess liquidity in the banking system complicates day-to-day monetary policy conduct.
- Operational target recommendation:
  - PBC should consider defining a short-term interest rate as its operational target.
  - Specification should avoid strict commitment to control the short-term interest rate precisely.
  - Options:
    - Announce a short-term bills rate (fixed or maximum bid rate) to communicate policy stance and expect interbank rates to remain on average close to this policy rate (preferred).
    - Or declare the short-term bills rate as the operational target but allow some fluctuation around the pre-announced level.
- Banks’ margins monitoring and lifting interest rate controls:
  - Shifting to a short-term money market rate implies lifting interest rate controls on banks’ deposit and lending operations to allow market-based allocation of savings and to improve financial intermediation and monetary policy effectiveness.
  - Removing benchmark lending and deposit rates allows the market to determine the shape of the yield curve.
  - If profitability concerns persist, the PBC could monitor banks’ margins for loan portfolios (referenced Box 3).
- Excess reserves:
  - Bringing excess reserves to levels consistent with banks’ minimum settlement balances facilitates reliance on a short-term rate as the operational target.
  - Lowering and eventually removing remuneration of excess reserves (consistent with developed-country practice) while not absorbing reserves in excess of normal working balances may lead to an expansion of bank loans.
  - Recommendation: shift to a short-term interest rate operational target only when banks’ reserves are brought down to a level consistent with banks’ minimum working balances.
  - Alternative: increase remuneration of excess reserves to a market level if used to mop up excess liquidity on a permanent basis.
- Liquidity-absorbing versus liquidity-providing operations:
  - Consider conducting policy from a structural liquidity deficit position.
  - Reliance on administrative measures (window guidance and forced placement of PBC bills) suggests PBC lacks confidence that liquidity-absorbing market-based operations would achieve objectives.

*Source: excerpt from IMF staff paper (Box 2 and accompanying sections).*

### Box 3. Monitoring Banks’ Margins: Country Examples

### Box 3. Monitoring Banks’ Margins: Country Examples

### Mechanisms to prevent oligopolistic behavior and ensure transparency
- Thailand: central bank and banks agreed to establish the minimum retail rate as a reference lending rate for small but good-quality borrowers.
  - The minimum retail rate included four components: the average cost of funds, the operating costs, a tax levied on financial transactions, and a profit margin.
- Malaysia: historically, all rates were anchored to each bank’s declared base lending rate, which was based on a bank’s costs of funds.
  - During a period, the base lending rate was subject to central bank’s guidelines.
  - In 1991, it was freed from administrative control, allowing it to become akin to the prime rate in use in some countries.

### Context within monetary framework and liquidity operations
- In shallow markets, reliance on market-based monetary operations can be facilitated when the central bank conducts the bulk of its monetary interventions as liquidity-providing operations, reducing the scope for collusion or overshooting because the banking system must borrow from the central bank.
- When the central bank conducts the bulk of interventions as liquidity-absorbing operations, banks can choose between lending to the central bank or to customers, requiring interest rate tenders and raising the risk that interest rates may overshoot.
- Central banks have used instruments to create structural liquidity shortages, including mandatory banks’ deposits or forced placement of central bank bills.
  - Such central bank assets have been remunerated at market rates to limit distortionary effects.
- The PBC has relied on reserve requirements and, at times, forced placement of PBC bills to withdraw excess liquidity.
  - Reserve requirements should be remunerated at a rate in line with short-term money market rates to limit distortionary effects.
  - Forced placement of PBC bills should follow a pre-announced rule and be remunerated in line with market rates to create a level playing field among financial institutions.
- A move to a structural liquidity shortage is best implemented in combination with a gradual exit strategy of the PBC from the foreign exchange market, since banks’ reserve growth is largely attributable to international reserves accumulation.

### Policy implications for monitoring banks’ margins and market-based policy
- Current limits to banks’ deposit and lending rates could be replaced by a mechanism to monitor banks’ margins for their loan portfolio as a whole, rather than for each individual loan.
- Consideration could be given to conducting monetary policy from a structural liquidity deficit position, using transparent rules-based instruments to induce banks to borrow from the central bank and create a liquidity shortage.
- An important prerequisite for shifting to fully market-based monetary policy is to grant the PBC full discretion to make interest rate changes so it can use its policy interest rate more actively.

### Cross-country examples related to liquidity surplus management (contextual examples)
- Mexico: central bank used mandatory remunerated deposits distributed based on banks’ liabilities with market-based remuneration.
- Bank of Spain (BDE), 1970-80s: used non-remunerated reserve requirements and forced deposits remunerated at below-market rates; after 1990, substituted non-remunerated required reserves with mandatory holdings of BDE bonds.
- Netherlands (DNB), 1980s: used mandatory market-rate-remunerated deposits and DNB bills to create an operational liquidity deficit; in 1994, DNB started issuing 6-month certificates of deposit at market rates.

### Recommendations summarized for transitioning to market-based monetary policy
- Adopt a short-term interest rate as the operational target.
- Reduce banks’ excess reserves balances to levels in line with banks’ minimum working balances to enable conventional liquidity management and foster interbank borrowing.
- Supplement the policy rate with a corridor for short-term money market interest rates.
- Replace administrative rate limits with portfolio-level margin monitoring and use structural liquidity deficits to limit overshooting risks.

*Source: Mehran, Laurens, and Quintyn (1995); material excerpted from the provided IMF document.*

### Appendix V. The Role of Money and Asset Prices in the ECB Monetary Strategy

### Appendix V. The Role of Money and Asset Prices in the ECB Monetary Strategy

### ECB objective and two-pillar decision framework
- The primary objective of the European Central Bank’s (ECB) is price stability. 58
- Monetary policy decisions are based on two pillars:
  - Economic analysis: focuses on shorter-term price movements largely influenced by interplay of supply and demand in goods, services and factor markets.
  - Monetary analysis: focuses on longer-term price trends closely linked to underlying trends in the money stock.
- The framework aims to provide the Governing Council with all relevant information and to give the public a clear, consistent rationale for policy decisions.

### Role and development of monetary analysis (focus on M3)
- The ECB gives importance to monetary analysis without having a monetary target.
- Within the monetary pillar there is a specific focus on the analysis of the components and counterparts of M3.
- This focus reflects the recognition that monetary growth and inflation are closely related in the medium to long run and provides a nominal anchor beyond horizons conventionally adopted for inflation forecasts.
- Over time, monetary analysis has been deepened and broadened. 59
- Macroeconomic projections play an important but not all-encompassing role; other relevant indicators include:
  - a broad range of price and cost indicators;
  - aggregate demand and its components;
  - labor market conditions (including wage negotiations);
  - fiscal developments (including administered prices, taxes);
  - financial market conditions (yield curve; asset prices; exchange rate);
  - private sector expectations (inflation; real growth) based on financial market prices and surveys.

### Empirical linkages between money and inflation
- The source presents a table titled "Table A4.1. Correlation Between Long-Term Trends in Monetary and Inflation, 1986–2004."
- A graphical depiction shows series ranging from -0.4 to 1.0 on the vertical axis and quarters from -12 -9 -6 -3 0 3 6 9 12 on the horizontal axis, with annotations "money is lagging inflation" and "money is leading inflation."
  - Vertical axis values included: -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
  - Horizontal axis values included: -12 -9 -6 -3 0 3 6 9 12 (quarters)

### Asset prices in the monetary strategy
- The ECB does not target asset prices.
- Asset prices are taken into account to the extent that doing so supports price stability over the medium term.
- Rationale for monitoring asset prices:
  - They play a key role in the monetary policy transmission process.
  - They help to identify the nature of shocks.
  - They reveal information about private sector expectations.
- The ECB monitors asset price dynamics closely because strong appreciations and subsequent rapid reversals can entail potentially very high costs for price stability and for the economy as a whole.

### Policy response to asset price booms and the role of monetary analysis
- Under certain circumstances, a policy of “leaning against the wind” of an incipient identified bubble might be considered:
  - The central bank would adopt a tighter policy stance in the face of an inflating asset market than it would otherwise allow if confronted with a similar macroeconomic outlook under more normal market conditions.
  - Given uncertainty about the appropriate policy stance, a central bank would err on the side of caution to avoid feeding the bubble with accommodative policy.
  - It would possibly tolerate a certain deviation from its price stability objective in the shorter term in exchange for enhanced prospects of preserving stability in the medium to long term.
- Monetary analysis can help assess whether excess creation of liquidity and over-extension of credit are driving excessively valued assets.
  - Detecting and understanding the link between monetary aggregates (and their counterparts) and asset valuations helps form an opinion on whether observed movements might reflect an overly expansionary monetary policy contributing to asset price bubbles.
- Empirical research cited indicates that asset price bubbles which end in economic and financial distress were often preceded by excessive monetary developments.

*Source: Appendix V. The Role of Money and Asset Prices in the ECB Monetary Strategy (content unit provided).*

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