China & the World Economy Week 9: Lecture 1 & 2 - 'Monetary Policy in China - Past, present and future'

Question 1

History of China’s banking sector

Answer 1

1949: Mono-banking system (PBOC).
1978: Market reforms → creation of BOC, ABC, CCB, ICBC.
1993–1995: Commercialisation of banks (not privatisation).
2001: WTO accession → required opening to foreign banks.
2003: Balance sheets cleared of non-performing loans (NPLs).
2005–2010: IPOs of big five banks.
2018: Postal Savings Bank became state-owned commercial bank → big six.
(Your note): Foreign banks struggled due to dominance of big four; China prepped its banks to compete globally.

Question 2

What are the key features of China’s financial markets and institutions?

Answer 2

Urban/Rural Credit Cooperatives → small banks for SMEs.
1990: Stock markets in Shanghai and Shenzhen.
2005: Split share reform → more private ownership.
Limited manager ownership.
Corporate bond and bill markets growing.
Pension funds exist but limited; now investing in stocks/bonds.

Question 3

What are the key characteristics of China’s monetary policy framework?

Answer 3

Dominated by state-owned banks.
Historically used direct controls (e.g. lending quotas).
Shift toward interest rate-based policy in last decade.
PBOC targets M2 (cash + deposits).
M2 growth set by government, not PBOC.
(Your note):
PBOC has two mandates: control inflation and support output.
M2 growth (~5.5%) is intermediate target; nominal GDP (PY) is final target.

Question 4

How does China achieve money market equilibrium in its monetary policy?

Answer 4

Two approaches:
Set monetary base → interest rate adjusts.
Set interest rate → money supply adjusts.
China uses both methods.
(Your note):
Diagram shows money market equilibrium.
Higher interest rates → lower money demand (shift to higher-yield assets).

Question 5

What are the main instruments of monetary policy in China?

Answer 5

Open market operations (repos and reverse repos).
Reserve requirement ratio (main control tool).
Benchmark interest rates (Loan Prime Rate since 2019).
Rediscounting (PBOC buys loans at discount).
Deposit insurance (to promote competition).
(Your note):
“Repo” = repurchase.
Interest rate bands help smaller banks compete.

Question 6

What are China-specific monetary policy tools introduced since 2013?

Answer 6

Standing Lending Facility (SLF):
Short-term lending (1–3 months) to large banks.
Medium-Term Lending Facility (MLF):
3–12 month loans with broader collateral.
Pledged Supplementary Lending (PSL):
Targeted lending to sectors like agriculture and small businesses.
Funds go to policy banks (e.g. China Development Bank).

Question 7

Monetary policy during COVID

Answer 7

Deflation → real interest rate rises → investment falls.
IS curve shifts left → output falls from Y₁ to Y₂.
Policy responses:
Monetary expansion (shift LM right).
Fiscal stimulus (shift IS right).
(Your note):
IS-LM model applies due to closed capital account.
Deflation risks a spiral: lower output → more deflation → lower output.

Question 8

What is shadow banking in China and why is it significant?

Answer 8

Illegal loan dealers (high-interest loans to SMEs).
Trusts and hedge-fund-like firms.
Property developer financing.
Banks used shadow banking to bypass regulations.
Industrial firms also engaged in shadow lending.
Recent reforms:
Shadow banking must now appear on bank balance sheets.
Resulted in decline in shadow banking activity.
Still a major source of debt in China.

Question 9

What are the key takeaways about China’s monetary policy system?

Answer 9

China’s monetary policy is shaped by:
State-dominated banking
Underdeveloped financial markets
Capital account controls
Since 2000:
Shift toward market-based tools.
Introduction of interest rate instruments.
Shadow banking remains a challenge.
COVID and deflation have tested the system’s flexibility.