Comparison of Monetary Policies of India and China

Prof. SubalakshmiSircarEconomic Environment and PolicySubmitted on 24th December 2014

Prepared by:

Group 4 Section B

Anup Nair – 14P072

DevangNahar – 14P075

DikshaMahajan – 14P077

K. Mohana – 14P087

PrashantGhabak – 14P093

Varun Dave – 14P118

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Table of Contents

ContentsINTRODUCTION.........................................................................................................................................3

China Monetary System : A brief overview.........................................................................................4

Monetary Policy Instruments in China.....................................................................................................6

Internationalisation of Renminbi............................................................................................................12

Monetary Policy of India: An Overview.............................................................................................14

References.................................................................................................................................................18

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INTRODUCTION

China and India, over the past decade have followed completely different growth

trajectories. India’s growth was fuelled by rising domestic consumption whereas China

relied heavily on exports and foreign investments. The Indian economy has slowed down

since 2008 whereas China up till now has registered above 8% growth rate though it is

showing signs of slowing down. Each economy has its own unique sets of problems due to

structure, government policies and maturity of financial institutions and markets. This

results in different monetary policies objectives and mechanisms by which a central bank

can influence the economy. China and India are no different in this regard.

India’s growth is supply side constrained. Internal consumption has risen steadily over the

years but supply is restricted due to insufficient capacity. This is generally attributed to

lack of investments and lack of agility in policy making. Thus rising demand and limited

supply has pushed up the prices resulting in persistent inflation. Dependence on imports

for key raw materials like oil also pushes up the prices of derived goods. Rigid policies also

played a part in reducing foreign investments which could have been used to bridge the

gap between savings and investments.

China on the other hand is a demand constrained economy. Massive investment has

created excess capacity. However there is a decline in private consumption which has

forced the Chinese enterprise to turn to the rest of the world for generating demand. This

increases the current account surplus and leads to widening of the monetary base, which

coupled with cheap credit, have been known to generate bubbles. The USD/CNY peg also

leads to massive forex inflows, increasing the monetary base.

The monetary policy, in response to the above issue, varies a lot between the two countries.

In this report we will try to examine the key instruments affecting monetary policy and

how they differ in India and China.

China Monetary System : A brief overview

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The People's Bank of China was established on December 1, 1948 by consolidation of the

Huabei Bank, the Beihai Bank and the Xibei Farmer Bank. The State Council made PBC

function as a central bank in 1983.

The PBC plays a crucial role in China's macroeconomic management. The amended Law of

the People's Republic of China on the People's Bank of China, provides that the PBC

performs the following major functions:

(1)Drafting and enforcing relevant laws to ensure that rules and regulations can fulfill its

functions; 

(2) Formulating and implementing monetary policy in constraints the law; 

(3) Issuing and controlling the Renminbi

(4) Regulating financial markets like the inter-bank lending market, the inter-bank bond

market, foreign exchange market and gold market; 

(5) Preventing and mitigating systemic financial for financial stability; 

(6) Maintaining the Renminbi exchange rate at equilibrium level; Maintaining the state

foreign exchange and gold reserves; 

(7) Managing the State treasury fiscally; 

(8) Making payment and settlement rules to ensure normal operation of the payment and

settlement systems; 

(9)Monitoring money-laundering related suspicious fund movement; 

(10) Developing statistics system for the financial sector and consolidation of financial

statistics as well as the conduct of economic analysis and forecast 

(11) Credit reporting industry in China and building up of credit information system;

(12) Participating in international financial activities at the capacity of the central bank; 

The People’s bank of China’s website states that the objective of its monetary policy

is to maintain the stability of the value of the currency and thereby promote

economic growth.

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The following are monetary policy instruments used by the People’s bank of China:

reserve requirement ratio

central bank base interest rate

rediscounting

central bank lending

open market operation and

Other policy instruments specified by the State Council.

Monetary Policy Instruments in China

The PBC classifies its monetary policy instruments into four categories

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1. Ratio Instruments

2. Interest rates instruments

3. Quantitative instruments

4. Other instruments like central bank bills.

Price-based indirect instruments

In China price-based instruments have two different underlying mechanisms of action.

First type of instruments, transform the central bank’s policy stance via the interest rate

channel of monetary transmission. Second type of instruments, act under the disguise of

price-based instruments. Example, PBC lending and deposit rates. There are two different

ways of transmission of interest rate changes: a) The transmission of interest rate changes

according to the interest rate channel where a interest rate change by the central bank

affects the refinancing costs of commercial banks and thus changes the interest rates

charged by the commercial banks to 3rd parties; and b) the transmission of interest rate

changes as result of administered interest rate changes compels commercial banks to

change the interest rate for money that is already at their disposal resulting in changes of

commercial bank’s interest rates to 3rd parties.

a) PBC lending and deposit rates

The PBC dictates the monetary policy using two types of interest rates: 1) Benchmark

lending rate and 2) rediscount rate. The former gives the commercial banks a certain

freedom in setting their own interest rates according to their assessment. While these and

other liberalizations indicate progress towards market-determined interest rates, interest

rates are still controlled. The central bank has to ensure that the commercial banks have

access to funds at rates below the deposit rates to ensure their profitability.

To adjust the benchmark lending rate the central bank needs to get the consent of the State

Council. This dependency limits the central bank’s flexibility as far as pre-emptive or fine

tuning of monetary policy is concerned. The insufficient instrument independence of the

PBC is the cause that monetary policy in China is not flexible enough to react timely to

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changes in the monetary policy environment. To mitigate this, the PBC has now been

empowered to add a surcharge on its central bank lending rate at its own discretion.

b) Discount and rediscount rate

In 2004, the central bank installed the rediscount rate as the benchmark rate, i.e. the

central could change the central bank lending rates within a range around the rediscount

rate. This did not need a prior approval of the State Council. However, the impact of the

rediscount instrument itself is too small to have a large impact on the growth of monetary

base. Thus, the rediscount policy primarily intends to influence the commercial paper

market

c) Reserve Requirements

The central bank had introduced minimum reserve requirements to control the financial

sectors liquidity. At first, different reserve obligations were set for the different deposits

with regard to their origin and the institution holding the reserves. In 1985, the central

bank changed this. It combined all different reserve requirements and set one minimum

reserve requirement at 10 %. In 1998, central bank shifted its monetary policy from direct

control to more indirect control. Open market operations (OMO) were made the the main

instrument of monetary policy.

The three salient features of the Chinese reserve requirement are:

Minimum and excess reserves are interest bearing.

High ratios of excess reserves are held the financial system.

The PBC introduced a policy of differentiated required reserve ratio for different

financial institutions

d) Open market operations (OMO)

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In 1993, the Central bank introduced the instrument of open market operations in its

monetary policy. Since the institutional foundation was lacking, the central bank decided to

suspend OMOs in the year 1997.

In 1998 OMOs were re-introduced. With a better institutional foundation, OMOs were an

immediate success. OMOs have now become a key instrument for conducting monetary

policy in China. Before 2003 open market operations were generally carried out once a

week. Open market operations now are generally conducted on two days per week –

Tuesday and Thursday.

Open market operations include national bonds, central bank bills and financial bonds from

other financial institutions. They are traded as repurchase operations and as direct market

operations. Repurchase operations include repos and reverse repos. Repurchase

agreements done for the purpose of monetary base withdrawal are called as repos.

Reverse repurchase agreements undertaken for fueling monetary liquidity are called as

reverse repos. The Central bank withdraws monetary base by issuance of central bank bills

and injects monetary base with their redemption.

Quantity based direct instruments:

a)    Window Guidance

The PBC started to adopt the policy of “window guidance” in 1998.The framework for the

Chinese window guidance was closely modeled according to the Japanese system. This

policy uses benevolent compulsion to persuade banks and other financial institutions to

stick to official guidelines. Central banks make use of moral pressure to make financial

players operate consistently with national needs. A major point of the concept is the

temptation to influence the market participants through words rather than strict rules. The

PBC has a major influence on the lending decisions, despite the phrase guidance, which

implies a voluntary aspect in the system. It is effective especially in case of the four state-

owned commercial banks.

b)    Direct PBC lending

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Direct PBC lending as a monetary instrument is in the legacy of the planned economy, the

usage of which was officially discontinued in 1994. However, the last decade or so was

marked with a high amount of the central bank money permanently being in the financial

system, evidence for instance, by excess reserve ratios well above the 10 % margin in the

1990s which only gradually came down to 7.61 % in 2001 and 5.38 % at the end of 2003.

c)     Capital controls

A third instrument within the quantity-based instrument toolbox of the central bank is

capital controls. However, the instrument of capital controls differ fundamentally from

window guidance and direct PBC lending as the capital controls’ aim is not the amount-

driven credit allocation but the quantitative limitation and guidance of financial flows

between China and the rest of the world.

Other non-central bank policy instruments

1)  Price controls:  Since 1998, three kinds of prices have been predominant in China

a) market-regulated prices, which are set by the market through supply and demand and

are not faced with any intervention from authorities;

b) Government guidance prices, which can come either as a benchmark price or a floating

range set by the government. The floating band is usually between 5 and15 %; and

c) Government prices, responsible government authorities set the prices which are treated

as fixed and are unchangeable unless approved by these authorities.

Some prices have to be set by the central government. There are other prices that can be

set and regulated by the province, municipality etc. The relevant price department or other

related departments can set these prices.

2) Wage controls

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Historically, in 1978, China’s wage regime was characterized by a centrally regulated salary

system that, among other things, determined the wages according to regions, occupations,

industries and sectors. The heart of the system was a classification scheme with more than

300 standardized occupational classifications used for the salary formation. After 1978, the

wage regime had undergone three sets of reforms in 1985, 1992 and 1994–1995,

respectively. The two reforms in1985 and 1992 incorporated an indexation of wages to the

development of the consumer price index.

Thus, high inflation had an impact on the wage level setting and higher wages, in turn,

triggered higher inflation rates. This constituted circles that easily led to an inflationary

spiral through ever increasing inflationary expectations.

Internationalisation of Renmi n bi

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During the era of the command economy, the value of the Renminbi was set to unrealistic

values in exchange with western currency and severe currency exchange rules were put in

place. With the opening of the mainland Chinese economy in 1978, a dual-track currency

system was instituted, with Renminbi usable only domestically, and with foreigners forced

to use foreign exchange certificates. The unrealistic levels at which exchange

rates were pegged led to a strong black market in currency transactions.

In the late 1980s and early 1990s, China worked to make the RMB more convertible.

Through the use of swap centers, the exchange rate was brought to realistic levels and the

dual track currency system was abolished. As of 2014, the Renminbi is convertible

on current accounts but not capital accounts. The ultimate goal has been to make the RMB

fully convertible.

There is difference between how RNB is handled in mainland China and how it is handled

outside it.

RMB in Mainland China

Subject to Mainland China regulations

Mainland authorities and local banks responsible for verification of RMB

transactions

CNY FX rates can be accessed offshore only for documented goods trade with

Mainland China

Regulated interest and exchange rates

RMB outside Mainland China

Major offshore RMB center: HK, Singapore, UK and more

Conforms to prevailing market practice for other foreign currencies

Offshore RMB markets build up breadth and depth with deepened liquidity

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Fully liberalised interest and exchange rates

Internationalization of the renminbi (RMB) is one of the more contentious and widely

debated aspects of economic reform in the People’s Republic of China (PRC). Wider use

of the RMB in international transactions, both commercial and financial transactions and

those undertaken by central banks and other official institutions, can be understood as a

natural response to the growing weight of PRC trade and investment flows in the world

economy. At the same time, top PRC officials have declared repeatedly currency

internationalization to be a stated goal of policy, while the People’s Bank of China and

other government agencies have pursued a variety of initiatives designed to encourage

the currency’s wider use. Thus, whether wider international use of the RMB is a

spontaneous market reaction or a manifestation of the PRC’s growing ability and

willingness to influence the shape and structure of the global economy is a matter of

interpretation.

So too is the role of RMB internationalization in the process of the PRC’s economic growth

and development. Some will say that the cause of RMB internationalization is being

advanced mainly in the interest of financial institutions, which see scope for doing

international business in the currency as a lucrative source of potential income. Others

argue that currency internationalization is supported by PRC firms that see the ability to do

cross-border business in their own currency as a useful way of saving costs and

maintaining competitive advantage. Those firms do not see why they should have to

continue to incur the additional costs of conducting such business in United States (US)

dollars and having to hedge the resulting exposures.

Similarly, it is argued in some circles that RMB internationalization is a natural corollary of

the process of financial development and deepening currently under way in the PRC. As

financial markets gain depth, width, and liquidity and are progressively opened to foreign

investors, greater international use of the currency will come naturally. The counterpoint is

that currency internationalization and the capital account liberalization required to

advance it can be or are being used to ratchet up the pressure on PRC regulators to

accelerate domestic financial reforms and hasten the process of financial development and

opening.

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Monetary Policy of India: An Overview

The main motives of monetary policy in India are:

  Ensuring price stability

  Maintaining adequate flow of credit to the productive sectors of the economy to back economic growth

   Financial stability

The emphasis among the objectives changes from time to time,

Monetary Policy: Major trends

Major drought and terms of trade shocks over 1965-67, led to a fiscal tightening, with a

decrease in deficits and in public investment. Monetary policy focused on a credit targeting

approach. Fiscal-monetary policies were closely interconnected, as the budget deficit was

financed. Severe monetary and fiscal measures followed the oil price plus agricultural

supply shock over 1973-75. In both the cases there was an unnecessary loss of output. An

emphasis on expanding supply would have been more useful. After the 1979-80 oil shock, a

cut in public investment and acute monetary tightening was avoided. Recovery was fast,

however, deficits and supply side inefficiency continued.

The similarly closed, import substitution and public investment driven model of

development followed, allowed macro-policy to be driven towards domestic requirements.

Commercial banks’ ability to multiply the reserve base and create broad money was

countered through strict compulsory reserve and statutory liquidity requirements through

some extent. This, together with administered prices, controlled inflation too politically-

acceptable levels. Thus, political business cycles in India largely took the form of a decrease

in long-term development expenditures and interpositions that skewed allocative

efficiency, not of increased creation of money.

Since the seventies, major development ideas changed to increase openness. In India also

the bad effects of controls were becoming prevalent. Some liberalization started in the mid-

eighties, but a dominant thrust for external openness came from the mid 1991 balance of

payment crisis when foreign exchange reserves were down to 11days of imports. The crisis

brought home the lesson that many interest controls and credit rationing were destructive

to growth and stability. It made possible the implementation of the series of pending

committee reports. Current account and partial capital account liberalization, and a slow

move to more flexible exchange rates followed. While controls continued on domestic

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portfolios and debt and equity inflows were liberalized. Equity shares risks, while short-

term debt flows create a big repayment burden in unfortunate times. On foreign debt, the

sequence of relaxation favored commercial credit and longer term debt. Major reforms

were taken towards development of equity, forex money and government securities

markets.

Although low by developing country standards, Indian inflation was more than world rates.

Cumulating of large public debt made the fiscal-monetary combination followed in the past

unsustainable. The automatic monetization of the government deficit was stopped and

auction based market borrowing adopted for meeting the fiscal deficits. The repressed

financial regime was disassembled, interest rates became more market determined and the

government began to borrow at market rates. All administered interest rates were

deregulated except the savings bank deposit rate. RBI initiated a delivery versus payment

mechanism for settlement of trades in government securities was, leading to establishment

of the CCIL (Clearing Corporation of India),a central counterparty to undertake guaranteed

settlement for government securities, repos in G-secs and forex market trades.

The basic objectives of monetary policy remained price stability and development, butin

line with the recommendations of the Chakravarty Committee (RBI, 1985), the operating

procedures had shifted from credit controls towards flexible monetary targeting with

feedback from the mid-1980s till 1997-98. However, deregulation of the financial markets

combined with the increasing openness of the economy in 1990s made money demand

more unstable, and money supply more remote. The RBI itself noted monetary policy based

on demand function of money, in these cases, was expected to lack meticulousness.

The informal nominal money supply targeting proved inadequate under these changes;

interest rates were volatile in the 1990s. After the adverse impact of the nineties peak in

interest rates, the Reserve Bank moved towards using the interest rates an instrument,

basing its actions on a number of indicators of monetary conditions. There was no formal

inflation targeting, but policy statements gave both inflation control and facilitating growth

as key objectives. A specific value of 5 percent was given as the desirable rate of inflation,

with the aim to bring it even lower in the long-term. The aim was to reduce reliance on

reserve requirements, particularly the Cash Reserve Ratio (CRR),shifting liquidity

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management towards OMOs in the form of outright purchases/sales of G-secs and repo and

reverse repo operations.

Monetary Policy Instruments

The RBI monitors and analyses the movement of a number of indicators including interest

rates, inflation rate, money supply, credit, exchange rate, trade, capital flows and fiscal

position, along with trends in output and develops policy perspectives.

The Reserve Bank’s Monetary Policy Department (MPD) formulates monetary policy. The

Financial Markets Department (FMD) handles day-to-day liquidity management

operations. There are several direct and indirect instruments that are used in the

formulation and implementation of monetary policy.

The Direct instruments are:

Cash Reserve Ratio (CRR): The share of net demand and time liabilities that banks

must maintain as cash balance with the Reserve Bank.

Statutory Liquidity Ratio (SLR): The share of net demand and time liabilities that

banks must maintain in safe and liquid assets, such as government securities, cash

and gold.

Refinance facilities: Sector-specific refinance facilities (e.g., against lending to

export sector) provided to banks.

The indirect Instruments are:

Liquidity Adjustment Facility (LAF): Consists of daily infusion or absorption of

liquidity on a repurchase basis, through repo (liquidity injection) and reverse repo

(liquidity absorption) auction operations, using government securities as collateral.

Repo/Reverse Repo Rate: These rates under the Liquidity Adjustment Facility (LAF)

determine the corridor for short-term money market interest rates. In turn, this is

expected to trigger movement in other segments of the financial market and the real

economy.

Open Market Operations (OMO): Outright sales/purchases of government securities,

in addition to LAF, as a tool to determine the level of liquidity over the medium

term.

Marginal Standing Facility (MSF): was instituted under which scheduled commercial

banks can borrow over night at their discretion up to one % of their respective

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NDTL at 100 basis points above the repo rate to provide a safety valve against

unanticipated liquidity shocks

Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills

of exchange or other commercial papers. It also signals the medium-term stance of

monetary policy.

Market Stabilization Scheme (MSS): This instrument for monetary management was

introduced in 2004. Liquidity of a more enduring nature arising from large capital

flows is absorbed through sale of short-dated government securities and treasury

bills. The mobilized cash is held in a separate government account with the Reserve

Bank.

The Reserve Bank looks at both short term and longer term issues related to liquidity

management. In the longer term, it monitors the developments in global financial markets,

capital flows, the government’s fiscal position and inflationary pressures, with an eye

toward encouraging strong and sustainable economic growth.

 

References1. https://www.imf.org/external/np/vc/2007/070507.htm  2. http://www.thechinaguide.com/index.php?

action=preparation/moneyCurrency

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3. http://www.economonitor.com/blog/2013/12/china-monetary- policy-under-financial-repression/

4. http://www.wsj.com/articles/china-central-bank-pboc-cuts- interest-rates-1416567408

5. http://www.pbc.gov.cn/publish/english/963/index.html

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