Making Monetary Policy Work in China: A Report from the Money Market Front Line

This paper examines the current state of monetary policy in China: its institutions, effectiveness and limits. It explains the reasons why the transmission mechanisms of monetary policy do not yet work effectively in China and some of the broad policies that are required in order to meet this challenge. The problem is primarily explained by excess liquidity in the banking system and a lack of investible debt instruments. The paper also assesses and measures the PBoC’s three-pronged efforts to sterilise FX inflows (bill issuance, reserve requirement increases and window guidance), estimating that the authorities managed to sterilise some 47% of inflows in 2004. However, analysis of the flows involved suggest that proportionally more are being added to base money at present, and that the domestic costs of sterilisation are rising. It also shows that FX inflows are undermining China’s monetary policy independence, causing money market rates to fall, undermining bank profitability as well as causing other micro-economic problems.