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UPDATED: January 15, 2007 No.3 JAN. 18, 2007
Features and Challenges of Monetary Policy

A commentary by Zhou Xiaochuan, Governor of the People's Bank of China, published in Caijing magazine, reveals that compared with developed countries with a mature market economy, China follows a multi-purpose

monetary policy. Zhou also illustrates the coexistence of price-based and quantity-based regulatory measures and discusses how the significance of reform may, over a period of time, outweigh the independence of the Central Bank's monetary policy. Excerpts follow:

Multi-targeting system

Given China's present economic development, an inflation targeting system will not be taken into consideration for the time being. During the transitional period of the economy, the market plays an increasingly important role in pricing resource commodities, service products and production factors. This will surely impose extra influence on the price and quantity of the currency, a phenomenon that does not exist in mature market economies. If currency instability is to occur in China, it might be attributed to problems relevant to the transitional period rather than the price or quantity of the currency.

At the same time, as a low-income developing country, China regards economic growth and employment as important objectives, and the Central Government has to face up to this reality. The goal of economic growth is indirectly corresponding to those expected to be achieved in terms of employment and the international balance of payments. Although the Central Bank's major function is to stabilize the currency and maintain low inflation, currently, it's still necessary for China to adopt a multi-targeting regime, dealing with inflation while keeping an eye on economic growth, international payment balance, employment and especially the financial reform.

Two types of regulatory instruments

Since the 1980s, China has experienced three high-inflation episodes, which took place in 1985, 1988 and 1995, respectively. However, influenced by the Asian financial crisis, deflation hit China from 1998 to 2000. These experiences show a strong interaction between currency supply and inflation. The People's Bank of China notices that at the current stage of economic development, the monetary aggregates constitute an important part of the monetary policy.

Meanwhile, the role of the money supply varies with the development of the economy. Its impacts on the economy and inflation should never be judged in accordance with rigid rules. In the case of China, we must take into account the monetarization process that always accompanies the reform.

By monetarization we mean that in the market economy, the price of certain products (like houses), which used to be directly distributed under the planned economic system, should also rise in accordance with workers' income. But it has resulted in an unparalleled growth of money supply and nominal GDP. This is also different from the situation in mature market economies. For years, the money supply in China has been growing faster than the nominal GDP and the growth of extra supply is, to a large extent, corresponding to the progress of the monetarization. Of course, this phenomenon will not last forever.

On the other hand, in the transitional period, interest rate and exchange rate regimes, the financial market and the structure of the financial sector are all undergoing gradual improvement, with rising price elasticity. Only by experiencing such a "slow transition" can the effective monetary policy transmission mechanism take shape. Therefore, it's necessary for the Central Bank to make use of both price- and quantity-based tools in carrying out the monetary policy.

Besides, the two types of tools will also interact with each other, that is, when the quantity is not within the reasonable extent, the price transmission mechanism will go wrong. At the same time, without in-depth reforms, the quantity-based monetary policy will also face all kinds of problems and affect the efficiency of the monetary policy.

Based on repeated analyses, the Central Bank should currently make comprehensive use of quantity- and price-based instruments to implement the monetary policy. It's hoped that the reliance on the quantity-based instruments will gradually diminish while more price-based instruments are brought into use. However, currently, both types of instruments are used either simultaneously, or in turn, include open market operations, deposit reserve requirements, interest rate, exchange rate, etc.

Reform coming first

A slowdown in reform will negatively impact China's economic development and the implementation of the monetary policy and more importantly, in the long run, it will hinder the formation of the mechanisms and systems that will ensure that the monetary policy can function as expected. Hence, from the perspective of the Central Bank, the process of pushing forward reform is also the process of maintaining currency stability (low inflation) and establishing a well-performing economic and financial system. We place much store in the reform and believe that this is the only way to cope with potential financial crises in the future. This is a different approach to that taken by more mature market economies.

The inflation targeting system, though not adopted in China at present, is a very important direction for future development. But, if priority is given to reform, then cooperation and coordination between the Central Bank and other government departments, under the leadership of the State Council, is vital to achieve tangible results, something that seems more important than the independence of monetary policy for the time being.

Still there remain several other problems. First, for years the growth rate of China's money supply (M2) has been higher than that of nominal GDP. Second, theoretically, the trade surplus and long-lasting high growth rate of M2 are likely to lead to inflation. Nevertheless, no obvious increase in the consumer price index has occurred except in a brief period in 2004. Third, under the influence of the Asian financial crisis, in order to remove itself from deflation, the Chinese Government has taken a series of measures: corporate restructuring, banking reform, boosting domestic demand and attracting foreign direct investment by improving basic infrastructures through a proactive fiscal policy. As a result, the country's manufacturing sector has sharply developed its productivity, which results in falling prices because of overcapacity. Fourth, China now boasts a high savings rate. Especially since the Asian financial crisis broke out, the savings rate has continued to climb, and is about 10 percentage points higher than that at the time of the crisis. A high savings rate will make it possible to make a large amount of new investment in basic infrastructure, industrial productivity and exports, but this will also lead to overcapacity. These intertwined factors make the analysis of economic and currency issues a complicated job.

Against this backdrop, we must think about the monetary policy and the use of relevant tools in an innovative way by taking careful actions based on close observation. As a developing economy in its transitional period, China must press ahead with reform, as only in this way will the monetary policy be effectively implemented and can we balance the relationship between reform, stability and development.

Why Is the Income Gap Widening?

The widening income gap between China's rich and poor has become a major concern. According to Fan Gang, Director of the National Economic Research Institute, there are three reasons for the disparity: an imperfect economic system, uneven development levels and deficient public policy. Excerpts of his analysis, published in People's Daily, follow:

Defects in the economic system are quite significant in the widening income gap. A lot of people believe the income gap is caused by corruption and illegal income, which are typical of an ill-developed system. At present, the government is trying to resolve a series of problems left over from the old system, especially corruption. The basic definition of corruption is to use public resources for private benefits. Under the traditional Chinese system, this was easily done. Corruption occurs when preference is given. The market-oriented reform aims to restore a large number of private rights. Corruption is not a problem caused by reform. Instead, it is exposed in the process of reform. The only solution is to proceed with the economic reform.

There is another problem pertaining to monopoly industries. Some enterprises monopolize production and operating resources. A relatively large income gap has therefore appeared between natural resources industries, monopoly industries and competing industries. These problems are not caused by a market economy. On the contrary, they are the result of the absence of a market economy.

A big challenge to economic development is in the imbalance of income in rural areas and between urban and rural areas, as well as regional disparities. This kind of gap usually occurs in underdeveloped and developing economies. As a lot of China's labor force is still concentrated in rural areas, it is difficult to raise the income of farmers. Even those who have migrated from the countryside find it difficult to increase their earnings, for there are limited jobs for these workers. Approximately 80 percent of workers are in the low-income category. Some do not even earn enough to be taxed. This problem can only be fundamentally resolved through sustainable economic development and full employment. It is extremely difficult to obtain an average income level through social redistribution by means of taxes and subsidies.

There are also problems in public policy, which the central and local governments need to address. The government needs to decide how to increase the earnings of low-income earners, how to protect the rights of low-income earners and how to ensure their education and basic medical services. If these measures are not sound, those who need special care and support will receive inadequate protection.

To fundamentally resolve the abovementioned problems, the government must push forward reform to ensure sustainable and long-term development, adjust public policy and create more jobs. Perhaps public policy adjustments can be achieved in a short period of time, but the reform of old systems and economic development are time-consuming.

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