Post-1990 Chinese monetary policy is modeled with an augmented McCallum-type rule that takes into account the People's Bank of China's emphasis on targeting the rate of money supply growth. People's Bank policy appears responsive to the gap between target and actual nominal GDP as well as to external pressures. Additional cointegration analysis yields estimates of the gap between estimated money demand and actual money supply that appear to track the inflationary trends evident over our sample period. Chinese inflation and monetary policy outcomes seem reasonably captured using a standard monetary approach without the need to appeal to China-specific “structural” factors
There has been an outpouring of recent research on the question of the exchange rate between the US dollar and the Chinese renminbi, with a number of economists making a case for much larger renminbi revaluation than the initial 2% shift announced on July 21, 2005. Notwithstanding the external effects of the ongoing revaluation, allowing some freedom from the fixed exchange rate constraint increases the People's Bank of China's scope for effective monetary control. Ba Shusong, deputy director-general of the Finance Institute of the State Council's Development Research Center, for example, emphasized that the fixed exchange rate had “jeopardized” the independence of Chinese monetary policy.1 In this study we find a consistent monetary policy response to real output that is combined, however, with apparent sensitivity to external pressures. The movement away from the old fixed exchange rate policy may well reflect the Chinese authorities' awareness of the benefits for monetary policymaking rather than necessarily representing a response to foreign demands for exchange rate adjustment.
In recent years monetary policy analysis has been increasingly dominated by the estimation of the Taylor rule (Taylor, 1993), whereby central bank interest-rate setting is related to the gap between inflation and its target value and the gap between actual real GDP and its potential level. When interest rates are already very low, a problem with the Taylor rule is that it may call for negative interest rates that cannot be delivered in practice, however. In such cases as Japan, therefore, McCallum's (1988) alternative rule based on explaining movements in the monetary base as a function of GDP and velocity growth may be more applicable (see also McCallum, 1993 and McCallum, 2003). In this paper we consider how this same McCallum rule may also be applied to China. Estimation of a Taylor rule would not be sensible here as not only does the People's Bank of China not have a target interest rate as such but also loan and deposit rates remained largely administratively determined over our sample period. Only recently has any movement from the specified interest rates been permitted. And, when the People's Bank of China announced a rise in loan and deposit rates on October 28, 2004, for example, there was still no scope provided for exceeding the basic deposit rate laid down in the communiqué (People's Bank of China, 2004a).
Given that the People's Bank's money supply targets have generally emphasized broad money (M2), we consider the behavior of M2 as a dependent variable in our empirical work in addition to the monetary base series originally suggested by McCallum (1988). We consider the 1990–2003 period, thereby including the 1993–1994 inflation spike, the subsequent anti-inflationary policy, the attempts to reflate the economy after the 1997–1998 Asian financial crisis, and the pressures for renminbi appreciation that emerged after 2001. Our analysis of Chinese monetary policy relative to the McCallum rule suggests that monetary policy was typically too tight until around 2001. We also find that, if we augment the basic McCallum rule, there is a significant monetary policy response to the rate of change of foreign exchange reserves that suggests less than full sterilization, as well as a significant shift that appears to coincide with the onset of deflation at the time of the Asian financial crisis. Our analysis concludes with a forecasting exercise that points to the central bank loosening policy too much in 2003–2004.
This study models Chinese monetary policy from 1990 to 2003 in terms of a McCallum-type rule that takes into account the People's Bank of China's emphasis on targeting the rate of money supply growth. People's Bank policy appears responsive to the gap between target and actual nominal GDP as well as to external pressures. We also find evidence of a policy shift as deflation set in during 1998 following the onset of the Asian financial crisis. Additional longer-run analysis reveals cointegration between the People's Bank's M2 target aggregate and prices, real output and interest rates. Estimates of the gap between estimated money demand and actual money supply appear to track quite well the swings between inflationary and deflationary pressures over our sample period. This suggests that Chinese inflation and monetary policy outcomes can be satisfactorily modeled using standard empirical techniques and are not just a figment of China-specific “structural” factors.
