China should adopt new intermediate target for monetary policy, say IMF economists

The People's Bank of China (PBoC) should adopt a new intermediate target for its monetary policy, by shifting away from monetary aggregates and towards "price-based controls, such as interest rates", according to economists at the International Monetary Fund (IMF).

In China, the central bank aims to "maintain the stability of the value of the currency". It has traditionally used quantity controls on bank lending and other direct instruments, such as the reserve requirement ratio, as a way of influencing monetary aggregates in the economy.

Specifically, the PBoC uses M2 – a measure of money that includes cash, checking deposits and ‘near money' such as savings deposits – as a target. Wei Liao and Sampawende Tapsoba, both at the IMF, said that China "has continued to rely heavily on M2 targets" even as the authorities modernise the financial system.

In China's Monetary Policy and Interest Rate Liberalization: Lessons from International Experiences, Liao and Tapsoba note the success of targeting any monetary aggregate "depends on the stability of the money demand function".

China is undergoing a period of economic reform, as the authorities look to open up parts of its financial system to foreign capital, and relinquish their control over interest rates in the economy.

The working paper analysed demand for money in eight countries across the globe, and found the long-run relationship between money balances, output, and interest rates is "altered" by both financial liberalisation and innovation.

"The emergence of new interest-bearing assets triggered by financial development may increase the interest rate sensitivity of money holdings; and the extensive use of credit cards and leveraging tools may reduce the dependence of money demand on income," the authors explained.

The Chinese economy has already changed in many ways. Only half of the financial intermediation in 2012 took place in the "traditional" banking sector", whereas 10 years ago the proportion was closer to 90%.

The working paper found there was a "stable" relationship between M2, output and interest rates in China between 2000 and 2008, but this is "no longer evident" in the years that followed.

"Our study finds that there is a significant structural shift in money velocity around 2009," Liao and Tapsoba said. "Such a structural shift… might be related to the brisk growth of off-balance-sheet activities and nonbank products."

This threatens the efficacy of M2 as an intermediate target for monetary policy. "Our results imply that China will need to shift toward more price-based tools, such as interest rates, as an intermediate target for its monetary control," they added.