Posted by: Dirk | April 11, 2013

Chinese monetary policy – how does it work?

The Chinese financial system is different. The central bank, the People’s Bank of China, conducts monetary policy differently from Western inflation-targeting central banks. This has created much confusion about how Chinese monetary policy works. Finn M Körner and I have finally published our working paper online. You find it here. This is the full abstract:

Chinese monetary policy constitutes a marked example of a clash between theory and practice. In theory, a fixed exchange rate regime with capital mobility turns the money supply into an endogenous variable while expansionary pressure can be alleviated by the central bank by foreign currency transactions. For China, this standard view is contended by the ‘compensation thesis’ as proposed by Lavoie and Wang (2012) according to which the central bank maintains discretion over money supply by using alternative balance sheet instruments. In this paper we show that the People’s Bank of China’s (PBoC) activities can be better characterized by the ‘compensation thesis’ view of alternative money supply operations. In addition, we can thus characterize the PBoC’s policy stance as being directed at targeting inflation and exchange rate stability via a five-phase policy mix using sterilization bonds and reserve requirements according to macroeconomic conditions. After downgrading the loans-to-deposits ratio of 75% to the status of an indicator and given the rise in lending despite a high reserve ratio, the quantity-driven approach to monetary policy of the PBoC faces an uncertain future.

Comments are welcome.



  1. The bottom line difference between capitalism and communism is the control of money supply. And it is the major factor of animosity and the such desire for destruction of communism.
    In capitalism, private banks control the money supply, they have 10% and lower reserve requierments (Australia has 0%) while the communisam had 100%.

    With 10% rr banks create credits which turn into deposits (money creation) while states have to borrow it from those banks.
    With 100% rr, banks can loan only someones savings (deposits) while states finance deficits with money creation. This is the reson behind debt free private sector with which communist world entered transition into capitalist system. 100% rr enables inflation that serves as debt forgivness in a given time period.
    On the other hand, money supply with credit creation (leveraging) provides a low inflation and higher and higher debt levels that in time reaches a ceiling and guarantees appearance of deflation (deleverage).

    Most of the countries in transitions switched from 100% to 20% rr allowing for inflation of real estate prices that are encountering their deflation since 2008.

    I wondered what is the difference in China. Now i know, their transition is gradual and controled so the real estate bubble is also controled and supported with inflation of the rest of the economy. They gradually transition from 100% rr down toward 10%. They are at 75% rr now. Much smarter then what Jeffrey Sachs did with other countries in transition. They did it on his recomendation.

    P.S. I am really surprised at how many economists do not know who control money supply in capitalism.
    Michael Kumhof of MMF is recomending 100% rr as a solution to the EU crisis without probably ever knowing that that is the monetary system of communism that was destroyed.
    There was and is such a blind spot in capitalist world about what communism was that they will implement it without ever knowing about it.
    Central planning is a euphemism for 100% rr for banks.

    I lived in communism, mixed economy and in US, and now back into transition country.

  2. Agreed that the Chinese banking system is different from the western way of banking. They have so far been able to achieve good results meaning thereby they are the net creditors to the world. By sacrificing consumption they have achieved good export levels and have consolidated their financial position.

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