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Research Proposal: Role of the Interest Rates’ Instrument In Mainland China’s Monetary Policy Transmission
Project Abstract
Recent years have seen Mainland China transform from direct control in their economic systems to having indirect controls within the economic measures. To this effect, this transmission would see the improvement in monetary policy instruments such as the Open market operations, reserve requirements and the interest rate systems. This study is focussed on the reform that happened within the interest rate system,and specifically how these changes have affected the transmission of the monetary policy in the country. Analysing the role of the interest rates that has gained prominence as an instrument used by the People’s Bank of China would be effective in determining the effectiveness of the monetary policy. This research proposal provides background information on this research specifically understanding the monetary policy instrument in the country and the research methodology to be incorporated into the study in determining the role and impact of the interest rate instrument.
Introduction
The developments happening in Mainland China have considerable effects on the rest of Asia, as it affects its domestic territory (Peng and Frank 5). This is due to the rising economic and financial integration within the region. Hence, the country is expected to have balanced and sustainable growth to maintain both monetary and financial stability. To this effect, monitoring the country’s macroeconomic development is fundamental in assessing monetary and financial conditions (Peng and Frank 5). Notably, this is not a simple task because of the monetary policy transmission mechanism, which has not been fully comprehended. This was proven by an overheated debate in 2004 on increasing pressures and the proper policy responses. Different commentators have provided different views on the effectiveness of adjusting interest rates for macroeconomic controls.
An extensive amount of literature has suggested that the monetary policy transmission in Mainland China has begun to mirror that of developed economies. It has been recommended that the actual behavior of monetary policy has moved in the identified direction due to the recent removal of interest rate controls and the broad remodeling of monetary policy moving from the utilization of quantity targets to having the People’s Bank of China (PBC) managing a key short-term interest rate. One example has been a recent statement by PBC on improving the liquidity management strategies so that timely policy signals can be released for guiding the market expectations of interest rates of that monetary policy objectives.
Conversely, it is still challenging to ascertain the role and impact of interest rates within China’s monetary transmission process due to several reasons. One of them is that the PBC utilizes multiple instruments such as the reserve requirements and implicit credit quotas for conducting monetary policy. Scholars using the standard monetary policy transmission models have to deal with the challenge of having accurate representations of the stance of monetary policy while utilizing either the price or quantity variables. The possibility of misrepresentations raises a significant bias with the context of getting the tactical policy response functions of the PBC. The second reason is that the country’s monetary policy framework is undergoing an evolving process in terms of its transition to having a flexible exchange rate regime. Since the exchange rate is a fundamental channel of monetary policy, shifts in this regime will considerably affect the interest rates and the wide range of credit conditions.
To this effect, this study of monetary policy will need to acknowledge that the policy instruments used by the PBC undergo an endogenous evolution in relation to the state of the economy. The PBC will be prompted to respond to incoming reports on outputs and inflation by enforcing changes to its policy stance. The shifts in the policy stance will affect the expectations of the agents on the future economic evolution. Isolation of the systematic component of monetary policy is necessary for inferring anything in the effectiveness of the monetary policy. According to Gertler and Karadi, the standard recursive strategies in the VAR models that use timing constraints on the impacts of monetary policy in other variables are not plausible in removing the endogeneity bias in the monetary policy (47).
This research intends to understand the workings of monetary policy in Mainland China due to the country’s growing weight in the global economy. Within the market economies, the study relies considerably on the role of interest rates in the decisions focussed on allocating resources and the transmission of monetary policy.Therefore, an examination of whether China’s steady transition to being a market economy has considerably affected monetary policy operations. Specifically, the research question is what has been the role of interest rates in the transmission of monetary policy?
The research will acknowledge the challenges in assessing the monetary policy instruments in Mainland China, explicitly identifying its shocks and assessing the macroeconomic effects. Notably, the study will take up the assumption that while the participants within financial markets do not have complete information on PBC’s actual reaction function, they can make reasonable predictions on the changes in the primary policy instruments concerning the country’s economic state. The use of high-frequency financial market information will enable the study to distinguish between the ‘surprise’ component of the monetary policy from its ‘expected’ part. This will be substantial in identifying monetary policy shocks. The research will also show that the high-frequency identification strategy effectively assesses several interesting aspects of the country’s monetary policy compared to the conventional VAR analyses. Furthermore, this analysis will aid in resolving different puzzles within China’s economic policy, including the counterintuitive response of the macroeconomic variable to the monetary policy shocks.
Review of the Literature
Mainland China’s Economic System
This research acknowledges that the economic and financial system is transitioning from planned to market and price-based. In implementing a gradual transformation approach, its nature demands that the transition period should see the simultaneous placements of price and quantity-based measurements. Furthermore, particular non-central bank instruments specifically aid in reaching price stability during the entire duration. Price stability is not the sole aim of China’s monetary policy. The PBC focuses on three primary fundamental targets: mandatory price stability, the less fundamental economic growth target, and the additional exchange rate target.
According to the Law of the People’s Republic of China on the People’s Bank of China, specifically Article 3, the focus of its monetary policies is the maintenance of the stability of its currency’s value, hence promoting economic growth. To this effect, the country’s central bank is committed to attaining two distinct ultimate targets in pursuing its monetary policy. The PBC needs to aim at an approach that will actualize price stability. The second aim is that the policy needs to support the general economic policy and promote economic growth. Mehran et al. interpreted this provision to mean that the country’s long-term economic growth can only be actualized with long-term price stability (18). The scholar’s view was that price stability is the principal aim of the PBC. The bank has claimed that its pursuit in implementing the monetary policy is mainly attaining the currency’s stability. When a PBC official was asked about the two formal ultimate targets: price stability and economic growth and specifically their ranks in terms of importance, he ambiguously indicated that the PBC does not work to support the two targets but solely the first target of price stability. Only after attaining the price stability target, the central bank may focus on other targets that promote economic growth.
However, it is essential to note that the PBC is also a non-independent central bank, which raises doubts on how strongly it can ignore economic growth as one of its goals. In Mainland China, the decision process within the central bank is not fully independent from input from the State Council’s directive (MacMahon et al. 4). Also, governments prefer having an economic growth bias instead of a low inflation bias. Therefore, Mehran et al.’s interpretation will only be supported within a context of an independent central bank constitution such as the European Central Bank (ECB). To this effect, considering the Law of the People’s Republic of China in the PBC, it is prudent to state that the latter is in pursuit of at least two final targets in the implementation of monetary policies. These include the significant economic target and the less fundamental political target.
Monetary Policies In Mainland China
China utilizes multiple monetary policy instruments, which implies that it does not conform to the standard monetary policy description characterized by a policy interest rate or the money supply. The PBC has classified its monetary policy instruments into four categories (Ping 9). The categories include the instruments with ratios such as the reserve requirements, the instruments with interest rates, the central bank lending rates, the quantitative instruments such as the Open Market Operations (OMOs), and the other instruments such as the central bank bills (Geiger 4).
The Interest Rate Instrument.
The interest rate channel is a price-based indirect instrument of monetary policy (Geiger 71). A simple description is given to the interest rates rel;y on the prevailing economic situation. In a perceived expansionary monetary stance, the monetary authorities will increase the primary lending rate. Subsequently, in a wholly market-based environment, a strict perspective in the lending rate gets transmitted to the inter-bank money market rates in all maturities (Geiger 71). This means that the refinancing expenses of commercial banks would increase due to the increased primary lending rate. Commercial banks’ more significant financing expense prompts the imposition of higher interest rates due to the outflow of commercial credits. In turn, the high-interest rates would cause lower demand for credit from the non-banking sectors, thereby slowing the actual industry. The opposite also applied to a situation with a very restrictive monetary stance. Therefore, the interest rate affects the ultimate targets through their interactions with intermediate targets,
In China, the definition and effect of the simplified interest rate channel are not clear enough. After finishing its long process of interest rate liberalization in late 2015 – Research Paper Writing Help Service, the PBC would update its monetary policy framework to incorporate the corridor system of interest rates (Funke and Andrew 101). The underlying tenet for the corridor system is that the PBC provides a lending facility tooland a deposit facility to represent the upper and lower bounds of the corridor respectively. This sets up an interbank interest rate corridor. The PBC’s interest rate target has to be a value that is within the corridor’s boundaries. Therefore, the Interest rate target would become the newest anchor in the country’s financial system which is similar to the benchmark short term interest rates in Europe and North America. Following this system, the new policy target would be the pledged 7-day interbank market rate (Funke and Andrew 101). The Standing lending facility (SLF) will have rates that encompass the corridor’s upper bound. The pledged 7-day interbank market rate is applicable to every financial institution which includes the non-bank financial institutions that have the trading authorization. The Medium-Lending Facility (MLF) that was established in 2014: 2024 – Essay Writing Service | Write My Essay For Me Without Delay permits the PBC to avail funds with longer maturities while stabilizing the market expectations with maturities that range from3 months to one tear, teh MLF’s have also been beneficial inm improving the transmission rate as it sets up the borrowing costs to be at the curves long end.
The partial interest rate liberalization has prompted the country to have two distinct underlying mechanisms in actions (Geiger 72). First, the country has some instruments which transform the policy stance of PBC via the interest rate channel that is OMOs or other minimum requirements. In practice, the PBC conducts its monetary policy through a scaling of size in its OMO or has the SLF and MLF rates adjusted (Funke and Andrew 102). OMO mainly entails a repurchase agreement of the reverse repurchase agreements. The repurchase agreements will eliminate the liquidity from the system since the PBC is selling the short term bonds to the commercial banks. Conversely, the reverse repurchase agreement entails purchasing the repurchase contracts. These two tools will allow the PBC to have control over the country’s money supply and interest rates with a short-term duration (Funke and Andrew 102). To this effect, the short-term interest rates become increasingly important in PBC’s operations. Secondly, different instruments are not yet subjected to an entire liberalization, to act under the price-based instruments. These include the PBC lending and deposit rates. These two different action mechanisms bring forth two different ways of transmission in the changes in interest rates.
The interest rates channel is a monetary policy instrument used in China due to its ability to affect economic activity by changing capital costs. The primary effect of interest rates makes it a primary channel for monetary policy transmission in developed economies (Peng and Frank 6). Due to the reforms and structural changes implemented in Mainland China in the past few decades, the role of interest rates has been rising steadily. Ha and Fan noted that the fixed capital investments started to respond to the changes in interest rates from the mid-1990s (Peng and Frank 7). Nonetheless, retail sales that are an index to show private consumption seem not to be responsive to interest rates due to the latter’s substitution effect that arises after it is changed being offset by the income effect (Kamber and Madhusudan 8). Notably, the development of the housing market and the tremendous growth in mortgage loans in the country have implied that the households are more likely to respond to changes in interest rates.
There is also a broad perception that the country’s underdeveloped financial system and the different interest rate controls hinder monetary policy transmission. Nonetheless, the country would liberalize several segments within its money and bond markets in the past three decades (Li and Ming-Hua). Despite the liberalization of the interbank lending rate beginning in the 90s, the yields from treasury and financial bonds that the state-owned financial institutions have issued have been determined by the market entirely since 1999. Many of the corporate bonds in the country are generally linked to the interbank borrowing rates, precisely the Shanghai Interbank Offered Rate (SHIBOR). While the government has been known for imposing controls in the bank lending rates in the form of floors and deposit rates in the form of a ceiling, the two would be removed in 2013 and 2015 – Research Paper Writing Help Service, respectively.
To cause an effect on the market rates, the PBC has been establishing an interest rate corridor system with the individual rate in the excess banking reserves being considered the floor and the ceiling being the interest rate in the standing lending facilities (SLF) (Kamber and Madhusudan 6). This corridor from the monetary policy framework has been noted to provide the upper and lower bound effectively. From February 2016: 2024 – Do my homework – Help write my assignment online, it incorporated the daily open market operations to stabilize the money market rates and signal the financial markets on the monetary policy stance. The introduction of the average rule for the reserve assessment of the commercial banks would also supplement the aforementioned measures, especially in reducing the volatility of short-term rates related to the reserve maintenance dates (Kamber and Madhusudan 6). Generally, interest rate liberalization, among other reforms, would allow the PBC to improve its policy framework.
Several scholars have pointed out the increasing importance of benchmark interest rates within the transmission of monetary policy in China (Chen et al. 6; He and Wang 9. It is, however, prudent to note that the present empirical research is mixed concerning the effect of PBCs monetary policy rates on the market interest rates. One study by Porter and Xu indicated that an increase of 100 basis points to the benchmark lending rates prompted the growth of 75 basis points to the 7-day repo rate. This impact, however, dies out fast after three days. Similarly, an increase in the deposit rate has a different effect on reducing the interbank state to imply a positive supply response to depositors. He and Wang indicated that while the positive outcomes arise from the higher regulated deposit rates and reserved requirements concerning the money and bond market rates, the effectiveness of the monetary policy is attained by the former instrument over the letter one (31). In this research, the assumption taken is that the absence of clear-cut evidence on the interest rate channel in Mainland China may not necessarily indicate a weak effect of the monetary policy. This could result from the inaccurate determination of market shocks that drive the policy and market parties in a similar direction.
Aside from the instruments used by the PBC that affect the market interest rates, Bernanke and Blinder indicated that a fundamental exercise in the assessment of monetary policy is assessing if the instruments ultimately affect the macroeconomic variables and how they cause the determined effect (Bernanke and Blinder 920). With respect to Mainland China, this concern is vital since the authorities also rely on direct controls that considerably influence bank credit and economic activities. This could affect the predictive power on the change range of monetary policy and interest rate. Notably, Bernanke and Blinder ran several Granger causality tests to assess the predictive ability of the policy instruments in regards to economic activity. This will effectively determine the change range of monetary policy and interest rate as accurately as possible.
Research Rationale
The primary research question for the study is what has been the role of interest rate in the transmission of monetary policy and subsequently making the letter a stabilization tool? Many scholars have noted that mainland China has been demonstrating trends similar to that of advanced economies concerning its monetary policy transmission. To this effect, this study seeks to assert or disapprove the notion identified by different scholars. The research hypothesis is that the monetary policy transmission in China is increasingly resembling that of advanced economies, as evidenced by the trends in the interest rate instrument.
If the research findings assert or approve the study’s findings, this would mean that the country is on the right track in terms of liberalizing its market and precisely attaining independence and feasibility of its monetary policy. If the hypothesis is disaffirmed, then the monetary policy instrument is less effective in attracting further liberalization. Failing to do that will have the country operating below potential. The PBC will urgently need to resort to alternative monetary policy instruments to move it close to attaining price stability and maintaining economic growth. These reforms may be reached by improving the finance and banking sectors to mitigate the output volatility and achieve higher symmetry within the transmission of policy.
Research Methodology
The research collected is primarily the high-frequency Chinese financial data precisely following the monthly time series from the People’s Bank of China (PBoc) website. It is prudent to note that the high-frequency Chinese financial market data relates to the central monetary policy announcements. Therefore, data for the relevant variables are collected before and after the policy announcement to determine the effect and ultimately find the role of interest rates in the monetary policy transmission in Mainland China. The short-term data on lending rates will be collected from the Industrial and Commercial Bank of China (ICBC) website. Short-term information will cover 12 months and below. The IMF’s International Financial Statistics also provides essential data to identify the real interest rate (Egan and Anthony 80). The calculation formula for the rate will be (it−πt), representing the lending interest rate, and the πt represents the annual change in the Consumer price index.
Regression analysis will be incorporated at the statistical data analysis technique to be incorporated after collecting the data. The research assesses the maturity of the country’s yield, the impact from the monetary policy announcements, and finally gets the results for different subsets of policy announcements. This data is considered based on the underlying notion that any price alterations in a tight window around the announcement are affiliated with an unanticipated change in the monetary policy stance. These announcements will relate to the lending rate adjustments, the changes in reserve requirement rayon, and the report on the quarterly monetary policy report.
The examination of the predictive power of the central bank’s policy instruments for economic activity through various Granger causality tests (Bernanke and Blinder 904). Mainly the research will consider the annual growth in industrial production, retail sales, manufacturing PMI, fixed asset investments, and the broad major of credit. They are to be regressed in their lags and the lags of the five significant monetary policy variables. These include the yearly growth of money supply denoted as M2, the reserve requirement ratio, the ten-year government bond yield, the 7-day repo rate, and the one-year benchmark lending rate. The typical statistical criteria for optimal lag selection will be incorporated, and the number of lags will be formally restricted to four.
Conclusion
This research intends to establish the role of interest rates in the transmission of monetary policy in Mainland China. The research acknowledges that comprehending the workings of monetary policy in the country can be difficult, especially in the gradual transition into the flexible exchange rate regime. Also, the country using multiple instruments for monetary policy purposes could impede the process. Nonetheless, the research seeks to assess the impact of the policy announcements in the PBC in response to the financial market. These announcements bring forth specific changes in the financial market, which is fundamental in informing the study.
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