Law of the People's Republic of China on the People's Bank of China provides the People's Bank of China is to establish

a monetary policy committee, whose responsibilities, composition and working procedures shall be prescribed by the State Council and shall be filed to the Standing Committee of the National People's Congress. On April 5, 1997, the State Council released Rules on Monetary Policy Committee of the People's Bank of China, which stipulates that the Monetary Policy Committee is a consultative body for the making of monetary policy by the PBC, whose responsibility is to advise on the formulation and adjustment of monetary policy and policy targets for a certain period, application of monetary policy instrument, major monetary policy measures and the coordination between monetary policy and other macroeconomic policies. The Monetary Policy Committee of the PBOC holds a routine meeting every quarter, usually in March, July, September and December, but the exact dates are not disclosed to the public beforehand. The opinions expressed in the meeting of the Monetary Policy Committee will be recorded in the short form of "meeting minutes", which would be released after the meetings are held.

The monetary policy committee was founded in June 1997. In the beginning the Monetary Policy Committee was made up of 11 people: the PBOC's Governor and two Deputy Governors, a Deputy Head of the National Economic &Commerce Committee, a Vice Minister of the State Development and Reform Commission (NDRC), a Vice Finance Minister, the Administrator of the State Administration of Foreign Exchange (SAFE), the Chairman of China Securities Regulatory Commission (CSRC), two chairmen of the four State-owned banks ((Industrial Bank of China, China Construction Bank, Agricultural Bank of China, Bank of China) and an expert from the academia. In 2000, the chairman of China Insurance Regulation Committee (CIRC) joined the committee. In 2001, the Commissioner of National Bureau of Statistics was added into the group. Chinas remarkable growth has been financed recently by a rapid expansion of money and bank credit that is producing an increasingly unsustainable investment boom. This renews concerns that the country may not be able to avert a replay of the painful boom and-bust cycle such as the one it endured in the mid-1990s. CommentsMonetary policy is usually the first line of defense in such situations. But Chinas monetary policy has been hamstrung by the tightly managed exchange-rate regime. This regime prevents the central bank the Peoples Bank of China (PBC) from taking appropriate policy decisions to manage domestic demand, because interestrate hikes could encourage capital inflows and put further pressure on the exchange rate. CommentsThere is, of course, a vigorous ongoing debate about Chinas exchange-rate policy. Chinas rising trade surplus has led some observers to call for a revaluation of the renminbi to correct what they see as an unfair competitive advantage that China maintains in international markets. Others argue that the stable exchange rate fosters macroeconomic stability in China. But this debate misses the point.

CommentsWhat China really needs is a truly independent monetary policy oriented to domestic objectives. This would enable the PBC to manage domestic demand by allowing interest rates to rise in order to rein in credit growth and deter reckless investment. An independent monetary policy requires a flexible exchange rate, not a revaluation. But what could take the place of the stable exchange rate as an anchor for monetary policy and for tying down inflation expectations? CommentsWe recommend a low inflation objective as the anchor for monetary policy in China. Theoretical research and the practical experiences of many countries both show that focusing on price stability is the best way for monetary policy to achieve the broader objectives in the charter of the PBC: macroeconomic and financial stability, high employment growth, etc. The low inflation objective need not involve the formalities of an inflation-targeting regime, such as that practiced by the European Central Bank and the Bank of England, and is similar in approach to that recommended for the United States by US Federal Reserve Chairman Ben Bernanke. CommentsHow could such a framework be operated effectively in an economy in which financial sector problems have weakened the monetary transmission mechanism? This is a key concern because, notwithstanding recent reforms, the banking system remains fragile. Nevertheless, we believe that a minimal set of financial sector reforms essentially making banks balance sheets strong enough to withstand substantial interestrate policy actions should suffice to implement a low inflation objective. CommentsAlthough full modernization of the financial sector is a long way off even in the best of circumstances, the minimal reforms that we recommend could strengthen the banking system sufficiently in the near term to support a more flexible exchange rate anchored by an inflation objective. Indeed, price stability, and the broader macroeconomic stability emanating from it, would provide a good foundation for pushing forward with other financial sector reforms. CommentsThe framework we suggest has the important benefit of continuity. The PBC would not have to change its operational approach to monetary policy. Only a shift in strategic focus would be needed to anchor monetary policy with a long-run target range for low inflation. Monitoring of monetary (and credit) targets would still be important in achieving the inflation objective. Furthermore, it should be easier to adopt the new framework when times are good like now, when growth is strong and inflation is low. CommentsThere is some risk that appreciation of the exchange rate if greater flexibility were allowed could precipitate deflation. What this really highlights, however, is the importance of framing the debate about exchange-rate flexibility in a broader context. Having an independent monetary policy that could counteract boom-and-bust cycles would be the best way for China to deal with such risks. CommentsContrary to those who regard the discussion of an alternative monetary framework as premature, there are good reasons for China to begin right now to build the institutional foundation for the transition to an independent monetary policy. Indeed,

early adoption of a low inflation objective would help secure the monetary and financial stability that China needs as it allows greater exchange-rate flexibility China is not different from the rest of the world in a sense that Newtons three laws of motion and law of universal gravitation work in China just as everywhere else and basic principles of economics hold in China just as in everywhere else. Chinese central bank, just as every other central bank around the world, would like to see better growth in credit when they want to stimulate growth, and tighten monetary policy when they need to fight inflation. In that sense, they are the same. The difference is just how monetary policy is run.

Policy tools
1. Interest rates Just like other central banks, the Peoples Bank of China (PBOC) changes target interest rates. But unlike most central banks in the developed world, which tend to control only the short-end of the curve (like the Federal funds rate), the PBOC control all rates across maturities and type of rates, i.e. both lending and deposit rates. The absolute control on all rates have been relaxed somewhat in recent years, and particularly in the recent months, where banks are free to set lending and deposit rates with wider deviations from the benchmark rates. 2. Open market operation This tends to get somewhat less attention among major tools, but PBOC does perform open market operation in the forms of bill selling, reverse repo, etc., which regulate liquidity in the banking system 3. Reserve requirement ratio (RRR) This is a tool that tends to be used much less in the developed world, but the PBOC actively manipulate reserve requirement ratio. One of the big reasons why the PBOC uses this tool extensively is related to how foreign exchange mechanism for Chinese Yuan is arranged. Chinese Yuan (CNY) has a soft peg mainly with the US dollar. The PBOC announces the daily exchange rate fixes of CNY against other currencies every day, and the market price of CNY is allowed to deviate within a tight range (currently 1% from the daily fix). Massive trade surplus and capital inflow for the most part of the last decade meant that demand for CNY was strong. But because the authorities did not want CNY to appreciate too quickly, they have to intervene in order to keep CNY within a tight range,

and the movements of daily fixes are usually small. That means creating more CNY to meet the demand. But here comes the problem: with current and capital account in surplus (excluding the reserve account), the intervention is so massive that the Chinese banking system almost permanently had too much liquidity. There are ways to lock up the excess liquidity: either by selling bills to absorb, or increasing RRR. 4. Loan targets This is perhaps lesser known tools of Chinas monetary policy, because most developed countries do not use it. The fact is that the Chinese banking system is dominated by stateowned and policy banks, which makes it possible for the government to direct specific amount of lending to where it sees necessary.

central bank reacts to inflation being either above or below a target by adjusting interest rates up or down. If there is low inflation, lower interest rates should stimulate investment and maybe consumption, but lets leave that discussion here for now for reasons that will become apparent later. Assuming the exchange rate is fixed, whatever happens to interest rates should not change net exports (doubtful in the long run, but anyway). Low demand is supposed to have led to low inflation, perhaps 1%. This signals to the central bank that demand has been falling and should be propped up. Therefore, the central bank lowers interest rates. Now, what? The costs of capital decline, and investments becomes cheaper than before. Also, expectations change towards higher inflation in the future as people realize that with lower interest rates more people will start to invest. So, investment projects that are costly and demand a lot of capital increase in size and number, thereby increasing aggregate demand. The inflation rate comes back up, the problem is solved. The opposite occurs if rising demand causes inflation. However, something has not quite worked that way recently. The main channel of increased investment spending is real estate. Its costly and therefore the interest rate matters a lot, both for commercial and residential real estate. After a

housing boom, with prices falling and expecting to fall further, will people go into debt to build new homes or modify existing ones? Will entrepreneurs build new offices, or expand existing ones? If the interest rate gets to zero and people still dont start new projects, then weve hit the zero lower bound the interest rate cannot be lower than zero (except for some pretty mind-boggling scenarios, which might be worth looking at, but not now and not here). For the Chinese central bank, the Peoples Bank of China (PBoC), a liquidity trap is a bit different. They can decide to build real estate no matter what happens, since the government has complete control over the PBoC. But wont that lead to problems in the long run? Michael Pettis thinks so: For this reason the idea that we can grow out of the debt problem once again by keeping investment high is wrong. First, it would only increase capital misallocation and debt levels, and would require even lower growth in the future. We cant keep pushing the cost off into the future, as attractive an option as that always seems. Second it would put unbearable pressure on household income and consumption, and so ensure that the one thing China needs above all a rapid rise in household consumption is all but impossible. When I was reading this for the first time, it all made sense to me. Keeping investment high is wrong, youd just keep pushing costs off into the future and a rise in household consumption is all but impossible. Financial crisis would seem to be coming to China. Except that although his reasoning might be right, theres a different line of reasoning available. Before going down a different road, let me just comment quickly on the logic of Michael Pettis. I agree that investment is very high in China, perhaps too high, but nobody can know for sure. The same thing applies to the efficiency of it all, but I would agree with Michael that the marginal efficiency of capital is probably decreasing. Regarding the consequences, however, I am not so sure. Let me develop a different scenario, where the economy moves along a road with persistently high (but not hyper!) inflation for a decade or so. The financial problem for China from a balance sheet perspective is that some lenders cannot repay borrowers because their nominal income stream (either from profit or labor) is too low. This is because the efficiency of capital has not been what it should have been in order to fulfill all financial contracts. Now, there are two solutions to fix the balance sheet. One could allow for bankruptcy or renegotiation of debt until all (rewritten) contracts can be honored. A different idea is to rewrite financial contracts by increasing the rate of inflation. How would this work? Lets assume that the Chinese central bank (PBoC) decides to help debtors by increasing the money supply. At the same time, the government decides to let public sector wages increase. This is classic expansionary policy straight from your economics textbooks (IS/LM chapter, shift of LM and IS outwards). However, in the textbooks the

understanding of Keynes is flawed. No inflation results because we are in a liquidity trap (if your textbook says so, congratulations! Most do not.) China, however, is not in a liquidity trap. Inflation is very likely to rise when wages rise, accompanied by a rise in money supply. The consequences for balance sheets are clear. Nominal incomes will rise, which will allow more debtors to repay their debt, which is of course nominally fixed. The creditors will get their money back, but the purchasing power of that money will have decreased. This outcome is preferable to that of a financial crisis, which would have resulted from not inflating the economy, so capital owners should accept it as the better outcome. From an economic point of view, inflating comes with lower transaction costs than renegotiating all debt contracts and might therefore be the superior solution. Since debt contracts are all changed in the same way, it might also be more just. Now we turn to the macroeconomic consequences of elevated inflation. The main equation here is Y = C + I + G + NX. Net exports (NX) will probably go down slightly, as the domestic price level increases. This will lead to a re-balancing of the world economy, so that outcome is good. Consumption (C) might rise if workers think theyre richer they do get higher wages. Also, interest rates will remain quite low, as monetary policy is still expansionary. A boom of debt-driven consumption would definitely be in the cards, especially if real debt burdens fall at the same time. This has worked in countries as diverse as the US and Spain in the years leading up to a crisis. Investment (I) is kind of exogenous, as most enterprises still get their capital from the government, either directly or indirectly. Since the nominal tax income of the government rises and its real debt declines as well, investment might go up or down. Lets assume that the Chinese government adjusts investment in order to get aggregate demand to where it wants it to be. This would be Keynesian fine-tuning like most developed countries had in the 1960s. Government spending (G) is also controlled by the government and can be used to either stimulate the economy and increase inflation, or to slow it down by restraining public investment. This is just a back-of-the-envelope assessment of how China might move towards rebalancing its economy without having a financial crisis or other kinds of abrupt change. One of the main assumptions is that an inflation rate of 5-10% could be sustained without losing control over it. After all, the Chinese government has full control over the financial side and should be able to maintain a policy of sustained elevated inflation, as promoted (for other countries) by the IMFs Olivier Blanchard, among others.

Inflating the Chinese price level would redistribute incomes from capital owners to workers and spur domestic demand, while also leading to a turnout as regards the external position. Imports would increase and exports decline because both domestic incomes and relative price changes would pull in the same direction. Note that in this scenario, given that the fixed exchange rate is maintained, foreign investors do get their money back at full (dollar) value. It might be the case that these Chinese policies would lead to higher global inflation as well, as some claim that policies of the past did lead to sustained lower inflation. In that case, purchasing power would decline on all financial assets, not only those in China. Whether politics in China and other countries will allow this scenario of adjustment remains to be seen. However there is a road open for China that would lead to rebalancing, both domestically and internationally, which has some uncertainties. These must be compared to those of sustaining the export-led growth model, basically an even bigger currency mismatch in the PBoC balance sheet and ever more unproductive capital investments.