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Comparison of Monetary Policies

of India and China


Prof. SubalakshmiSircar
Economic Environment and Policy
Submitted on 24th December 2014

Prepared by:
Group 4 Section B
Anup Nair 14P072
DevangNahar 14P075
DikshaMahajan 14P077
K. Mohana 14P087
PrashantGhabak 14P093
Varun Dave 14P118
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Table of Contents
Contents
INTRODUCTION........................................................................................................... 3
China Monetary System : A brief overview........................................................4
Monetary Policy Instruments in China........................................................................6
Internationalisation of Renminbi...............................................................................12
Monetary Policy of India: An Overview.............................................................14
References............................................................................................................... 18

INTRODUCTION
China and India, over the past decade have followed completely different
growth trajectories. Indias growth was fuelled by rising domestic
consumption whereas China relied heavily on exports and foreign
investments. The Indian economy has slowed down since 2008 whereas
China up till now has registered above 8% growth rate though it is showing
signs of slowing down. Each economy has its own unique sets of problems
due to structure, government policies and maturity of financial institutions
and markets. This results in different monetary policies objectives and
mechanisms by which a central bank can influence the economy. China and
India are no different in this regard.
Indias growth is supply side constrained. Internal consumption has risen
steadily over the years but supply is restricted due to insufficient capacity.
This is generally attributed to lack of investments and lack of agility in policy
making. Thus rising demand and limited supply has pushed up the prices
resulting in persistent inflation. Dependence on imports for key raw materials
like oil also pushes up the prices of derived goods. Rigid policies also played
a part in reducing foreign investments which could have been used to bridge
the gap between savings and investments.
China on the other hand is a demand constrained economy. Massive
investment has created excess capacity. However there is a decline in
private consumption which has forced the Chinese enterprise to turn to the
rest of the world for generating demand. This increases the current account
surplus and leads to widening of the monetary base, which coupled with
cheap credit, have been known to generate bubbles. The USD/CNY peg also
leads to massive forex inflows, increasing the monetary base.
The monetary policy, in response to the above issue, varies a lot between
the two countries. In this report we will try to examine the key instruments
affecting monetary policy and how they differ in India and China.
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China Monetary System : A brief overview


The People's Bank of China was established on December 1, 1948 by
consolidation of the Huabei Bank, the Beihai Bank and the Xibei Farmer
Bank. The State Council made PBC function as a central bank in 1983.
The PBC plays a crucial role in China's macroeconomic management. The
amended Law of the People's Republic of China on the People's Bank of
China, provides that the PBC performs the following major functions:
(1)Drafting and enforcing relevant laws to ensure that rules and regulations
can fulfill its functions;
(2) Formulating and implementing monetary policy in constraints the law;
(3) Issuing and controlling the Renminbi
(4) Regulating financial markets like the inter-bank lending market, the interbank bond market, foreign exchange market and gold market;
(5) Preventing and mitigating systemic financial for financial stability;
(6) Maintaining the Renminbi exchange rate at equilibrium level; Maintaining
the state foreign exchange and gold reserves;
(7) Managing the State treasury fiscally;
(8) Making payment and settlement rules to ensure normal operation of the
payment and settlement systems;
(9)Monitoring money-laundering related suspicious fund movement;
(10) Developing statistics system for the financial sector and consolidation of
financial statistics as well as the conduct of economic analysis and forecast
(11) Credit reporting industry in China and building up of credit information
system;
(12) Participating in international financial activities at the capacity of the
central bank;

The Peoples bank of Chinas website states that the objective of its
monetary policy is to maintain the stability of the value of the
currency and thereby promote economic growth.
The following are monetary policy instruments used by the Peoples bank of
China:

reserve requirement ratio


central bank base interest rate
rediscounting
central bank lending
open market operation and
Other policy instruments specified by the State Council.

Monetary Policy Instruments in China


The PBC classifies its monetary policy instruments into four categories
1. Ratio Instruments
2. Interest rates instruments
3. Quantitative instruments
4. Other instruments like central bank bills.
Price-based indirect instruments
In China price-based instruments have two different underlying mechanisms
of action. First type of instruments, transform the central banks policy
stance via the interest rate channel of monetary transmission. Second type
of instruments, act under the disguise of price-based instruments. Example,
PBC lending and deposit rates. There are two different ways of transmission
of interest rate changes: a) The transmission of interest rate changes
according to the interest rate channel where a interest rate change by the
central bank affects the refinancing costs of commercial banks and thus
changes the interest rates charged by the commercial banks to 3rd parties;
and b) the transmission of interest rate changes as result of administered
interest rate changes compels commercial banks to change the interest rate
for money that is already at their disposal resulting in changes of commercial
banks interest rates to 3rd parties.
a) PBC lending and deposit rates
The PBC dictates the monetary policy using two types of interest rates: 1)
Benchmark lending rate and 2) rediscount rate. The former gives the
commercial banks a certain freedom in setting their own interest rates
according to their assessment. While these and other liberalizations indicate
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progress towards market-determined interest rates, interest rates are still


controlled. The central bank has to ensure that the commercial banks have
access to funds at rates below the deposit rates to ensure their profitability.
To adjust the benchmark lending rate the central bank needs to get the
consent of the State Council. This dependency limits the central banks
flexibility as far as pre-emptive or fine tuning of monetary policy is
concerned. The insufficient instrument independence of the PBC is the cause
that monetary policy in China is not flexible enough to react timely to
changes in the monetary policy environment. To mitigate this, the PBC has
now been empowered to add a surcharge on its central bank lending rate at
its own discretion.
b) Discount and rediscount rate
In 2004, the central bank installed the rediscount rate as the benchmark
rate, i.e. the central could change the central bank lending rates within a
range around the rediscount rate. This did not need a prior approval of the
State Council. However, the impact of the rediscount instrument itself is too
small to have a large impact on the growth of monetary base. Thus, the
rediscount policy primarily intends to influence the commercial paper market
c) Reserve Requirements
The central bank had introduced minimum reserve requirements to control
the financial sectors liquidity. At first, different reserve obligations were set
for the different deposits with regard to their origin and the institution
holding the reserves. In 1985, the central bank changed this. It combined all
different reserve requirements and set one minimum reserve requirement at
10 %. In 1998, central bank shifted its monetary policy from direct control to
more indirect control. Open market operations (OMO) were made the the
main instrument of monetary policy.
The three salient features of the Chinese reserve requirement are:
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Minimum and excess reserves are interest bearing.


High ratios of excess reserves are held the financial system.
The PBC introduced a policy of differentiated required reserve ratio for
different financial institutions

d) Open market operations (OMO)


In 1993, the Central bank introduced the instrument of open market
operations in its monetary policy. Since the institutional foundation was
lacking, the central bank decided to suspend OMOs in the year 1997.
In 1998 OMOs were re-introduced. With a better institutional foundation,
OMOs were an immediate success. OMOs have now become a key
instrument for conducting monetary policy in China. Before 2003 open
market operations were generally carried out once a week. Open market
operations now are generally conducted on two days per week Tuesday and
Thursday.
Open market operations include national bonds, central bank bills and
financial bonds from other financial institutions. They are traded as
repurchase operations and as direct market operations. Repurchase
operations include repos and reverse repos. Repurchase agreements done
for the purpose of monetary base withdrawal are called as repos. Reverse
repurchase agreements undertaken for fueling monetary liquidity are called
as reverse repos. The Central bank withdraws monetary base by issuance of
central bank bills and injects monetary base with their redemption.
Quantity based direct instruments:
a)

Window Guidance

The PBC started to adopt the policy of window guidance in 1998.The


framework for the Chinese window guidance was closely modeled according
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to the Japanese system. This policy uses benevolent compulsion to persuade


banks and other financial institutions to stick to official guidelines. Central
banks make use of moral pressure to make financial players operate
consistently with national needs. A major point of the concept is the
temptation to influence the market participants through words rather than
strict rules. The PBC has a major influence on the lending decisions, despite
the phrase guidance, which implies a voluntary aspect in the system. It is
effective especially in case of the four state-owned commercial banks.
b)

Direct PBC lending

Direct PBC lending as a monetary instrument is in the legacy of the planned


economy, the usage of which was officially discontinued in 1994. However,
the last decade or so was marked with a high amount of the central bank
money permanently being in the financial system, evidence for instance, by
excess reserve ratios well above the 10 % margin in the 1990s which only
gradually came down to 7.61 % in 2001 and 5.38 % at the end of 2003.
c)

Capital controls

A third instrument within the quantity-based instrument toolbox of the


central bank is capital controls. However, the instrument of capital controls
differ fundamentally from window guidance and direct PBC lending as the
capital controls aim is not the amount-driven credit allocation but the
quantitative limitation and guidance of financial flows between China and the
rest of the world.
Other non-central bank policy instruments
1) Price controls: Since 1998, three kinds of prices have been
predominant in China
a) market-regulated prices, which are set by the market through supply and
demand and are not faced with any intervention from authorities;
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b) Government guidance prices, which can come either as a benchmark price


or a floating range set by the government. The floating band is usually
between 5 and15 %; and
c) Government prices, responsible government authorities set the prices
which are treated as fixed and are unchangeable unless approved by these
authorities.
Some prices have to be set by the central government. There are other
prices that can be set and regulated by the province, municipality etc. The
relevant price department or other related departments can set these prices.

2) Wage controls
Historically, in 1978, Chinas wage regime was characterized by a centrally
regulated salary system that, among other things, determined the wages
according to regions, occupations, industries and sectors. The heart of the
system was a classification scheme with more than 300 standardized
occupational classifications used for the salary formation. After 1978, the
wage regime had undergone three sets of reforms in 1985, 1992 and 1994
1995, respectively. The two reforms in1985 and 1992 incorporated an
indexation of wages to the development of the consumer price index.
Thus, high inflation had an impact on the wage level setting and higher
wages, in turn, triggered higher inflation rates. This constituted circles that
easily led to an inflationary spiral through ever increasing inflationary
expectations.

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Internationalisation of Renminbi
During the era of the command economy, the value of the Renminbi was set
to unrealistic values in exchange with western currency and severe currency
exchange rules were put in place. With the opening of the mainland Chinese
economy in 1978, a dual-track currency system was instituted, with
Renminbi usable only domestically, and with foreigners forced to use foreign
exchange certificates. The unrealistic levels at which exchange
rates were pegged led to a strong black market in currency transactions.
In the late 1980s and early 1990s, China worked to make the RMB more
convertible. Through the use of swap centers, the exchange rate was
brought to realistic levels and the dual track currency system was abolished.
As of 2014, the Renminbi is convertible on current accounts but not capital
accounts. The ultimate goal has been to make the RMB fully convertible.
There is difference between how RNB is handled in mainland China and how
it is handled outside it.
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RMB in Mainland China


Subject to Mainland China regulations
Mainland authorities and local banks responsible for verification of RMB
transactions
CNY FX rates can be accessed offshore only for documented goods trade
with Mainland China
Regulated interest and exchange rates

RMB outside Mainland China


Major offshore RMB center: HK, Singapore, UK and more
Conforms to prevailing market practice for other foreign currencies
Offshore RMB markets build up breadth and depth with deepened
liquidity
Fully liberalised interest and exchange rates
Internationalization of the renminbi (RMB) is one of the more contentious
and widely debated aspects of economic reform in the Peoples Republic of
China (PRC). Wider use of the RMB in international transactions, both
commercial and financial transactions and those undertaken by central
banks and other official institutions, can be understood as a natural
response to the growing weight of PRC trade and investment flows in the
world economy. At the same time, top PRC officials have declared
repeatedly currency internationalization to be a stated goal of policy, while
the Peoples Bank of China and other government agencies have pursued
a variety of initiatives designed to encourage the currencys wider use.
Thus, whether wider international use of the RMB is a spontaneous market
reaction or a manifestation of the PRCs growing ability and willingness to
influence the shape and structure of the global economy is a matter of
interpretation.
So too is the role of RMB internationalization in the process of the PRCs
economic growth and development. Some will say that the cause of RMB
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internationalization is being advanced mainly in the interest of financial


institutions, which see scope for doing international business in the currency
as a lucrative source of potential income. Others argue that currency
internationalization is supported by PRC firms that see the ability to do crossborder business in their own currency as a useful way of saving costs and
maintaining competitive advantage. Those firms do not see why they should
have to continue to incur the additional costs of conducting such business in
United States (US) dollars and having to hedge the resulting exposures.
Similarly, it is argued in some circles that RMB internationalization is a
natural corollary of the process of financial development and deepening
currently under way in the PRC. As financial markets gain depth, width, and
liquidity and are progressively opened to foreign investors, greater
international use of the currency will come naturally. The counterpoint is that
currency internationalization and the capital account liberalization required
to advance it can be or are being used to ratchet up the pressure on PRC
regulators to accelerate domestic financial reforms and hasten the process of
financial development and opening.

Monetary Policy of India: An Overview


The main motives of monetary policy in India are:
Ensuring price stability
Maintaining adequate flow of credit to the productive sectors of the
economy to back economic growth
Financial stability
The emphasis among the objectives changes from time to time,
Monetary Policy: Major trends
Major drought and terms of trade shocks over 1965-67, led to a fiscal
tightening, with a decrease in deficits and in public investment. Monetary
policy focused on a credit targeting approach. Fiscal-monetary policies were
closely interconnected, as the budget deficit was financed. Severe monetary
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and fiscal measures followed the oil price plus agricultural supply shock over
1973-75. In both the cases there was an unnecessary loss of output. An
emphasis on expanding supply would have been more useful. After the 197980 oil shock, a cut in public investment and acute monetary tightening was
avoided. Recovery was fast, however, deficits and supply side inefficiency
continued.
The similarly closed, import substitution and public investment driven model
of development followed, allowed macro-policy to be driven towards
domestic requirements. Commercial banks ability to multiply the reserve
base and create broad money was countered through strict compulsory
reserve and statutory liquidity requirements through some extent. This,
together with administered prices, controlled inflation too politicallyacceptable levels. Thus, political business cycles in India largely took the
form of a decrease in long-term development expenditures and interpositions
that skewed allocative efficiency, not of increased creation of money.
Since the seventies, major development ideas changed to increase
openness. In India also the bad effects of controls were becoming prevalent.
Some liberalization started in the mid-eighties, but a dominant thrust for
external openness came from the mid 1991 balance of payment crisis when
foreign exchange reserves were down to 11days of imports. The crisis
brought home the lesson that many interest controls and credit rationing
were destructive to growth and stability. It made possible the implementation
of the series of pending committee reports. Current account and partial
capital account liberalization, and a slow move to more flexible exchange
rates followed. While controls continued on domestic portfolios and debt and
equity inflows were liberalized. Equity shares risks, while short-term debt
flows create a big repayment burden in unfortunate times. On foreign debt,
the sequence of relaxation favored commercial credit and longer term debt.
Major reforms were taken towards development of equity, forex money and
government securities markets.
Although low by developing country standards, Indian inflation was more
than world rates. Cumulating of large public debt made the fiscal-monetary
combination followed in the past unsustainable. The automatic monetization
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of the government deficit was stopped and auction based market borrowing
adopted for meeting the fiscal deficits. The repressed financial regime was
disassembled, interest rates became more market determined and the
government began to borrow at market rates. All administered interest rates
were deregulated except the savings bank deposit rate. RBI initiated a
delivery versus payment mechanism for settlement of trades in government
securities was, leading to establishment of the CCIL (Clearing Corporation of
India),a central counterparty to undertake guaranteed settlement for
government securities, repos in G-secs and forex market trades.
The basic objectives of monetary policy remained price stability and
development, butin line with the recommendations of the Chakravarty
Committee (RBI, 1985), the operating procedures had shifted from credit
controls towards flexible monetary targeting with feedback from the mid1980s till 1997-98. However, deregulation of the financial markets combined
with the increasing openness of the economy in 1990s made money demand
more unstable, and money supply more remote. The RBI itself noted
monetary policy based on demand function of money, in these cases, was
expected to lack meticulousness.

The informal nominal money supply targeting proved inadequate under


these changes; interest rates were volatile in the 1990s. After the adverse
impact of the nineties peak in interest rates, the Reserve Bank moved
towards using the interest rates an instrument, basing its actions on a
number of indicators of monetary conditions. There was no formal inflation
targeting, but policy statements gave both inflation control and facilitating
growth as key objectives. A specific value of 5 percent was given as the
desirable rate of inflation, with the aim to bring it even lower in the longterm. The aim was to reduce reliance on reserve requirements, particularly
the Cash Reserve Ratio (CRR),shifting liquidity management towards OMOs in
the form of outright purchases/sales of G-secs and repo and reverse repo
operations.
Monetary Policy Instruments
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The RBI monitors and analyses the movement of a number of indicators


including interest rates, inflation rate, money supply, credit, exchange rate,
trade, capital flows and fiscal position, along with trends in output and
develops policy perspectives.
The Reserve Banks Monetary Policy Department (MPD) formulates monetary
policy. The Financial Markets Department (FMD) handles day-to-day liquidity
management operations. There are several direct and indirect instruments
that are used in the formulation and implementation of monetary policy.
The Direct instruments are:
Cash Reserve Ratio (CRR): The share of net demand and time liabilities
that banks must maintain as cash balance with the Reserve Bank.
Statutory Liquidity Ratio (SLR): The share of net demand and time
liabilities that banks must maintain in safe and liquid assets, such as
government securities, cash and gold.
Refinance facilities: Sector-specific refinance facilities (e.g., against
lending to export sector) provided to banks.
The indirect Instruments are:
Liquidity Adjustment Facility (LAF): Consists of daily infusion or
absorption of liquidity on a repurchase basis, through repo (liquidity
injection) and reverse repo (liquidity absorption) auction operations,
using government securities as collateral.
Repo/Reverse Repo Rate: These rates under the Liquidity Adjustment
Facility (LAF) determine the corridor for short-term money market
interest rates. In turn, this is expected to trigger movement in other
segments of the financial market and the real economy.
Open Market Operations (OMO): Outright sales/purchases of
government securities, in addition to LAF, as a tool to determine the
level of liquidity over the medium term.
Marginal Standing Facility (MSF): was instituted under which scheduled
commercial banks can borrow over night at their discretion up to one
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% of their respective NDTL at 100 basis points above the repo rate to
provide a safety valve against unanticipated liquidity shocks
Bank Rate: It is the rate at which the Reserve Bank is ready to buy or
rediscount bills of exchange or other commercial papers. It also signals
the medium-term stance of monetary policy.
Market Stabilization Scheme (MSS): This instrument for monetary
management was introduced in 2004. Liquidity of a more enduring
nature arising from large capital flows is absorbed through sale of
short-dated government securities and treasury bills. The mobilized
cash is held in a separate government account with the Reserve Bank.
The Reserve Bank looks at both short term and longer term issues related to
liquidity management. In the longer term, it monitors the developments in
global financial markets, capital flows, the governments fiscal position and
inflationary pressures, with an eye toward encouraging strong and
sustainable economic growth.

References
1. https://www.imf.org/external/np/vc/2007/070507.htm

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2. http://www.thechinaguide.com/index.php?
action=preparation/moneyCurrency
3. http://www.economonitor.com/blog/2013/12/china-monetarypolicy-under-financial-repression/
4. http://www.wsj.com/articles/china-central-bank-pboc-cutsinterest-rates-1416567408
5. http://www.pbc.gov.cn/publish/english/963/index.html

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