Global central banks typically pursue two goals, maintaining low and stable prices while also promoting growth or employment. In contrast, the People’s Bank of China (PBoC) has several official and multiple unofficial goals, many of which conflict. At present it faces daunting challenges, including balancing growth, minimizing currency volatility, promoting economic stability, preventing asset price bubbles, ensuring adequate market liquidity and deleveraging the financial system.
Further complicating the PBoC’s efforts is the proliferation of non-bank financial institutions and dramatic growth in the shadow banking market, triggered by interest rate liberalization. This is making the task of implementing monetary policy significantly more difficult.
To address these challenges, the PBoC has developed three distinct styles of monetary policy: traditional monetary tools, quasi-monetary tools and regulatory methods.
Traditional monetary policy tools include adjusting interest rates (deposit and lending rates, reserve requirement ratios) and using market influence (including loan targets and window guidance). Historically, these tools were sufficient to allow the PBoC to control the cost and quantity of liquidity available between state-owned banks lending and state-owned enterprises borrowing. These interest rates remain important because they impact the real economy and send a strong policy signal, but they are seen as excessively blunt and less effective in an era of interest rate liberalization, and thus are rarely used.
To overcome the limitations of traditional monetary policy and help it more effectively and efficiently control financial markets, the PBoC has recently introduced a wide range of quasi-monetary policy tools. These include the Medium-term Lending Facility (MLF), Pledged Supplementary Lending Facility (PSL), and Short-term Lending Facility (SLF). The PBoC’s usage of these quasi-monetary policy tools has increased dramatically in the past few years while outstanding amounts have soared as the central bank strives to ensure adequate market liquidity and reduce volatility. In addition, by altering the interest rates and funding tenors for different tools, the PBoC can strongly influence the cost of liquidity and investor behavior.
Finally, the PBoC is using new regulatory powers to influence the demand and supply of market liquidity. The recently introduced Macro Prudential Assessment (MPA) and newly proposed Unified Regulations will give the central bank wide-ranging powers to manipulate the demand for and use of financial instruments by banks and other financial institutions – directly affecting market-driven interest rates.
Previously, the limited tools available to the PBoC meant that interpreting monetary policy was quite straightforward. The recent trifurcation of monetary policy implies that monitoring and interpreting the PBoC’s intentions has become considerably more difficult. In addition, while the new monetary policy tools should reduce market risk and complexity over the long term, in the short term they will likely create more volatility and uncertainty for investors. Prudence in selecting investments is especially important in the current environment, as is a focus on security and liquidity.