Zhou Xiaochuan

Governor, People's Bank of China

 

Distinguishedguests, ladies and gentlemen,

 

This high-levelseminar on China's Monetary Policy Transmission Mechanism jointly held by thePeople's Bank of China and the International Monetary Fund is an important andmeaningful cooperation between the PBC and the IMF. First of all, on behalf ofthe People's Bank of China, I would like to express the warmest congratulationson the opening of this seminar and the most sincere welcome and appreciation toforeign experts headed by Mr. Lipschitz, Director of the IMF institute, and theChinese experts and scholars present at this seminar. During the meeting, Mr.Marvin Goodfriend discussed the analysis framework for monetary policytransmission mechanism; Mr. Hervé Ferhani presented on the impact ofbanking soundness and competitiveness on monetary policy transmissionmechanism; Mr. Lajos Bokros, Director of the World Bank financial servicesadvisor/ Europe and Central Asia office and Prof. Bennett T. McCallum from CarnegieMellon University spoke on the experience of post-transition and industrial countriesrespectively; and this afternoon, Prof. Noriyuki Takayama from HitotsubashiUniversity will talk about the impact of ageing and social securities system onmonetary policy transmission from the Japanese experience. Their research andpresentations are very helpful for us to learn the useful country experienceand further improve the monetary policy transmission and adjustment mechanism.With respect to China's monetary policy transmission mechanism, I would like toadd the following points:

 

I.                    Thestudy of monetary policy transmission should be attentive to the micro foundation,and to the sensitivity, speed and effects of banks' and other financial institutions'response to monetary policy. Only with a sound micro foundation, could monetarypolicy transmission mechanism be improved.

 

In recent years,in order to establish a micro foundation sensitive to price signals, much importancehas been attached to strengthening corporate governance and the role ofshareholder value. Whether economic agencies at the micro level are profit-maximizinghas direct impact on the monetary policy transmission and its effectiveness. Ifmicro economic agencies are not profit maximizing, it is no surprise that priceinstruments of monetary policy hardly works.

 

With thedeepening of the economic reform, it can be observed that financialinstitutions are gradually moving towards profit maximization, though still farfrom what would have been in a market economy. Some financial institutions,especially large ones, have not shed the bureaucracy-oriented mentality, a legacyof the centralized economy. In their business objectives, personal promotion isusually prioritized over profit indicators, which will definitely affect thetransmission of price instruments of monetary policy.

 

In order toenhance the micro foundation, China has been strengthening financialsupervision over the years. It should be noted that the choice of regulatory intensityand indicators has direct impact on monetary policy effectiveness. For instance,with increasing concern on the rise of non-performing loans (NPL), theregulatory authority required that NPL ratio be reduced to a certain level.This regulatory indicator played its role to the extent that commercial banksdid reduce NPL ratios. However, in order to comply with the regulatory requirementof lower NPL ratio, some financial institutions increased lending in an attemptto inflate the denominator and grow out of the NPL problem. This exacerbated theexcessive credit growth problem. At this point, some people started to realizethat we should worry not only about the NPL ratios, but also the quantity ofNPLs. Again, this was also an over-simplified perception. It was only aftersome time of market development, much experience and years of discussion, that consensuswas finally reached in 2003 on the importance of capital adequacy. Only when agenciesat the micro level put in place risk control and capital constraint, could monetarypolicy transmission mechanism work.

 

The Chinesefinancial community has always watched the evolution of the Basel Accordclosely. As early as in 1994, the PBC initiated the regulatory indicators on commercialbank's capital in its circular 38 entitled "Notification on Balance Sheet Managementof Commercial Banks", and required that the ratio of monthly averagecapital of commercial banks to monthly average risk-weighted assets be no less than8 percent, while the ratio of average core capital of commercial banks tomonthly average risk-weighted assets be no less than 4 percent. The CommercialBanking Act of 1995 also stipulated that capital adequacy ratio (CAR) ofcommercial banks be no less than 8 percent.

 

However, for anextended period of time, no regulatory actions were ever taken against bankswith inadequate capital. Concession was even allowed in the calculation of CAR.Compromise was made in the loan asset classification and bad debt provisioning rulesin 1997. In the absence of realistic classification and sufficient riskprovisioning, CAR can hardly indicate the risk of the bank. These problems madeit impossible for bank regulatory rules to rein in the excessive credit expansionof the commercial banks. The result was that bank rules were not fullyimplemented and capital ratio was notably inadequate.

 

In fact, theBasel Accord is a comprehensive regulatory and internal assessment system. Its essentialindicator, capital adequacy ratio embraces earning objective while effectivelycontaining the excessive expansion of the bank. The numerator of CAR indicates thecapital adequacy of the bank and robustness of the buffer against shocks. Themore capital, the more resilient a bank is against risks. Meanwhile, dynamicsof capital depends on retained profit. When a bank calls for additionalcapital, the investors look at the earnings of the bank. An unprofitable bankcan hardly attract external finance. In addition, expansion through merger and acquisitionis also subject to capital constraint. The denominator of CAR assigns differentrisk weights to assets so as to drive banks towards less risky business andaway from high risk business. Risky business must be supported by more capital.This effectively contains the excessive growth of risky assets. The Basel IIinitiated the so-called "internal rating base" (IRB), encouraging banks toidentify asset risks through internal rating system. The risk weighting systemencourages non-asset business, or commission-based business. The Accord willalso boost asset securitization since securitization lowers risk level of assetsthus lowers capital requirements. In a way, it encourages banks to shift, sterilizeand lower risks by all means. In this sense, such an indicator is a combinationof incentive and control mechanisms, while encouraging technical innovations toimprove credit asset quality.

 

Nevertheless, aprincipal problem in applying CAR to Chinese banking institutions is thatdifferent banks bear different historical legacy, which is difficult to measureby a unified standard. This historical problem should be solved by moreaggressive reforms before more stringent regulations could be applied and serveas the core objective to improve their corporate governance and businessoperation. In this spirit, in 2003, the China Banking Regulatory Commission initiatedthe 3-year plan for banks to comply with Basel II .

 

Some technicalissues deserve attention, which, if not properly dealt with, may dampen the effectivenessof the policy. For instance, for banks with inadequate capital, the so-called "shadowcalculation" may leave a lot of leeway. For banks with lower than 4 percent ofcapital adequacy ratio, strict regulatory measures have been taken. However,for banks with capital ratio sliding down from 8 percent to 4 percent, noadequate restrictions are imposed. In this respect the differentiated reserve requirementratio to be applied from April 25 will help regulatory implementation. In sum,only when the micro foundation with well-defined business objectives andcontrol mechanisms is in place, could monetary policy transmission work.

 

II.                  In atransition economy, policy-makers tend to rely on quantity measures and avoidprice instruments. In fact, the experience of price reform shows that pricemechanism is often more effective than expected.

 

Monetary policy transmissionmechanism to a great extent determines the choice of instruments. In themonetary policy conduct, there have always been disputes on the pros and consof price and quantity instruments. Currently, price instruments such asinterest rate and exchange rate coexist with quantity instruments such asliquidity absorption and foreign exchange control.

 

For an extendedperiod of time in China, quantity measures were preferred while price instrumentswere seldom used. This was the expediency given the constraints of thetransmission mechanism as well as the result of the policy legacy from thedemand economy mentality. A centrally planned economy emphasized quantity control.When demand and supply are out of balance, quantity indicators are oftenimposed to increase supply or contain demand. The same mentality, when appliedto the financial sector, tends to tighten liquidity when there is inflationarypressure, and in the sequence of policy choice, price instruments are onlyconsidered after quantity control. Some believe that in financial sectortransition, the borrowers, e.g. the SOEs, and lenders, e.g. state-owned banksare not sensitive to price movements. However, empirical studies did not supportthis assumption. China has been gradually moving to focus on the use of price instruments.An example would be that when inflationary pressure emerged at the beginning ofthis year, the central bank adjusted its lending rate and rediscount rate.

 

As a matter offact, the effects of and responsiveness to price instruments usually turn outfar better than expected. Examples are abundant. It is foreseeable that withmarket liberalization of the economy, price mechanism will play a more prominentrole and there will be more willingness to use price instruments. It should benoted that when the actual price is close to equilibrium, price is elastic andprice instruments are more effective. Whereas if the actual price is too farfrom equilibrium, price may not longer be elastic and price instruments ceaseto be effective. This can be proved by empirical    analysis.

 

III.                Thestudy of monetary policy transmission should also look at the game betweenmacro adjustment and micro agencies.

 

Thedecision-making process and policy implementation have always been a gamebetween macro adjustment and micro agencies. "When there is a policy, there arecountermeasures to circumvent the policy" would be a vivid description of thisgame relation. Monetary policy transmission and its effectiveness are noexception. Any information structures and monetary policy conduct models willaffect the monetary policy transmission. For instance, market can often findways to preempt a monetary policy measure or sterilize its effects through expost actions. Changes in the asset portfolio can help evade policyrestrictions. An excellent example would be the textbook version of how micro agencycould minimize the effects of official reserve requirement.

 

In a transitioneconomy, political bargaining and lobbying for "exemption" should be guardedagainst. In the transition process, due to difference of regions and sectors,to a policy that would have been applicable across the board, there will belarge number of applications for "exemption". In the financial sector, sincequite a number of financial institutions have a variety of policy lendings as ahistorical legacy, any restrictive policy may arouse one-to-one bargaining and dampenthe monetary policy effects. For instance, central bank lending was originallydesigned to provide short-term liquidity assistance, but evolved to be persistentlyabused for all sorts of reasons. When a change in central bank lending rate iscalled for, there will be bargaining for exemption. The floating lending rate recentlyadopted by the central bank was to curb the one-to-one bargaining bahavior inprinciple. Otherwise, central bank lending rate as a monetary policy instrumentwill fail in the transmission.

 

IV.               Thestudy of monetary policy transmission mechanism should care about incentivemechanism.

 

For an extendedperiod of time, no sufficient importance has been attached to incentives. Thecurrent situation in China is that banks with good or bad performance havelittle difference in terms of rewards. In order for policies to be effective, positiveincentives must be put in place to break the old system of "eating from thesame big pot", and "same reward for good and bad performers". The phenomena of the"subsidizing the lean by exploiting the strong" or "the fast oxen get whipped "should be guarded against. Distorted incentives will not only bring down a goodbank, but also result in "adverse selection" and "moral hazards". There areample examples in the financial sector. For instance, good performers in termsof earnings, tax payment and share-holder return are usually not positivelyrewarded, whereas financial institutions in distress are often the priority ofre-capitalization and favorable NPL disposal policies. It is worth noting thatwith market developments, the capital market will promptly catch the differencesamong banks. With corporate restructuring and eventual public listing of thestate-owned commercial banks, the market will gradually play the role ofincentive mechanism, thus enhance the effectiveness of monetary policytransmission.

 

In this respect,we can learn a good deal from the experience of countries of more mature marketeconomy. And prompt corrective action (PCA) is a valuable tool. Measures mustbe available to impose sufficient external pressure on financial institutions whoserisk profile and asset quality worsen. These actions also carry the unmistakenmessages that poor performance is not welcomed but restricted. A typicalexample would be the Federal Depository Insurance Corporation ImprovementAct (FDICIA) of 1991. The main content of the act is capital adequacy categoriesand their corresponding corrective actions. Banks with capital adequacy ratio of10 percent and more are defined as adequately capitalized. When capital ratioslides to 8 percent, mandatory corrective actions such as "may not take trustdeposits" is imposed. Banks of lower than 8 percent capital are "under capitalized"and the correction actions include "may not take trust deposits; may not makeany capital distribution or pay a management fee; growth of total assets mustbe restricted; must submit capital restoration plan and prior approval isrequired to acquisitions, branching, and new lines of business and some discretionaryactions". Additional discretionary corrective actions may be imposed. Fro banksof lower than 6 percent capital, in addition to the above measures, "transactionswith alliance must be restricted; interest rates paid on deposits, and bonusesand salary raises to senior executives officers must be restricted". Banks withunder 4 percent capital adequacy ratio are "critically undercapitalized", andmust be prohibited from paying interest on subordinated debts and activitiesmust be restricted. If things do not improve within 4 quarters, they must be placedunder receivership. These actions proved effective in containing the businessexpansion of risky institutions and prevent risk from worsening.

 

Currently, alarge number of countries have adopted different PCA systems. We would say thedifferentiated reserve requirement ratio is an experiment to establish positiveincentives under the given circumstances in China. In any country, because ofthe differences in the legal system and regulatory authority, agencies have differentcompetence and tools at hand. Therefore, it often calls for a combination offorces and measures to implement such PCAs. Currently in China, the incentive systemis vulnerable. Reform will be accelerated to solve the historical problem andlay the level field for competition. Only when incentive system is established andimproved to guard against "reverse selection" and "moral hazards", could theeffectiveness of monetary policy be ultimately assured.

 

V.                 Thestudy of monetary policy transmission mechanism should also consider the impactof ageing and social security system on the effects of monetary policy.

 

The current financialsituation is characterized by fast growth of money supply and credit but mutedCPI growth and high investment ratio. In 2003, investment ratio increased by 6 percentagepoints and M2-GDP ratio was very high. This should draw our attention. Anoptimal economic structure would have a higher consumption-GDP ratio. Final consumptionis an important signal for future investment. Without a clear signal from risingfinal consumption, the future return and sustainability of investment are doubtful.To address this problem, it was suggested that consumer credit be increased,together with a number of supporting measures in pricing consumer credit,financing support and regulations. However, in this process, it is important tokeep a balance between establishing social security system and encouragingcredit consumption.

 

Some analysisshows that consumption in China is greatly constrained by two factors. One,inadequate social security system, especially the unfounded pension and healthcare system dampened consumer confidence. On top of it is the concern over theeducation expense for children. In the transition to market economy, someservices that used to be public goods gradually turn to operate under the ruleof market. Meanwhile, no social security system is put in place. This deterredconsumption, increased prudent savings and affected consumer confidence. It is encouragingnews that Liaoning Province initiated the pilot programme on social security systemreform. The intensity of the reform is probably not enough and more in-depth researchis needed. The second constraint is the demographic structure. China willgradually move to an ageing society. The social security system is stilllargely built on a pay-as-you-go basis, which effectively makes the young generationsave more to account for the surging claims on the pension system. Under thesecircumstances, efforts to encourage consumer credit need to look at the inter-generationconsumption behavior. If the young generation takes advantage of consumercredit while the share of aged population in the society increases, the sustainabilityof the PAYG system will be threatened, so will the future payments of the alreadyunder-funded pension system. From this standpoint, careful consideration mustbe given to establishing and improving the social security system where thecentral bank's concern is established from a macro adjustment perspective. Moreover,any deficiency in the social security system may dampen the transmission ofmonetary policy intended to encourage consumption, and make such a monetarypolicy move impotent.

 

A broader view revealsthat another big threat to monetary policy and financial stability is fiscaldeficit. Excessive and rolling government securities also affect theeffectiveness of monetary policy transmission. The current deficit in China isnot large but implicit fiscal deficits are more difficult to deal with. Economicgrowth may help reduce the NPLs evolved from policy credit, implicit deficits ofthe under-funded social security system is more problematic. If no solution isfound for the social security issue, implicit fiscal deficits will hamper themonetary policy transmission and thus dampen the desired effects of monetarypolicy measures.