China's Monetary Policy During the Recent Financial Crisis

by Yegen Xie

The recent financial crisis triggered by the burst of the real estate bubble and devaluation of complex financial derivatives has created a profound influence across the world. All major economies suffered from a sudden contraction of liquidity and the globalizing Chinese economy was no exception.

Having experienced a dramatic turn from an overheating economy into recession, the Chinese government, blessed with its affluent foreign exchange reserves and its set of macroeconomic policy tools and control, quickly shifted its macroeconomic targets and adjusted its financial and monetary policies (PBC, 2010). Compared to the ambitious 4 trillion Renminbi (RMB, approximately $550 billion) stimulus package, China’s monetary policies during 2007 to 2009 can be described as moderate but, at the same time, effective. This article provides a brief introduction to how China’s monetary policy was adjusted to address the financial crisis.

China’s Involvement in the International Financial Crisis
As the third largest economy in the world, China has benefited from globalization. Yet the other side of the coin is China’s dependence on international trade, which plummeted due to the crisis spreading around China’s major trading partners (USCBC). China’s GDP growth, which was over 10% after 2003 and peaked at 13% in 2007, plummeted to 9% and 8.7% in 2008 and 2009, the lowest level since 2000 (World Bank, 2010).

Exports, which were the engine of growth, dropped from a record high RMB 1428.5 billion in 2008 to RMB 1201.6 billion in 2009, a drop by 16%, contributed 3.9% less to the 2009 GDP’s growth compared to a year earlier (China Customs Stat, 2010). Additionally, job creation plummeted. The gap between newly created jobs and job seekers, nearly 15 million in 2008, reached 20 million in 2009 (Sui & Cheng, 2007). Even worse, Chinese consumer confidence decreased greatly: The index dropped from a record high 100 in June 2007 to 85.9 in March 2009. The Producer Confidence Index dropped from 143.1 in the June 2007 to 94.9 in December 2008 (NBS, 2008).

China’s financial markets turned from three years of prosperity to nearly a decade of nadir. The Shanghai Stock Exchange Composite Index sank to 1664.93 in October 2008 (NBS, 2007, 2008) after having grown by 600% within two years to 6124 (October 2007). The market for Initial Public Offerings dried out and the volume of traded shares sank to less than RMB 20 trillion from record high 30.5 trillion in 2007 (NBS, 2007, 2008). Surveys showed that more than 70% of investors lost approximately 70% of their stock investments in 2008, while only 6% investors reported a positive performance (Zhang, 2008).

China’s Monetary Policy 2007-2009
Controlling inflation has been the key concern of China’s pre-crisis monetary policy since consumer price index (CPI) had been far above 3%. Meanwhile, the real estate market strengthened the government’s willingness to tighten policies to prevent Chinese economy from derailing (PBC, 2007, 2008, 2009).

However, as the crisis hit China’s economy, the government quickly switched its monetary policy objective from preventing the economy from overheating and controlling inflation to mitigating the effects of the financial crisis and controlling inflation, and thus loosened the once tight monetary policy in late 2008. This change shows that the government has a clear view of the economic trends (PBC, 2009). China’s monetary policy during the crisis can be divided into central bank monetary policy and government direct intervention.

People’s Bank of China’s (PBC) Monetary Policy: A 180 Degree Turn Around
China’s central bank, the PBC, had to deal with the sudden shift of highly volatile capital markets. Unlike the US Federal Reserve, who tried to mitigate the crisis by lowering interest rates, the PBC had a stronger preference for adjusting banks’ reserve requirements rate as its second key policy tool (PBC, 2007, 2008, 2009). In the first and second quarters of 2008, the PBC raised the reserve requirement for deposit-taking financial institutions in five steps from 14.5% to 17% to reduce money supply growth and to cool the overheated financial and real estate markets. As the crisis began to affect China, the PBC quickly lowered the reserve ratio in three steps down to 14.5% and the benchmark interest rate for loans from 7.47% to 5.31% (PBC, 2009).

In addition, the PBC tried to stabilize the real estate market and international trade. The PBC adjusted the housing mortgage loan rate to 70% of the benchmark interest rates for loans (MOF, 2008). Meanwhile, to further stimulate the markets, the PBC established standards for second housing mortgages, enabling second-time real estate purchasers to borrow from commercial banks.

Government Intervention
As the only state-owned commercial bank which did not go public, the Agricultural Bank of China (ABC) was notorious for its non-performing loans (NPL) problem and was the worst run state-owned commercial bank with non-performing assets up to RMB 800 billion at its peak. The huge amount of non-performing assets had already threatened the stability of China’s financial markets.

To mitigate this threat while not losing ABC’s control, the Ministry of Finance sold non-performing assets of ABC, and invited the Central Huijin Investment Company, a state-owned investment company, to inject $19 billion directly into ABC and holds now a 50% stake in ABC (Zhang, 2009). As a result, ABC’s NPL ratio was reduced from 23% to 4.5% in 2009, allowing ABC to be ready to go public and a huge time bomb in the financial system was deactivated.

During the post-crisis recession, countries that rely on international trading may manipulate their currencies to depreciate to transfer the crisis’ effects to their opponents, but this “beggar-thy-neighbor” policy can easily be imitated and resultein a lose-lose situation. To strengthen the financial market’s stability and as one step of China’s determination to stabilize the world economy, the PBC signed a currency swap agreement for US Dollars worth RMB 180 billion with South Korea, whose currency had depreciated by nearly 40% in 2008. To further stabilize Asian financial markets, China, in association with Japan and South Korea, signed a US dollar-based currency swap agreement with the Association of Southeast Asian Nations (ASEAN) worth $120 billion.

This arrangement showed the Chinese government’s determination to stabilize its economy at a critical moment when financial market fluctuation had hurt the global economy. This move also demonstrated the government’s willingness to take responsibility and contribute to its own effort to become an important player in the 21st century especially given that China had been greatly affected by the crisis.

The End of the Beginning, Not the Beginning of the End
China’s monetary policy did help the economy quickly address the crisis. There is significant evidence that China’s economy had been back on track with a forecasted 10% GDP growth rate for 2010 (Caijing, 2010), mainly led by a rebounding exports and domestic investments. Meanwhile, after touching the 1600 nadir in October 2008, the SSE Composite Index quickly climbed back to 3400 in August 2009.

To further stabilize the economy, the Chinese government has more to do : Preventing a second crisis that could be sparked by an overly expansionary monetary policy, by billions of speculative hot money inflows, by fluctuations during the exit of the stimulus policy and by a potential RMB appreciation (Martin & Morrison, 2008). At the same time, the government must fight against inflation and inflation expectations. The recent international financial crisis raised a series of challenges for Chinese policy makers. We have seen just the end of the beginning, rather than the beginning of the end of the challenges.

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