How does China manage its money supply?

Almost all countries in the world control their respective money supply through their central banks. The Federal Reserve Bank (FRB) controls the money supply in the United States and the People’s Bank of China (PBOC) controls the money supply in China.

China is the world’s largest and fastest growing economy, as of July 2020. The nation has a unique socialist open market economy. The Chinese government maintains strict control but remains open to free market forces. As a manufacturing and export-oriented economy that receives huge amounts of foreign exchange capital for its exports, the exchange rates of the Chinese currency also have an impact on the country’s money supply.

This article discusses the main methods used by China to control its money supply and exchange rates.

Key points to remember

  • The People’s Bank of China (PBOC), which is part of the centralized government, controls the money supply in China.
  • Due to its unique export-dependent economic system, China’s money supply policies differ from methods used by other countries.
  • China manages its money supply in two ways: controlling exchange rates and printing currencies.
  • The PBOC can also control the money supply by changing the reserve rate and the discount rate.

Understanding the money supply

Money supply, or money supply, is the total amount of money in circulation or existing in a country at any given time. Money supply has an impact on price levels, the availability of capital, inflation, and the overall business and economic cycle of a country.

High circulation speed results in increased purchasing power and lower interest rates, which in turn increases the amount of capital available for investment, business and spending. The reverse occurs with a low speed of the money supply.

Government authorities keep a close eye on the money supply and take the necessary measures tailored to the economy as a whole or to selected sectors. China’s money supply policies differ from conventional methods used by other countries due to the country’s unique economic system.

Traditional Chinese economy

As a manufacturing and export-oriented economy, China has a trade surplus. He sells more to the world than he buys.Chinese exporters receive US dollars (USD) for their exports but must pay local expenses and wages in local currency, Chinese yuan or renminbi (RMB). Due to the huge supply of US dollars and the demand for yuan, the rate of yuan may rise against the US dollar.

If this happens, Chinese exports become more expensive and lose their competitive price advantage in the international market.This is problematic for the Chinese economy, potentially resulting in lower or zero sales of manufactured goods, widespread unemployment and economic stagnation. China’s central bank PBOC is stepping in to avoid this situation, by keeping exchange rates lower through artificial measures.

From 2008 to 2020, the exchange rate of the Chinese yuan against the US dollar has remained stable and is between 6.1 and 7.1.

Changes over the past decade

China’s money supply in recent times has shown steady growth.Along with the money supply, China’s gross domestic product (GDP) has also grown in similar proportions.

The relationship between the Chinese currency and the economy is interesting because its export-dependent economic system works differently from that of other countries. From 2010 to 2020, major reforms led by the Chinese government increased China’s market orientation and opened up the Chinese economy.

The period saw the monetization of a variety of resources and their availability in the open market, which attracted large-scale foreign investment. Resources include manufactured goods, infrastructure, technology and natural resources, as well as human capital and labor. There was an increase in demand for the Chinese currency, which stimulated lending from commercial banks and ultimately increased the money supply. The money supply has grown considerably over the past 10 years.During high and constant growth rates, China has effectively managed the increase in the money supply while keeping the exchange rates stable.

How China controls its money supply

China uses various methods to manage its money supply. Here are the main methods used.

Control exchange rates

One of the main tasks of China’s central bank, the PBOC, is to absorb the large inflows of foreign capital from China’s trade surplus. The PBOC buys foreign currency from exporters and issues this currency in local yuan. The PBOC is free to publish any amount in local currency and have it traded for forex.

This publication of local currency banknotes ensures that exchange rates remain fixed or within a narrow range. This ensures that Chinese exports remain cheaper and that China retains its advantage as an export-oriented manufacturing economy. Importantly, China tightly controls foreign money entering the country, which has an impact on its money supply.

Sterilization

China is implementing various sterilization actions, which refer to monetary action the PBOC takes to limit the impact on the money supply of constant capital inflows and outflows. However, the actions of the PBOC can have negative consequences.

The bank increases the supply of local currency in domestic markets, which increases the risk of high inflation. To reduce the excess money supply, the PBOC sells the required amount of domestic currency bonds, which withdraws excess liquidity from open markets. The PBOC also purchases national currency bonds to inject liquidity into the markets when needed.

Printing currency

Another measure applied by China is the printing of national currency. The PBOC can print yuan as needed, although this can cause high inflation. However, China exercises strict state-dominated controls over its economy, which allows it to control inflation differently compared to other countries. In China, changes are being made to subsidies and other price controls to control inflation.

The reserve ratio

Commercial banks are required to keep a percentage of the total amount of their deposits with the country’s central bank, known as the reserve ratio. If central banks reduce the reserve rate, commercial banks keep less money in reserve and have more money available to increase the money supply (and vice versa).

The discount rate

If commercial banks borrow additional money from central banks, they pay interest on the amount at the applicable discount rate. Central banks can change the discount rate to increase or decrease the cost of such borrowing, which ultimately impacts the availability of money in open markets. Bank rate changes are widely followed around the world to control the money supply.

The bottom line

Some of the measures used by China to control the money supply apply globally to all countries, while others are specific to China. As the amalgamation of a socialist economy and a market economy, China has designed its own processes to keep a firm grip on its economy. China is established as a financial superpower and, thanks to its controlled measures, is experiencing economic growth.

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