How the PBOC Controls Money Supply and Interest Rates

For years, investors have looked to the US Federal Reserve for information on the direction of global markets: Decisions made by the US central bank influence assets around the world.

Increasingly, however, the markets are also focusing on changes in the world’s second-largest economy, trying to analyze its policy decisions to understand how China’s vast fund flows will react.

But the Federal Reserve system is quite different from China’s economic policy regime.

When it comes to where money is going in the US economy, investors are watching the changes the Fed is making to its “federal funds rate” target – the benchmark of interest that influences borrowing costs. , asset prices and exchange rates in the US economy. In China, such a signal is less clear because the country does not have a single representative key rate like the that of the Fed.

Instead, the central bank uses several tools to control interest rates and the amount of money in the Chinese economy. So, interpreting what China wants to achieve can sometimes be a confusing business.

Chinese policymakers also frequently add new tools or remove older tools as they modernize their country’s system into something more aligned with those of developed countries. Tracking these changes can make it more difficult to read central bank signals.

What is the central bank of China?

The central bank of China is called the People’s Bank of China, or PBOC for short. Like its counterparts in advanced economies, the PBOC has a dual mandate of maintaining price stability and promoting growth through the management of monetary policies.

Monetary policy refers to how central banks manage the money supply and interest rates in their economies. These policies are adjusted according to the economic conditions a country faces.

For example, when central banks want to boost growth in a downturn, they lower interest rates. This helps lower borrowing costs, which encourages businesses and individuals to take out loans to invest and make purchases to stimulate the economy.

How does China manage its monetary policy?

The PBOC website lists seven tools it uses to adjust its monetary policy. They are:

  • Open market operations, OMO

In China, open market operations primarily involve two processes called repurchase or reverse repurchase agreements. The first term, as used in China, means withdrawing liquidity from the system when the PBOC sells short-term bonds to certain commercial banks.

It also does the opposite for a “reverse” buyout deal, by buying out those contracts so that banks have more liquidity.

These operations allow the PBOC to control the money supply and short-term interest rates – assets are normally offered on terms ranging from seven to 28 days.

  • Minimum reserve ratio, RRR

The reserve requirement ratio refers to the amount of money that banks must hold in their coffers as a proportion of their total deposits. Lowering the required amount will increase the supply of money that banks can lend to businesses and individuals, and therefore lower borrowing costs.

Raising the ratio of what banks must keep in reserve has the opposite effect.

The PBOC controls benchmark rates on one-year loans and deposits, which affects borrowing costs for banks, businesses and individuals.

It last adjusted these rates in October 2015 and now gives commercial banks some leeway to go above or below the official level to determine the interest rates they charge.

A Chinese national flag flies above the headquarters of the People’s Bank of China (PBOC) in Beijing, China on Monday March 7, 2016.

Qilai Shen | Bloomberg | Getty Images

The PBOC offers banks the option of “rediscounting” the loans they grant to their customers.

The monetary policy tool involves the central bank buying back existing loans from commercial lenders, giving them additional liquidity. It’s a complicated concept, so here’s an example to illustrate the process:

A consumer takes out a $ 10,000 loan from a bank, with a promise to repay $ 12,500 at a later date. This loan agreement would be purchased by the bank for $ 10,000, which is a discount from the $ 12,500 it will ultimately receive in return. Subsequently, the bank sells this agreement to the PBOC for $ 11,000, which is another discount – or “rediscount” – from the paper value of the contract of $ 12,500.

The PBOC charges an interest rate on funds it lends to banks, which would impact other borrowing costs in the banking system.

  • Permanent credit facility, SLF

The permanent loan facility is also a type of PBOC loan to commercial banks. Introduced in 2013, these loans have maturities of one to three months – longer than financing options such as open market operations.

To receive money under this framework, banks must guarantee assets with high credit ratings as collateral. This means that these funds are generally only available to the larger lenders.

  • Medium Term Loan Facility, MLF

Chinese banks obtain funds with even longer maturities – typically three months to one year – from the PBOC through the medium-term loan facility. The funding channel, introduced in 2014, allows the central bank to inject liquidity into the banking system and influence the interest rates on longer-term loans.

Like the standing loan facility, banks must provide collateral to receive funds. Unlike the SLF, however, a wider range of guarantees is accepted in the mid-term version. This includes government bonds and notes, local government debt, and highly rated small business loans.

  • Additional secured loan, PSL

As one of the newer monetary policy tools in China, the additional pledged loans were introduced to guide long-term interest rates and the money supply. These funds are injected into selected banks so that they can provide loans to specific sectors such as agriculture, small businesses and slum upgrading. The banks that received these particular funds are the three Chinese “political” lenders: the Development Bank of China, the Agricultural Development Bank of China and the Import-Export Bank of China.

How has China’s monetary policy evolved?

In the past, the PBOC has mainly focused on managing the amount of money in its economy and setting quotas on how much banks can lend. This took a definite turn in 2018 when the central bank stopped setting these specific targets.

Instead, China is seeking to establish an interest rate regime like those used by the Fed and the European Central Bank. One possibility, analysts say, is an “interest rate corridor” with a floor and ceiling determined by the PBOC, while still allowing the market to set rates within that range.

But it is still a work in progress for the PBOC.

What else does the PBOC do?

One of the main responsibilities of the PBOC is to maintain the stability of the Chinese yuan. In addition to managing the money supply and interest rates, the central bank guides the movements of the yuan against a basket of currencies comprising the US dollar, euro, Japanese yen, and South Korean won.

As part of this mission, the PBOC manages the country’s foreign currency holdings, which it buys and sells to keep the yuan stable within the expected exchange rate range.

WATCH: How US and China’s monetary policies differ

About the author