Case Study - People's Bank of China
China, also known as People's Republic of China (PRC,) is currently the second-largest economy in the world. The country has grown very rapidly over the last few decades, which has a population of about 1.376 Billion people and Gross Domestic Product of around $20.85 trillion (“International Monetary Fund”). Given the massive size of the country, immense amounts of Chinese Yuan – the currency of China that is also referred to as Renminbi, which has an ISO code CNY/RMB – exchanges hand every day, which is basically the blood of the economy.
However, behind the large exchanges there is a key player that acts like a heart that manages the blood system of a human, which is the People's Bank of China (PBOC). It is the Central Bank of China that engages in monetary policy regulates financial institutions and influences another important aspect of China's financial system similar to the central bank of the United States (Fed) and Euro (ECB). However, the PBOC is more complicated than the Fed and ECB because China’s economy is in the process to shift away from a planned economy to a market-based economy. China went through various economical changes during the 20th century, especially with regard to its government. This lead to various reform of the PBOC, which in aggregate was complex. The People’s Bank of China was established on December 1, 1948 under the new government, the communist party. It was structured in a “vertical organizational leadership” manner that the PBOC followed guidance from the Minister of Finance – a national executive agency of the People’s Republic of China – (“People's Bank of China History”). The main purpose was to manage the flow of currency, and engage in monetary policy to manage money supply and demand and thus interests rates, which has major influences in the financial markets (“People's Bank of China History”). In 1983, the PBOC was established mainly as a central bank position (“People's Bank of China History”). However, the PBOC did not become the official central bank until 1995. Further, in 2003, under the influence of the state council – the chief administrative authority of the Republic of China – a bill was passed, where the PBOC duties were to manage monetary policy, maintain financial stability, and provision of financial services at a macro level (“People's Bank of China History”). The PBOC was modeled after the United States central bank the Fed, where the “PBOC manages monetary policy through operation offices, regional branches, prefecture-level sub-branches, and country-level sub-branches” (“People's Bank of China”). The purpose was to shift the “PBOC supervision” to “commercial operations” and to
help contain inflation risks ("People's Bank of China”).
The PBOC is managed by nine governors. Zhou Xiaochuan is currently the head governor, and he has six vice governors and two assistant governors to help him make decisions. The governor of the PBOC is nominated by the Premier of the People’s Republic of China – Prime Minister – and is later approved by the National People’s Congress – National Legislature of the People’s Republic of China, – who has the power to appoint and remove the head governor (Barry). The vice governors and assistant governors are appointed and removed by the Premier of the State Council (Barry). The governors get together and discuss monetary policy. The governors have five major monetary policy tools: open market operations, reserve requirement ratio, central bank lending, central bank base interest rate, and standing lending facility (“China's Monetary Policy”). Whereby, the PBOC engages in monetary policy to maintain the value of the Chinese Yuan and enhance economic growth ("Objective of the Monetary Policy.").
The structure of the PBOC consists of 12 regional branches, 6 overseas representative offices, two monetary authorities, and 16 functional departments, which acts as the veins of the PBOC when carrying out monetary policy (Barry). The structure of the PBOC is also complex in that China consists of 34 provinces. Of the 34 provinces, 31 provinces are highly influenced by the PBOC. However, the “31 provinces have their own economic decision to make and those are driven by the top but there is no one central decision-maker” while the Chinese economy shifts toward a market-based economy (Bass).
Since the 2008 global financial crisis the balance sheet of many major central banks around the world has massively increased their balance sheet. The PBOC has also massively increased its balance sheet from roughly $1.8 trillion to around $5 trillion, which is mainly caused by the fact that China runs a current account surplus ("Trading Economics"). Of the $5 trillion, roughly around $3.5 trillion is forex – foreign-exchange – reserves, which is the largest reserve in the world (Snider). The forex reserve on the PBOC’s balance sheet consists mainly of US dollars, however, the bank of china has also been “diversifying into euros, gold and sovereign debt of other countries like Australia and Japan” (Rapoza). The reason for the PBOC to hold large amounts of the reserve is mainly to peg and devalue the Chinese Yuan. The exchange rate of the Chinese Yuan to one U.S. Dollar was around 8.3 CNY/USD from 2001 to 2005, then PBOC started devaluing its currency from 2005 to 2007 to 6.8 CNY/USD (Kritzer). Now the exchange rate hovers around 6.82 CNY/USD (Kritzer). China often devalues its currency and also tries to contain inflation because they want to stay competitive thus deprecating the Chinese Yuan. The
forex reserve is also used to make “their sovereign bonds safer” and it also act as a safety net during the financial crisis, thus attracting investors (Rapoza).
Modern China has been trying to move away from a planned economy to a market-based economy. The purpose of the shift is to influence economic development and decision making in a decentralized manner (Bent). China, a communist country where economic developments are centralized (planned economy), is on the process to shift towards an economy where economic development is decentralized (market-based economy). This shift has created two inflation risks. The first inflation risk arises due to the increase in aggregate demand (AD) from the shift of the economy (Bent). When decentralized decision-makers put money in their “micro-economy” it is not regulated by the Chinese government, which causes AD to increase thus causing inflation to arise (Bent). The second inflation risk arises due to excessive liquidity in the market (Bent). China is a global supplier in the world. It’s a country that is known as the factory of planet Earth. This is the main reason China runs a current account surplus, thus leading the Chinese government to have excess capital to invest. Historically, the surplus capital was used to keep currency at a fixed rate by pegging the Yuan to the Dollar. However, due to China running a current account surplus, oftentimes, there is excess liquidity in the market thus leading to
inflation (Bent).
To combat the two inflation risks the PBOC has taken two actions with regard to monetary policy. One, the solution was that the PBOC sold central-bank bills, backed by the government of China, which are similar to Treasury bills (Areddy). This decreased the supply of money in the economy thus containing inflation risk. Second, a loan-to-value ratio was placed to limit the amount of credit that could be taken out by the decentralized decision-makers (Bent). The loan-to-value ratio acts similarly to reserve requirement or down payments, which reduces the amount of credit in the economy thus containing inflation risk.
China, the second-largest economy will most likely have a greater influence on almost every single country in the world as it has grown rapidly in the future. Further, the Chinese economy has shifted from a planned economy to a market-based economy, which has caused the PBOC to go through various reforms. Although, it is impossible to say what will actually happen in the future with regards to China going through the shift from a planned economy to a market-based economy, the consequences are likely to be significant worldwide.
Cordially,
Rojan Shrestha
November 13, 2016