China in Transition
Why China Hesitated to Raise Interest Rates
- Taking central bank independence into account
Chi Hung KWAN
Consulting Fellow, RIETI
In response to the rise in inflation and higher interest rates in the United States, the Chinese authority, which had been cautious about raising interest rates, finally moved to hike rates on October 28. When we say "authority" here, it is generally understood to mean the People's Bank of China, which is China's central bank. However, when it comes to monetary policy, the independence of the People's Bank is limited; it requires the authorization of the government (the State Council) when it comes to such important matters as changing interest rates. Unlike a central bank, whose policy objective is price stability, governments tend to make decisions regarding monetary policy taking other goals such as job creation into consideration. The Chinese government was, in this case, especially concerned about the possibility that higher interest rates would further reduce the profitability of state-owned enterprises, leading to more bankruptcies and unemployment. Thus, the lack of independence of the People's Bank's might have delayed the decision to raise interest rates.
The People's Bank of China has only a short history as a true central bank. Until 1983, the People's Bank of China not only functioned as a central bank, but also engaged in deposit and lending operations for companies and individuals. In September 1983, the State Council decided to have the People's Bank of China specialize in the functions of a central bank and set up the Industrial and Commercial Bank of China to handle the activities of a commercial bank, effective January 1, 1984. With the enactment of the Law of the People's Bank of China in 1995, the People's Bank of China officially became China's central bank. In 2003, the China Banking Regulatory Commission was formally established to assume responsibility from the People's Bank of China for financial supervision. Under the revised Law of the People's Bank of China of 2003, the People's Bank of China has the authority to set monetary policy, maintain currency stability and contribute to economic development "under the guidance of the State Council." However, the final say on important matters such as money supply targets, and changes to interest and foreign exchange rates still rests with the State Council; the People's Bank has yet to gain full independence.
Although the People's Bank of China has a Monetary Policy Committee, it is only an advisory body. At present, the chairman of the Monetary Policy Committee is People's Bank of China Governor Zhou Xiaochuan. The other committee members are You Quan, deputy secretary general of the State Council; Zhu Zhixin, vice minister of the State Development and Reform Commission; Li Yong, vice finance minister; Wu Xiaoling and Li Ruogu, both deputy governors of the People's Bank of China; Li Deshui, commissioner of the National Bureau of Statistics; Guo Shuqing, administrator of the State Administration of Foreign Exchange; Liu Mingkang, chairman of the China Banking Regulatory Commission; Shang Fulin, chairman of the China Securities Regulatory Commission; Wu Dingfu, chairman of the China Insurance Regulatory Commission; Xiao Gang, president of the Bank of China; and Yu Yongding, director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences.Yu Yongding is the only outside economic expert on the committee, most of which is composed of high-level bureaucrats. This effectively limits the bank's independence.
Compared to independent central banks, governments tend to place greater importance on economic targets such as the state of the economy and employment, even at the expense of price stability. However, even if monetary policies that aim to boost economic growth and employment are temporarily successful, in the long run they only spur inflation because there is no long-term trade-off between inflation and employment. Based on the experience of various countries around the world, there is a consensus among experts that a central bank should not be influenced by vested interests, and that it should remain independent from the government or political parties.
Likewise, in China, monetary policy should not be implemented for the benefit of specific sectors, such as state-owned enterprises. If authorities try to prolong the life of inefficient state-owned enterprises through a low interest-rate policy, it will exacerbate moral hazard and make it more difficult to improve investment efficiency. The independence of the People's Bank should therefore be strengthened to protect the value of the currency from pressure from the government and politicians. Specifically, the People's Bank should not be under the authority of the State Council, which is an administrative organ, but under the Standing Committee of the National People's Congress, which is a legislative body. Furthermore, the role of the Monetary Policy Committee should be enhanced so that it functions as the bank's supreme policy-making body. On the other hand, the number of government bureaucrats on the committee should be reduced and more outside experts should be brought in.
In Japan, the independence of the Bank of Japan was bolstered when the Bank of Japan Law was revised in 1997: The Policy Board, which is the bank's supreme decision-making body, no longer includes industry representatives and now comprises the governor, two deputy governors and six other independent members. In addition, board members cannot be dismissed for failing to adhere to the views of the government. Furthermore, the government can no longer order the Bank of Japan to carry out operations on its behalf. The Japanese experience can thus serve as a model for China.
- Related article
"China Moves to Raise Interest Rates - Room still remains for additional rate hikes," China in Transition, October 29, 2004
November 5, 2004
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