Globalization And China's Monetary Policy Reform

The monetary policies of developing countries are facing unprecedented challenges under globalization and becoming more and more important for sustainable growth. So the study of developing country's monetary policy has attracted increasing enthusiasm from both academics and policy-makers all around the world. China is not only the biggest developing country on the globe, but also a transitional economy that is moving from the traditional power-based command economy to modern rule-based market economy; the significance of the issues on monetary policy, particularly the reform of China's monetary policy under globalization could never be over-estimated.This paper investigates the effectiveness of China's monetary policy in the period of 1998-2003, in which China sped up its pace of opening up to the outside world under globalization while keeping a reasonably stable monetary policy or the so-called "stable and healthy" monetary policy. To the surprise of the author, China's monetary policy was largely ineffective in this period, because China's financial system was at the same time accumulating huge risks that greatly undermine the 7-8% yearly growth rate of the economy.Moreover, after 2002 when China finally became a member of the World Trade Organization, the interest rates directly controlled by the central bank began to give wrong signals to the market and misguided the flow of bank funds, while China's currency which had been pegged to the US dollar at the rate of 8.28 yuan for 1$ since 1998 was under increasing pressure to revalue. By the end of 2003, China's exchangerate policy experienced the greatest speculative attacks under the rigidity and reluctance of China's financial system to reform, the evidence of which was the rapid growing foreign exchange reserves and the picking-up of the inflation rates that had kept below 1% since 1998.The author starts to expose China's monetary policy problem from an international perspective and by international comparison and international experience. In the process the fundamental theories, particularly the goals, functions and tools of the central bank and/or monetary policy for an open economy are illustrated to compare China with both advanced market economies such as the United States and other developing economies.Game theory is then applied to analyze the behavior of China's commercial banks under strict controls of the central bank. And contrary to China's conventional wisdom that blames the troubled transmission channel for the ineffective monetary policy, the author's finding is that the central bank's too much control in many areas of the financial system and too little control in other areas are responsible for the huge banking risks and the policy's ineffectiveness, particularly the out-of-date reserve system, the structure of interest rates and lack of supervision of banks.Based on the above well-founded analysis and the popular theory of financial deepening, the author recommends for China's monetary authorities a systematic institutional reform in the financial system to reduce risk and to improve the effectiveness of monetary policy. The prescriptions include establishing risk rating system for all banks, mandatory and discriminatory deposit insurance system, letting interest rates charged by banks be determined by the market, abolishing interest rates on reserves, pegging the Renminbi to a basket of currencies or implementing credible crawling pegs, freeing international capital flows under prudential regulation and supervision, and improving the definition of money supply measures.This paper is composed of three parts. The first part introduces the background setting of the paper and surveys some of the most important literature on monetary policy. The second part puts China's central bank and monetary policy in an international perspective, and demonstrates the fundamental theories andinternational experience on the topic. The third part explores in detail the ineffectiveness of China's "stable and healthy" monetary policy under globalization, the institutional components of the repressed monetary and financial system and their impact on monetary policy, and the reforms needed to make China's monetary policy more effective.