Bank for International Settlements

People’s Bank of China

English

Research Papers in Economics

124  BIS Papers No 23
 
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Current Account Capital Account
Errors and Omissions Changes of Foreign Reserves
Challenges to China’s monetary policy 
People’s Bank of China 
In recent years, China’s economy has witnessed rapid, sustained and healthy growth, particularly after 
its accession to the WTO. Regardless of the considerable negative impact of SARS on several sectors 
and regions, GDP grew 9.1% in 2003, while CPI rose by 1.2%. Nonetheless, with financial and 
economic globalisation and domestic reform well under way, China’s monetary policy now faces 
severe challenges. 
1.  Strong growth of foreign reserves makes neutralisation more difficult 
China enjoys a balance of payments surplus, due to its robust growth and improving external 
conditions, which has resulted in rapidly increasing foreign reserves (Graph 1). The surplus is largely 
on the capital and financial accounts, with current account surpluses kept small and declining. From 
1994-2003, the annual current account surplus averaged USD 19.9 billion, while the annual capital 
and financial account surplus reached USD 22.2 billion. In the first half of 2003, the current account 
surplus actually declined year on year, while the capital account surplus grew significantly. FDI proved 
to be the major source of capital inflows, with the FDI surplus totalling USD 26.9 billion in the first half 
(total capital account surplus amounted to USD 44.4 billion). As a result, foreign reserves reached 
USD 346.5 billion by the end of June 2003. 
Graph 1 
Changes in China’s BOP and foreign reserves 
The People’s Bank of China (PBC) has clarified that its policy is not aimed at trade surplus, but at a 
relatively balanced current account. In order to maintain a sound balance of payments position, the 
People’s Bank of China has made efforts to relax constraints on foreign exchange purchases by both 
enterprises and individuals, including: 
•  Considering the adoption of a Qualified Domestic Institutional Investors (QDII) system, 
following the adoption of the Qualified Foreign Institutional Investors (QFII) system. BIS Papers No 23  125
 
•  Relaxing the constraints on enterprises’ foreign exchange holdings. 
•  Simplifying verification procedures for both imports and exports. 
•  Modifying regulations on multinationals’ non-trade foreign exchange sales and purchases, so 
as to facilitate their operation in China. 
•  Raising the limit for individuals’ foreign exchange purchases and relaxing the restriction on 
foreign currency taken abroad. 
•  Launching a pilot project on the reform of overseas investment regulation, gradually 
expanding channels for capital outflow. 
Since 2003, mounting pressure on China from abroad to appreciate its currency has triggered 
overreaction in financial markets, leading them to expect a renminbi appreciation. To maintain the 
economic stability of China and of Asia as a whole, China has taken steps to alleviate the appreciation 
pressures and maintain economic equilibrium both domestically and externally. First, it adheres to its 
commitment of keeping a stable renminbi. Second, efforts are being made to achieve a sound balance 
of payments position. Third, open market operations (OMOs) to sterilise the monetary impact of 
reserves have intensified since 2003. In particular, gross issuance of central bank bills by the PBC 
amounted to RMB 455 billion in the first eight months of 2003. In addition to OMOs, the PBC raised 
the reserve requirement by 1 percentage point, so as to moderate pressures on the monetary base 
and the monetary supply posed by the increasing renminbi position resulting from foreign exchange 
purchases. Fourth, the PBC has been keeping a closer watch on exchange rate movements of the 
renminbi and international currencies.  
Due to moderate global political conditions and reduced uncertainties, the world economy has gained 
momentum and external conditions for China are expected to improve further. In this setting, imports 
and exports will still be substantial and capital inflow will still see a rapid increase. Nonetheless, further 
US dollar weakness may lead to additional appreciation pressure on the reminbi. The reminbi interest 
rate is higher than the US dollar interest rate following successive interest rate cuts in the 
United  States, which creates arbitrage opportunities between the reminbi and the US dollar. 
Consequently, sales of foreign exchange could increase significantly and sterilisation could become 
even more difficult and costly. 
2.  A partially overheated economy fuels underlying inflation pressure 
The partial overheating can be seen in three aspects: 
•  There has been a substantial increase in fixed asset investment in several sectors and 
regions.  
Total fixed asset investment increased by 30.5% in the first three quarters of 2003, of which 
investment in the real estate sector increased by 33%. In the first eight months of 2003, real 
estate investment increased by over 50% (in some cases nearly 90%) in eight provinces out 
of the total 31 provinces and municipalities. Additionally, the investment structure in the real 
estate sector is not reasonable, with investment in residential space rising only by 28% and 
that in office building and commercial space rising by 39.8% and 44.6% respectively. 
•  Some industrial sectors experienced rapid growth and overlapped construction emerged 
again, which could lead to excess supply in these sectors in the future. In the first eight 
months, investment in steel, cement, aluminium, automobiles and textiles increased (year on 
year) by 140%, 130%, 150%, 84% and 140% respectively. 
•  Rapid investment growth has mainly been financed by the high increase in bank credit. Bank 
credit has funded 25% of fixed asset investment, which increased by 52%. The especially 
rapid growth in some sectors may thus imply significant financial risks. By the end of 
September, total outstanding loans, including RMB and foreign currency loans, had 
increased by 23.7%. New lending (net) reached RMB 2.7 trillion, 1.3 trillion higher than in the 
same period last year. RMB new lending (net) increased by RMB 2.5 trillion, 1.1 trillion 
higher than in the same period last year, or RMB 620.3 billion higher than all of 2002. 126  BIS Papers No 23
 
In response to overheating, the PBC mainly resorted to economic management efforts to contain the 
particularly large increase in the credit and monetary supply. This included open market operations to 
drain liquidity, higher reserve requirements, window guidance and structural adjustments (for instance, 
intensified regulation of lending to the real estate sector and a clampdown on illicit real estate loans). 
In general, policy measures taken have started to take effect. However, to completely eliminate the 
source of overheating requires further reforms on investment and financial institutions and greater 
efforts to boost capital markets to reduce the proportion of indirect financing. 
Associated with the partial overheating of fixed asset investment, producer prices and real estate 
prices rose continuously, with only a moderate rise in CPI. Therefore, China’s monetary policymakers 
have to be alert to either inflation or deflation, which highlights the importance of a correct assessment 
of the economic outlook. In the first nine months of 2003, CPI rose by only 0.7% year on year, which 
indicates that the large increase in credit and monetary supply since the last quarter of 2002 has not 
been fully reflected in CPI. However, the underlying inflation pressures are still worth monitoring 
closely. Once inflation pressures are transmitted to asset prices, including prices of real estate, stocks 
or other investment instruments, a bubble could take shape, which is even more damaging. On the 
other hand, the moderate positive increase in CPI mainly came from price rises for food and some 
services, whereas the movements in food prices mainly reflected seasonal factors and some external 
shocks, including SARS or natural disasters. According to the estimate of the National Bureau of 
Statistics, food prices rose by 2.2% in the first three quarters, which contributed 0.7 percentage points 
to the increase in the overall price level. In other words, if food and energy are excluded from the CPI 
basket, the core inflation could be negative, representing a still oversupplied market. 
Graph 2 
Changes in price indices in China 
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CPI (y-o-y)
Raw material purchase price
index (y-o-y)
Industrial goods producer
price index (y-o-y)
%
 
3.  The rising money market interest rate highlights the importance of 
coordination between monetary and fiscal policy 
After late August 2003, the interest rate in the money market rose rather quickly, due to the increase in 
reserve requirements and new stock issues. From 23 August to 30 September, the interbank lending 
rate gained 45 basis points and the repo rate 97 basis points. The rapid rise in the money market 
interest rate led to a substantial increase in the cost of bond financing and therefore a sharp decline in 
treasury bond prices. To maintain the stability of the money market interest rate, the PBC employed BIS Papers No 23  127
 
various monetary policy instruments, including combined open market operations of various types and 
maturities. The aim was to meet the need for liquidity of the financial system and ensure steady growth 
of the monetary base. Given that treasury bonds in China are mainly in medium and long maturities, 
instruments for open market operations are rather limited. As bond financing becomes more costly and 
the contribution of debt service payments to the fiscal deficit increases significantly, the Ministry of 
Finance is planning to adjust the maturity structure of treasury bonds, introducing more short-term 
treasury bonds. 
Faced with a complex economic and financial situation both at home and abroad, and severe 
challenges to monetary policy, the PBC will continue to be forward-looking, active and flexible in its 
monetary policy management. At the same time, it will keep on improving indirect management and 
enhancing coordination among various macroeconomic polices. Only in this way can the reminbi’s 
value be secured and monetary policy’s ultimate target of boosting economic growth be achieved. 

Globalisation and monetary policy in emerging markets

http://www.bis.org/publ/bppdf/bispap23h.pdf

Globalisation and monetary policy in emerging markets

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Research Papers in Economics