Instruments II: The Evolution of Policy Strategy

This is the second of a pair of chapters discussing how Chinese monetary policymakers deployed the instruments they had in the 2000s, and how their strategy evolved. Here we first look at policy strategy for influencing the interbank market. We argue that policy control here was limited by the structural liquidity surplus discussed in the previous chapter, as well as by the fact that many Chinese banks did not tend to continuously optimise their reserve holdings, making demand for reserves unpredictable. The People’s Bank of China could use open market operations to influence and smooth market rates, but not control them outright. The lack of control over market rates, as well as uncertainty about transmission from interbank market conditions to bank lending behaviour, forced authorities to rely more heavily on direct banking controls to restrain credit and money expansion.