Chinese inflation, monetary policy and the dollar peg

By J James Reade, Lecturer, Department of Economics, University of Birmingham, and Ulrich Volz, Senior Economist at the German Development Institute

China is grappling with rising inflation. Annual consumer price inflation reached a 28-month high of 5.1% in November (Financial Times 2010a). And even though inflation figures for December were a bit lower, at 4.6% (Financial Times2011a), they still contained rising prices, especially of staple foodstuffs. There can be no doubt that inflation is a policy priority for the Chinese government.

On 8 February 2011, the last day of the Chinese New Year celebrations, the People’s Bank of China, China’s central bank, raised the one-year base lending rate for the third time since October, taking the lending rate to 5.81% (Financial Times 2011b). In January, it had already increased the required deposit reserve ratio by half a percentage point for all banks, lifting the reserve ratio to 19.5% for the country’s main lenders (Financial Times 2011c).

This flurry of measures shows China’s central bank determination to fight inflation. Its central bank has, over a long time, made great efforts in reforming the conduct of monetary policy with more market-determined interest rates designed to improve the allocation of credit. Yet this monetary reform towards the use of more price-based mechanisms has been impeded by a lack of independence. Indeed, much of the influence over Chinese monetary policy rests with the National Development and Reform Commission, which dominates decisions over macroeconomic policy (see e.g. Financial Times 2010b). The Commission has favoured quantitative measures aimed at steering the amount, rather than the price, of credit, effectively preventing the central bank from using its entire monetary toolkit.

A closer look at the conduct of Chinese monetary policy shows that hitherto the interest rate has hardly been used as an effective monetary policy tool (e.g. Koivu 2009, Reade, and Volz 2010). Rather, monetary policy has relied upon open market operations for sterilising foreign exchange intervention and changes in the reserve requirement ratio to affect output growth (the reserve requirement ratio was raised six times in 2010, and again in January 2011). Moreover, even after the abolition of credit plans, which formed the basis of bank lending until the end of 1997, the central bank continues to issue direct lending guidelines and orders to commercial banks under the so-called window guidance policy.

The sixteen articles

The central bank’s struggle to combat inflation with market-based monetary policy tools has been highlighted recently when the State Council issued a set of new policy documents (“the Sixteen Articles”) outlining China’s new inflation-fighting strategy. As pointed out by Huang (2010), the Sixteen Articles don’t mention the term “monetary policy” at all. Instead, the strategy lists a host of administrative inflation-fighting measures at the micro level, ranging from a better management of farms for winter grains and oils to better cotton transportation in Xinjiang (Huang 2010).

So far, the reliance on monetary tools and administrative measures that emphasise the amount rather than the price of credit has had at least one advantage. It has helped China to largely insulate its monetary policy from international monetary movements (Reade and Volz 2010). While the maintenance of capital controls has certainly helped in this (Ma and McCauley 2007), arguably, it would have been much more difficult for the central bank to exert relatively autonomous monetary policy in the face of the dollar peg had it relied on a predominantly interest rate-based monetary policy. But even though the dominance of administrative tools in monetary policymaking has provided some policy space and diminished pressure on the central bank to adjust its interest rates to US monetary policy, it has come to the detriment of a development of Chinese financial markets and a more efficient allocation of capital. Indeed, negative real interest rates and a lack of attractive alternative investment opportunities in Chinese financial markets have helped fuel bubbles in the property and stock markets.

Overall, China’s monetary policy mix has worked reasonably well thus far – after all, the average inflation rate has been just 3.4% over the past four years in the face of average real GDP growth of 10.8%. Nevertheless, with rising inflationary pressure from abundant international liquidity, it will become increasingly difficult to contain inflation with a monetary framework centred on administrative measures rather than price-based policies. With negative real interest rates for deposits and growing asset and property bubbles, the time is certainly ripe for further monetary tightening in China. Instead of focusing on micro-management of the economy, as put forward in the Sixteen Articles that outline China’s new inflation-fighting strategy, the government should grant the central bank the room for further reform of its monetary policy approach. To make more efficient use of the interest rate instrument, this will also require a further loosening of the dollar peg.


Financial Times (2010a), “China Inflation Surges to 25-month High”, Financial Times, 11 November.

Financial Times (2010b), “China: What Didn’t Happen”, Financial Times, 28

Financial Times (2011a): “PMI Data Raise Fears Over Inflation in Asia”, Financial Times, 1 February.

Financial Times (2011b), “China in Fresh Interest Rate Rise”, Financial Times, 9 February.

Financial Times (2011c), “China Steps up Fight Against Inflation”, Financial Times, 14 January.

Huang, Yiping (2010), “A Good Example of Dealing with Macro Problems Using Micro Tools”,, 27 November.

Koivu, T (2009), “Has the Chinese Economy Become More Sensitive to Interest Rates? Studying Credit Demand in China”, China Economic Review, 20(3):455-470.

Ma, G and RN McCauley (2007), “Do China’s Capital Controls Still Bind? Implications for Monetary Autonomy and Capital Liberalization”, Working Paper 233, Bank for International Settlements, Basel.

Reade, JJ and U Volz (2010), “Chinese Monetary Policy and the Dollar Peg”, School of Business & Economics Discussion Paper 2010/35, Freie Universität Berlin.

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