Managing Multi-Objective Monetary Policy: From the Perspective of Transitioning Chinese Economy, Michel Camdessus Speech by Zhou Xiaochuan
1. Several questions
Should central banks have one objective or multiple objectives? Before the GFC, many major central banks focused on price stability and adopted inflation targeting. After the GFC, many central banks strengthened or were given financial stability and financial regulation roles. The persistently sluggish economic recovery also sparked theoretical discussions on monetary policy frameworks other than inflation targeting, such as nominal GDP targeting that focuses on both growth and inflation. For emerging market economies, monetary policy will undoubtedly be affected by balance of international payments and capital flows. Here the question is: should balance of international payments be an objective of central banks?
A related question is the independence of central banks. The general view is that central banks and monetary policy should be independent. Some may argue that the independence of central banks and the independence of monetary policy should be appropriately differentiated and the emphasis should be on the independence of monetary policy. For central banks with a single objective, it is relatively easy to be independent. However, if a central bank has multiple objectives, it may be harder to be immune from the political reality. The reason is that, on the one hand, multiple objectives require more coordination and joint efforts with other government agencies and regulators, and on the other hand, functions such as macro-prudential and financial regulation by themselves are sensitive mandates for central banks.
The third question is the relationship between monetary policy and fiscal policy. In theory, fiscal policy and monetary policy have clear division of function. In practice, they can often have frictions, while sometimes they may also overlap. In the wake of the GFC, fiscal policy was not adequately employed, which led to passive over-reliance on monetary policy. A specific question is: in the event of a systemic risk, especially when fiscal policy is constrained or fiscal resources are limited, should and if so, how do central banks join in rescue programs?
The fourth question is what is special about central banks in transition economies. Economic transition refers to transformation from Soviet-type central planning to a market economy. At the early stage of economic transition, market foundation for macroeconomic management usually lacks, financial markets and products are underdeveloped, fiscal resources are extremely limited with large financing gaps. If central banks do not promote financial reforms or development of financial markets, there would be no healthy financial institutions or market mechanisms, let alone smooth transmission of monetary policy. Furthermore, like other emerging market economies, transition economies have a low level of development and hoped to make up for the “lost decades”. It follows naturally that they would also put emphasis on economic growth. Therefore, we need to take this context into account when trying to understand the objectives of central banks in transition economies.
2. Objectives and roles of the People’s Bank of China (PBoC)
The single objective of maintaining price stability is an enviable arrangement, as it is simple, easy to measure and communicate. However, it is not yet realistic for China at this stage. For a long time, the annual objectives of the PBoC mandated by the Chinese government have been maintaining price stability, boosting economic growth, promoting employment, and broadly maintaining balance of payments. The feature of a transition economy also requires the PBoC to promote reform and opening up as well as financial market development. Reform and financial market development will help achieve financial stability and economic transition from a dynamic and medium-to-long term perspective, and transition will in turn support a more efficient and stable economy. The PBoC attaches high priority to price stability, which is an objective of most central banks. Boosting economic growth and promoting employment are broadly overlapping goals and some central banks also have similar objectives. However, the PBoC has some distinct roles, which include promoting reform and opening up, developing financial markets, and maintaining balance of payments, and the PBoC also works closely with other government agencies. Why does the PBoC have these objectives? Why the central bank, not the ministry of finance?
Why does the PBoC support and carry out reform and opening up? A common problem at the early stage of transition was substantial distortions in price and tax systems, distribution of goods and services through non-monetary means, and very inefficient resource allocation. Banks were not commercial banks in real sense. Commercial banking laws, accounting and auditing standards, loan classification and financial reporting systems were yet to be put in place. The question is: should the central bank use monetary policy to support the reforms to make the price and tax systems more market-based and to distribute goods and services by monetary means? Losses resulting from the distortions in resource allocation usually ended up in the banking system. An observation is that massive non-performing loans (NPLs) have led to the collapse of the banking system in many transition countries. China’s banking system faced the same problem in the process of transition. The Asian financial crisis aggravated and exposed these problems. Indicators such as capital adequacy ratio (CAR) and NPLs of China’s banking sector worsened substantially. Many international observers commented that large Chinese banks were “technically insolvent”. At that moment, in the absence of reform and opening up, there would have been no healthy financial system, no financial stability, impossible to achieve price stability, and no way to make monetary policy transmission effective. Therefore, at that stage of transition from central planning to a market economy, carrying out financial reforms as well as making the financial system healthy and stable may even override the conventional objective of price stability.
When the old banking system in transition economies is distressed and fiscal position is weak, small transition economies may manage to restore the health of financial institutions by selling them. It is also relatively easy to find foreign investors willing to take over. This was a common practice in transition countries in Central and Eastern Europe. But China had a large and multi-tiered banking system, and it was hard to find foreign investors capable and willing to get fully involved. China had to rely on its own efforts to rescue and transform banks. However, fiscal resources at that time were inadequate. In the 1990s, fiscal revenue only accounted for about 10% of GDP at the lowest point. Besides, public finance faced a heavy burden resulting from the legacy of the planned economy. As a result, the PBoC had to consider ways to rescue financial institutions and safeguard financial stability. During this process, the PBoC split non-performing assets from banks, recapitalized problem banks, and supported the efforts by large banks to go public, shift to mixed ownership, strengthen corporate governance and improve international competitiveness. Through reforms, the PBoC safeguarded macroeconomic stability and China recovered from the Asian Financial Crisis. At the same time, focus was put on institutional development, including regulatory regime, laws and regulations, accounting and auditing standards, loan classification and financial reporting systems, which laid the foundation for developing a sustainable and sound banking sector and maintaining financial stability.
Why does the PBoC develop financial markets? Transition economies typically have a rigid price system and lack financial markets and products that mature economies typically have. The overwhelming majority of centrally planned economies didn’t have stock markets or corporate bonds at the beginning of transition. There is a shortage in the variety of financial products, let alone derivatives for risk management. In this context, central banks would not be able to make monetary policy more market-based, nor develop a modern macroeconomic policy framework even if they want to. Moreover, monetary policy would not transmit normally. At the early stage of reforms in China, the financial sector did not have sufficient incentives to develop financial markets. Thus, the PBoC had to consider undertaking this task, also assigned by the central government. Therefore, promoting financial market development is an inherent requirement for the PBoC to better fulfill its monetary policy mandate.
Why does the PBoC pay attention to balance of payments? In fact, for all emerging market economies, balance of payments, capital flows, exchange rate and foreign exchange reserves are all key factors affecting macro economy and monetary policy. It is not surprising that central banks from emerging market economies pay close attention to balance of payments. The IMF knows better about this. In addition, transition economies have their own unique features. Most of them experienced the collapse of international trade and sharp deterioration in balance of payments due to severe distortions typically seen in price, trade and exchange rate polices under planned economy.
During transition to a market economy, China learned from the outward-looking development strategy of East Asian economies. This development strategy contributed to the reform and opening up in various sectors of the Chinese economy. It also increased China’s dependence on international trade and foreign capitals. As a result, balance of payments largely affected the central bank’s monetary policy, money supply and price stability objective. Therefore, the PBoC must pay attention to balance of payments, and needs to assume accordingly roles such as managing the exchange rate, foreign exchange market, foreign exchange reserves, gold reserves, and balance of payments statistics. The public finance was in an extremely difficult situation during the early and middle stage of the transition, as there were sizable explicit and implicit fiscal losses, and understandably did not actively take care of such issues as banking reform, exchange rate and balance of payments. China’s developments over the years have shown that both domestic and external demand has undergone adjustments in the right direction. China has also weathered the Asian financial crisis, indicating that it is right for the PBoC to pay attention to balance of payments.
Meanwhile, striking the right balance between multiple objectives and the effectiveness of monetary policy is tricky. The PBoC’s pursuit of multiple objectives indeed has some impacts on its independence. There are tensions. The PBoC is tasked with carrying out reforms, which had to deal with inappropriate tax rates and tax regime in the financial system, dealing with historical liability to transform large financial institutions into healthy and modern corporations. Accomplishing these tasks requires the PBoC to coordinate and work with other government agencies. Maintaining a close tie with the government allows the PBoC to press ahead with these reforms. Or to put it differently, when China was transitioning from a central-planned economy to a market-based one, if reforms were not fully implemented, there would not have been enough instruments to conduct monetary policy and the transmission would also have been difficult and if the central bank only emphasized keeping inflation low and did not tolerate price changes during price reforms, it could have blocked the overall reform and transition. In the 1990s, the Law of the People’s Bank of China had some languages on the PBoC’s independence. Once the PBoC’s reform tasks are largely completed, the current objective function might change in the future.
To put it in a nutshell, the PBoC has multiple objectives, which not only include such four annual objectives as ensuring price stability, boosting economic growth, promoting employment, and broadly maintaining balance of payments, but also cover two dynamic objectives, namely, financial reform and opening up, and financial market development. The choice of a multi-objective central bank has to do with China’s circumstances as a transition economy.
3. Challenges brought by multiple objectives
A multi-objective mechanism has indeed posed some potential challenges. The first one is whether the mechanism can be expressed as a multi-objective function that can be optimized. For instance, it can be expressed in linear or log-linear multi-objective function, and it also formulates duality relationship with a general equilibrium, which can be proved if weights on various objectives can be appropriately determined by market prices. Besides, there are other technical challenges, which are summarized as follows:
There may be some overlap of objectives. For the PBoC, there is some overlap between objectives such as economic growth and employment. But this is an easy problem to manage. We can identify the overlap, and assign different weights to the non-overlapping parts.
There could be conflict of objectives. We are all faced with dilemma and trilemmas when making decisions on economic issues, which requires trade-off and balancing act. Mathematically, this is unavoidable but normal. Objectives in conflict in the objective function will cancel each other out during optimization.
There may be difficulty in aggregating multiple objectives and determining weights. This is a technical issue and can be dealt with by a combination of simulating a market mechanism and expert opinions. I will discuss this later.
Fourth, complicated models and difficulty in communication. It is certainly desirable to have simple models and a single objective. Yet central banks are faced with a complicated world and have in many cases far from simple mandates. Many central banks are assigned more responsibilities after the global financial crisis. For instance, the Federal Reserve now needs to supervise systemically important financial institutions in addition to its mandates of maximum employment and stable prices. The ECB has been tasked to lead the bank single supervisory mechanism (SSM) in the process of building the European Banking Union. Bank of England has resumed the role of prudential regulator. Therefore complication and complexity are unavoidable, and the difficulty in communication is in essence a reflection of the complexity of reality.
Fifth, the linkage between monetary policy and economic globalization remains a challenge. Most of the traditional monetary policy models focus on domestic situation. As global interactions become more significant, there are growing discussions on spillovers and spillbacks, while financial stability has also become a global issue since 2008. Linking different countries and different types of models is understandably very difficult. Multi-objective and multi-variate methods in theory could help better model domestic and international relations and interactions. But such methods remain to be fully tested and face many challenges such as the curse of dimensionality.
4. Optimization problem of a multi-objective monetary policy framework
(1) Weights for multiple objectives
When a central bank pursues multiple objectives at the same time, mathematically it is a multi-objective optimization model, which is very common in economics. Its objective function can be in a linear or log-linear form. The central bank maximizes the objective function by choosing appropriate policy variables in a General Equilibrium (GE) or a Dynamic Stochastic General Equilibrium (DSGE) setting. One of the key issues here is how to determine the weights on the different objectives in the objective function.
We all know that the GDP is calculated as the summation of a linear function of goods and services produced in an economy. The weights used are fair value prices determined by market supply and demand. When a central bank tries to define its objective function in its optimization problem, it can simulate the process of how fair value prices are determined on the market. By taking into account the opinions from decision-makers and experts, it could come up with fair values similar to those determined by market supply and demand. These fair values can then be used as weights in its objective function.
Besides, there are tolerance ranges for different policy objectives. Within these ranges, weights could be adjusted according to the deviation in the range interval. For example, during the crisis, China increased the weights on financial stability and soundness of financial institutions. During the period of high inflation, the weight on price stability would be increased; and when there is a large current account surplus or deficit, the weight on BOP would be commensurately increased. This is a dynamic optimization process in term of an intertemporal equilibrium model. Though this might make the objective function seem unstable, it is difficult to avoid, and would not become an obstacle for the central bank to pursue a multi-objective mechanism.
(2) Complication of model with vectors
Multiple objectives also make a central bank’s macroeconomic models more complicated. We need to take into account more variables in form of vector as well as the dynamic relations between these variables. We need to use methods such as VAR and SVAR to derive behavioral functions, but there are also many other challenges. One such challenge is the curse of dimensionality, although there are some technical solutions. For an economy in transition, a bigger challenge is insufficient size of data sample with the incomparability and structural breaks resulted from the constant change of economic institutions. For instance, in China, samples before 1980s are almost useless. Data in the 1980s and 1990s are also less useful. This means there will only be a small sample for modeling and analysis.
(3) Difficulty in communication
Complicated models pose challenges to communication. Models used in monetary policy decisions are dynamic and in form of vector, and there are complex relations and interactions between variables and their lags. This is very different from how most people think and what is in the textbooks. People tend to think in a scalar way, and their logics are usually expressed in words rather than in vector. Central banks are therefore always faced with a dilemma in communication: if the communication is simple, although it can be better understood by the public, it may fail to reflect the complexity of issue at hand; and if the communication is too complicated and technical, it can only be understood by few economists and market participants. Every central bank faces such a dilemma. What the PBoC does is to emphasize our communication with experts. We convey our messages as accurately as possible to those experts and let the messages trickle down to the public through experts, while also communicating in simplified forms directly to the public.
5. Concluding remarks
Today I tried to discuss the background of PBoC’s multi-objective monetary policy framework and the reasons why we choose this framework. We do not deny that there are costs incurred when we made our choice. The key is that the costs should not outweigh benefits. Compared to central banks of other transition economies, the PBoC has promoted reform, developed financial markets, maintained financial stability and created conditions to achieve our monetary policy goals. The gain is greater than the loss. Some commented that our institutional choice has resulted in problems such as excessive credit growth, high leverage ratio and shadow banking. But these are only problems when compared to other emerging economies. China today is still in transition, and our monetary policy targets and ideas behind them are still evolving. China has gone through a long period of transition, which has been reflected in the PBoC’s institutional arrangement. Ultimately the transition to a market economy will by and large be completed. The PBoC’s objective function will become more simplified and international experience will be of more practical relevance to us. We are paying close attention to international discussions on the Chinese monetary policy and will adjust our policy in a dynamic way to meet the demand of China’s economy, reform and development.
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