IMF encourages China to shift to monetary policy based on inflation targeting and floating exchange rate

BOFIT Viikkokatsaus / BOFIT Weekly Review 2016/34

The latest IMF’s Article IV Consultation praises China’s formal deregulation of interest rates and adoption of a new exchange rate mechanism as steps towards an increasingly market-based policy regime. The IMF staff assessment found that it would be beneficial for China to introduce a floating exchange rate as rapidly as possible, preferably already by 2018. They further recommended widening the fluctuation band for current the trade-weighted exchange rate as a policy transmission mechanism, noting that a more flexible exchange rate would protect the economy from external shocks and confer monetary policy independence as access to capital markets opens up. The yuan’s current valuation is now largely in line with fundamentals according to the IMF.

The IMF would like to see Chinese monetary policy adopt a system where the government sets an explicit medium-term inflation target for policy guidance and gives the central bank operational independence over achieving the target. The IMF said the 7-day repo rate could be used as the new policy rate, providing a basis for the central bank’s earlier proposed interest rate corridor (see BOFIT Weekly Review 48/2015). The shift to market-based monetary policy should be accompanied by an increase in exchange rate flexibility. The IMF would also like to see consistent, clearly communicated monetary policy to improve its efficiency.

Unlike many market observers, the IMF sees China’s current accommodative monetary stance as appropriate. The staff noted that economic fundamentals suggest that real interest rates could even be higher. The IMF expects a pick-up in inflation, so interest rates should rise accordingly. Slightly higher interest rates would help quell the incessant build-up in indebtedness, particularly borrowing outside the official bank sector, which is beyond most of the regulatory controls.

In contrast, the IMF took a cautious view on China’s efforts to lift capital controls. The opening up of capital account should only proceed after China’s financial system and corporate governance are improved and exchange rate flexibility has increased.

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