Money supply, or money stock, is the total amount of money in circulation or in existence in a country at a given time. Money supply impacts price levels, capital availability, inflation, and the overall business and economic cycle of a country. A high velocity of circulation leads to more spending power and lower interest rates, which increases the amount of capital available for investments, businesses and spending. The reverse occurs with low velocity of money supply.
Government authorities closely observe money supply and take necessary actions suitable for the overall economy or for selected sectors. Almost all countries in the world control their respective money supplies through their central banks. The Federal Reserve Bank (FRB) controls supply in the United States and the People’s Bank of China (PBOC) controls supply in China (to find out more, read: How The Federal Reserve Manages Money Supply).
China is the second largest and fastest growing economy in the world. The nation has a unique socialist open-market economy. China's government retains tight control but remains open to free market forces. As a manufacturing and export-driven economy that receives tremendous amounts of forex capital for its exports, the Chinese currency forex rates also impact the country's money supply. This article discusses the main methods used by China to control its money supply and forex rates. China's policies differ from conventional methods used by other countries because of the country's unique economic system (To learn more, read: Socialist Economies: How China, Cuba and North Korea Work).
The Traditional Chinese Economy
As a manufacturing and export-driven economy, China runs a trade surplus. It sells more to the world than it purchases. Chinese exporters receive U.S. dollars (USD) for their exports but must pay for local expenses and wages in local currency yuan or renminbi (RMB). Due to the huge supply of U.S. dollars and the demand for yuan, the rate of yuan can rise against the U.S. dollar. If that happens, Chinese exports become costlier and lose their competitive price advantage in the international market. This is problematic for the Chinese economy resulting in lesser or no sales of manufactured goods, widespread unemployment and economic stagnation. The Chinese central bank PBOC intervenes to avoid this situation and keeps the rates lower through artificial measures.
For the last 10 years, the Chinese yuan exchange rate to the U.S. dollar has remained stable and in the range of 6.1 to 6.9. Graph courtesy: MacroTrends
Additional Changes in the Last Decade
The Chinese money supply in recent times has shown consistent growth. Graph courtesy: TradingEconomics
Along with the money supply, the Chinese GDP has also increased in similar proportions. Graph Courtesy: TradingEconomics
The relationship between China's currency and economy is interesting because its export-dependent economic system works differently from that of other countries. The last 10 years have seen substantial change, the most remarkable of which has been the opening up of the Chinese economy. Major reforms have increased China's market orientation.
The period has seen the monetization of a variety of resources and their availability to the open market, which has attracted large-scale foreign investment. The resources include manufactured goods, infrastructure, technology and natural resources as well as human capital and labor. There has been an increase in demand for the Chinese currency, which stimulated commercial bank lending and finally increased the money supply. The money supply has risen significantly over the last 10 years. During high and consistent growth rates, China managed the increasing money supply effectively while keeping the currency rates stable.
How does China check its money supply? Here are the principal methods used:
- Controlling Forex Rates: One major task of the Chinese central bank, the PBOC, is to absorb the large inflows of foreign capital from China’s trade surplus. The PBOC purchases foreign currency from exporters and issues that currency in local yuan currency. The PBOC is free to publish any amount of local currency and have it exchanged for forex. This publishing of local currency notes ensures that forex rates remain fixed or in a tight range. It ensures that Chinese exports remain cheaper, and China maintains its edge as a manufacturing, export-oriented economy. Above all, China tightly controls the foreign money coming into the country, which impacts its money supply. (For more, read: The Reasons Why China Buys U.S. Treasury Bonds.)
- Sterilization: The PBOC's actions create some adverse consequences. The bank increases the supply of local currency in domestic markets, which increases the chance of high inflation. To cut back on excess money supply, the PBOC sells the required amount of domestic currency bonds, which takes away the excess cash from open markets. The PBOC also buys domestic currency bonds to infuse cash in the markets when needed.
- Printing Currency: Printing domestic currency is another measure applied by China. The PBOC can print yuan as needed although this can lead to high inflation. However, China has tight state-dominated controls on its economy, which enables it to control inflation in a different way compared to other countries. In China, changes are made to subsidies and other price-control measures to check inflation.
- The Reserve Ratio: Commercial banks are required to keep a percentage of their total deposit amount with the central bank of the country, which is known as the reserve ratio. If the central banks reduce the reserve ratio, commercial banks keep less money as a reserve and have more money available to increase the money supply (and vice versa).
- The Discount Rate: If commercial banks borrow additional money from central banks, they pay interest on the amount per the applicable discount rate. Central banks can change the discount rate to increase or decrease the cost of such borrowings, which eventually impacts the availability of money in the open markets. Changes in discount rates are widely followed across the globe to control money supply.
The Bottom Line
Some of the measures used by China to check money supply apply globally to all countries while some are unique to China. As a fusion of a socialist and free-market economy, China has devised its own processes to keep a firm grip on its economy. China is established as a financial superpower and, through its controlled measures, it is experiencing economic growth.