China's monetary policy is complex and shifting. Here's what you need to know

  • China's central bank, the People's Bank of China, doesn't have a single primary monetary policy tool like the U.S. Federal Reserve.
  • The PBOC instead uses multiple methods to control money supply and interest rates in the world's second-largest economy.
  • Those tools include open markets operations, the reserve requirement ratio and various types of PBOC loans to Chinese banks.

Investors have for years watched the U.S. Federal Reserve for information about where global markets are headed: The decisions made by the American central bank influence assets around the world.

Increasingly, however, markets are also focusing on changes out of the world's second-largest economy, attempting to analyze its policy decisions to understand how vast flows of Chinese funds will react.

But the Federal Reserve system is quite unlike China's economic policy regime.

When it comes to where money is headed within the U.S. economy, investors watch for changes that the Fed makes to its target for the "federal funds rate" — the interest benchmark that influences borrowing costs, asset prices and exchange rates in the American economy. In China, such a signal is less clear because the country doesn't have a single representative policy rate like the Fed's.

Instead, the central bank uses multiple tools to control interest rates and the amount of money in the Chinese economy. So, interpreting what China wants to achieve can sometimes be a confusing affair.

Chinese policymakers also frequently add new tools or retire older ones as they modernize their country's system into something more aligned with those in developed countries. Keeping track of those changes can add to the difficulty of reading the central bank's signals.

What is China's central bank?

China's central bank is called the People's Bank of China, or PBOC for short. Like its counterparts in the advanced economies, the PBOC has the dual mandate of maintaining price stability and promoting growth through the management of monetary policies.

Monetary policy refers to the ways central banks manage the supply of money and interest rates in their economies. Those policies are adjusted according to the economic conditions that a country is facing.

For example, when central banks want to boost growth during a downturn, they cut interest rates. Doing so lowers borrowing costs, which encourages businesses and individuals to take out loans to invest and make purchases to stimulate the economy.

How does China manage its monetary policy?

The PBOC's website lists seven tools that it uses to make adjustments to its monetary policy. They are:

  • Open market operations, OMO

In China, open market operations mostly involve two processes called repurchase or reverse repurchase agreements. The former term, as it is used in China, means removing liquidity from the system when the PBOC sells short-term bonds to some commercial banks.

It also does the opposite for a "reverse" repurchase agreement, buying up those contracts, so banks have more cash on hand.

Those operations allow the PBOC to control money supply and interest rates on a short-term basis — the assets are normally offered on time frames ranging from seven to 28 days.

  • Reserve requirement ratio, RRR

The reserve requirement ratio refers to the amount of money that banks must hold in their coffers as a proportion of their total deposits. Lowering the required amount will increase the supply of money that banks can lend to businesses and individuals, and therefore cutting borrowing costs.

Increasing the ratio of what banks need to keep in reserve achieves the opposite result.

  • Benchmark interest rates

The PBOC controls the benchmark one-year lending and deposit rates, which affects the borrowing costs for banks, businesses and individuals.

It last adjusted those rates in October 2015 and now allows commercial banks some leeway to go above or below the official level in determining the interest rates that they charge.

A Chinese national flag flies above the People's Bank of China (PBOC) headquarters in Beijing, China, on Monday, March 7, 2016.
Qilai Shen | Bloomberg | Getty Images
A Chinese national flag flies above the People's Bank of China (PBOC) headquarters in Beijing, China, on Monday, March 7, 2016.
  • Rediscounting

The PBOC offers an option to banks to "rediscount" the loans that they extend to their customers.

The monetary policy tool involves the central bank buying up existing loans from commercial lenders, giving them some extra liquidity. It's a complicated concept, so here's an example to illustrate the process:

A consumer takes a loan of $10,000 from a bank, with a promise to re-pay $12,500 at a later date. That loan agreement is said to be bought by the bank at a price of $10,000, which is a discount to the $12,500 it will ultimately receive in return. Subsequently, the bank sells that agreement to the PBOC for $11,000, which is another discount — or "rediscount" — of the contract's paper value of $12,500.

The PBOC charges an interest rate on those funds it lend to the banks, which would influence other borrowing costs in the banking system.

  • Standing lending facility, SLF

Standing lending facility is also a type of PBOC lending to commercial banks. Introduced in 2013, such loans have a maturity period of one to three months — longer than funding options such as the open market operations.

To receive money through this framework, banks must guarantee assets with high credit ratings as collateral. That means such funds are usually only available to the larger lenders.

  • Medium-term lending facility, MLF

Chinese banks get funds with even longer maturities — typically three months to a year — from the PBOC through the medium-term lending facility. The funding channel, introduced in 2014, allows the central bank to inject liquidity into the banking system and influence interest rates for longer-term loans.

Like the standing lending facility, banks must put up collateral to receive funds. Unlike the SLF, however, a wider range of collateral is accepted under the medium-term version. That includes government bonds and notes, local government debt and highly rated loans of small companies.

  • Pledged supplementary lending, PSL

As one of the newest monetary policy tools in China, pledged supplementary lending was introduced to guide long-term interest rates and money supply. Such funds are injected into selected banks so that they can provide loans to specific sectors such as agriculture, small businesses and shantytown re-development. The banks that have received those particular funds are the three Chinese "policy" lenders: China Development Bank, Agricultural Development Bank of China and the Export-Import Bank of China.

How has China's monetary policy evolved?

In the past, the PBOC has mostly focused on managing the quantity of money in its economy and setting quotas on how much banks can lend. That took a definitive turn in 2018 when the central bank stopped setting those specific targets.

Instead, China is seeking to establish an interest rate regime like those used by the Fed and European Central Bank. One possibility, according to analysts, is an "interest rate corridor" with the floor and ceiling determined by the PBOC, while allowing the market to set rates within that band.

But that's still a work-in-progress for the PBOC.

What else does the PBOC do?

One of the PBOC's key responsibilities is to maintain the stability of the Chinese yuan. In addition to managing money supply and interest rates, the central bank guides movements of the yuan against a basket of currencies that include the U.S. dollar, the euro, the Japanese yen and the South Korean won.

As part of that mission, the PBOC manages the country's foreign currency assets, which it buys and sells to keep the yuan stable within the intended exchange rate range.

WATCH: How the US and China's monetary policies differ