Posts filed under “Think Tank”

Has China’s Economy Become More “Standard”?

Has China’s Economy Become More “Standard”?
John G. Fernald, Eric Hsu, and Mark M. Spiegel
FRBSF Economic Letter 2014-30
October 6, 2014




Financial liberalization in China has broad implications, including changing how its central bank’s monetary policy affects the nation’s economy. An estimate of Chinese economic activity and inflation based on a broad set of indicators suggests that the way policy is transmitted to China’s economy has become more like Western market economies in the past decade. Although Chinese monetary policy may actually have exacerbated its economic downturn during the global financial crisis, a move toward stimulatory policy has helped ease its slower growth more recently.

China’s economy has experienced remarkable structural and institutional changes in recent decades. These changes may alter the efficacy of countercyclical monetary and fiscal policy on Chinese economic activity and inflation. Many studies (for example, Geiger 2006 and He et al. 2013) have found that market-oriented policies, such as changes in interest rates and reserve requirements, were relatively less important in China than more direct credit policies, such as “window guidance” for commercial bank lending levels. However, ongoing developments in China’s financial sector should, at some point, lead China’s monetary transmission mechanism to look more similar to that in the U.S. and other Western market economies (as described in, say, Bernanke and Blinder 1992).

Motivated by the evolving financial system, a recent study by Fernald, Spiegel, and Swanson (FSS 2014) re-examines the Chinese monetary transmission mechanism. FSS use a statistical model developed by former Federal Reserve Chairman Ben Bernanke and others to analyze U.S. monetary policy (Bernanke and Boivin 2003 and Bernanke, Boivin, and Eliasz 2005). Known as a FAVAR model, this approach uses numerous related data series to alleviate concerns that individual data might suffer measurement error or be inconsistently available. Using this approach with recent data, FSS find that interest rates and reserve requirements are more important than direct quantity measures of lending, in contrast to earlier findings.

In this Economic Letter, we summarize the findings in FSS. We then extend the data sample to assess Chinese monetary policy during the country’s recent modest economic slowdown. Our results indicate that policy has played a stimulatory—and hence smoothing—role during the slowdown.

Challenges of using Chinese data

A challenge when examining China’s monetary transmission mechanism is the quality of Chinese data, which are often considered questionable (Holz 2008, Nakamura et al. 2014, and Fernald, Hsu, and Spiegel 2014). The approach in FSS overcomes this obstacle by using a large number of economic indicators to estimate two unobserved factors that drive the systematic component of the data, representing output and inflation. This allows the incorporation of data series with potentially large measurement errors, and it minimizes ad hoc decisions about which data best capture the true movements in the Chinese economy. Indeed, Bernanke and Boivin (2003) and Bernanke et al. (2005) found that this approach provided better empirical estimates for the U.S. economy by incorporating the wide variety of output and inflation measures available.

In addition, because of the rapid institutional and structural change in China, it is important to focus on recent data. For example, data from the 1990s may not be relevant for understanding the current Chinese economy. FSS focus on data since 2000. Importantly, that includes the global financial crisis as well as the first half of 2014.

Evolution in China’s monetary transmission mechanism

In a country with well-developed financial markets, monetary policy affects the economy through market-oriented channels. For example, when the Federal Reserve adjusts its target for the interest rate on overnight loans between banks, all market rates throughout the economy adjust. Those changes, in turn, influence economic activity and, eventually, prices. In contrast, in China during the 1990s, market-based monetary policy instruments—including changes in interest rates—were generally considered inadequate to control China’s economy due to the slow pace of reform in the banking and financial sectors. As a result, studies of this period suggest that interest rate policies pursued by the People’s Bank of China (PBOC) had little, if any, impact on the real side of the Chinese economy (see Geiger 2006 and He et al. 2013). Instead, policymakers used more direct credit policies, such as “window guidance” by the PBOC, under which credit expansion was managed by direct control over the volume of commercial bank lending.

As the 1990s came to a close, however, financial liberalization in China appeared to increase the impact of monetary policy—particularly interest rate policies—on the real side of the Chinese economy. The impact of nonmarket policies such as window guidance may diminish as the financial sector develops, in favor of more standard instruments, such as policy interest rates. Still, financial liberalization is incomplete, in that China still sets ceilings on bank deposit rates and floors on lending rates (Liao and Tapsoba 2014). Thus, how standard China’s monetary transmission mechanism currently is remains an open question.

The FAVAR approach

To investigate this issue, FSS incorporate estimates of the Chinese output and inflation factors into a standard statistical model of how monetary policy affects the economy, known as a vector-autoregression (VAR). The combination is known as a factor-augmented VAR, or FAVAR. Under this approach, we use a statistical method known as principal components to boil down a relatively large number of data series into two factors corresponding to economic activity and inflation. Creating these summary indexes greatly simplifies the statistical analysis of how changes in policy affect the economy over time. We update the set of 34 indicators used by FSS for Chinese output and inflation with data through June 2014. In addition to economic activity and inflation factors, we include three PBOC “policy variables”: the quantity of bank lending, bank reserve requirement levels, and a benchmark short-term interest rate set by the PBOC. The first variable captures changes in the PBOC’s window guidance. In principle, changes to any variable can affect all the other variables, but some respond more quickly than others. These differences help us identify policy changes.

For example, we allow lending to respond immediately to changes in economic activity or prices, but changes in reserve requirements or interest rates affect lending only with a time lag. We assume changes in lending that are not explained by current activity, inflation, or lags of other variables reflect policy changes. In contrast, changes in short-term interest rates can respond immediately to all other variables. So monetary policy “shocks” to interest rates are those rate movements not explained by current or lagged changes in other variables, or by lagged changes in the rates themselves.

Figure 1
Indicators of economic activity in China

Indicators of economic activity in China

Sources: CEIC, Bloomberg, Haver, and authors’ calculations.

Figure 1 presents estimates of our Chinese economic activity factor measured from detrended monthly changes in underlying indicators. The figure also shows China’s GDP growth, reported as four-quarter growth rates, and monthly growth rates for industrial production. For the latter two, we removed a slow-moving trend and rescaled them to have the same standard deviation. Clearly, all three series move together, albeit imperfectly. For example, although industrial production is one of the variables used to construct the economic activity factor, changes in industrial production before 2008 were only weakly related to economic activity or GDP growth. Our factor captures well China’s slowdown during the 2007–09 global financial crisis and its subsequent recovery. It is apparent that, while China weathered the economic downturn better than most countries, it also was hard-hit by the global downturn.

Implications for Chinese monetary policy

Figure 2
Economic activity factor: Actual vs. estimate

Economic activity factor: Actual vs estimate

Sources: CEIC, Bloomberg, and authors’ calculations.

Our model allows us to analyze the role of countercyclical policy during and since the global financial crisis. In Figure 2, the solid line shows the economic activity factor; the dashed line shows our model’s predictions of how that factor would have evolved had we “turned off” the monetary policy shocks, namely the innovations to the short-term interest rate and reserve requirements.

Surprisingly, we find that China’s relatively strong performance during the global financial crisis was not attributable to countercyclical monetary policy. That is, when we remove our estimated interest rate and reserve ratio innovations, our model predicts that China’s economy actually would have performed better during the crisis. The reason is timing: China was tightening monetary policy early in 2008. Given that changes in monetary policy feed through to the underlying economy with a lag, the contractionary effects hit the economy between late 2008 and 2009—exacerbating the effects of the global financial crisis on China. This illustrates the challenges of countercyclical monetary policy.

More recently, many commentators have noted China’s slowing economy. The dashed line shows that from about mid-2013 through the end of our sample in mid-2014, Chinese monetary policy has been modestly stimulatory. That is, monetary policy appears to have mitigated the depth of the country’s slowdown, in that our model predicts that economic activity would have been lower without monetary policy intervention. This stimulus comes primarily from changes in reserve requirements, since interest rates were unchanged from December 2010 through June 2014.


This Letter extends the statistical methods in Fernald, Spiegel, and Swanson (2014) to assess the impact of Chinese monetary policy on its economy. This FAVAR model addresses the data quality challenges posed by the Chinese economy, allowing us to incorporate a broad variety of poorly measured data. This method also allows us to examine the dramatic recent changes in the Chinese financial and economic systems, as it can be estimated on short data series.

According to our model, China’s monetary transmission mechanism is beginning to look more standard relative to Western market economies. In particular, interest rate and reserve requirement policies appear to play a more substantive role in determining both real economic activity and prices. As China continues to liberalize its financial sector, these standard monetary policy instruments are likely to gain further importance.

We also use our model to assess how Chinese monetary policy has affected its economic activity. We find that monetary policy exacerbated the severity of China’s modest downturn during the global financial crisis, primarily because the PBOC appears to have tightened policy just before the crisis hit. This illustrates the challenges faced in pursuing countercyclical policy. Nevertheless, we find that Chinese monetary policy has become more stimulatory recently, which may have helped ease its recent modest downturn in economic activity.

John G. Fernald is a senior research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco.

Eric Hsu is a research associate in the Economic Research Department of the Federal Reserve Bank of San Francisco.

Mark M. Spiegel is a vice president in the Economic Research Department of the Federal Reserve Bank of San Francisco.


Bernanke, Ben, and Alan Blinder. 1992. “The Federal Funds Rate and the Channels of Monetary Transmission.” American Economic Review 82(4), pp. 901–921.

Bernanke, Ben, and Jean Boivin. 2003. “Monetary Policy in a Data-Rich Environment.” Journal of Monetary Economics 50, pp. 525–546.

Bernanke, Ben, Jean Boivin, and Piotr Eliasz. 2005. “Measuring the Effects of Monetary Policy: A Factor-Augmented Vector Autoregressive (FAVAR) Approach.” Quarterly Journal of Economics 120(1), pp. 387–422.

Fernald, John, Eric Hsu, and Mark M. Spiegel. 2014. “Is China Fudging Its Figures? Evidence from Trading Partner Data.” Unpublished manuscript, Federal Reserve Bank of San Francisco.

Fernald, John, Mark M. Spiegel, and Eric Swanson. 2014. “Monetary Policy Effectiveness in China: Evidence from a FAVAR Model.” Forthcoming, Journal of International Money and Finance.

Geiger, Michael. 2006. “Monetary Policy in China (1994–2004): Targets, Instruments, and Their Effectiveness.” Wurzburg Economic Papers 68.

He, Qing, Pak-Ho Leung, and Terence Tai-Leing Chong. 2013. “Factor-Augmented VAR Analysis of the Monetary Policy in China.” China Economic Review 25, pp. 88–104.

Holz, Carsten A. 2008. “China’s 2004 Economic Census and 2006 Benchmark Revision of GDP Statistics: More Questions than Answers?” The China Quarterly 193(March), pp. 150–163.

Liao, Wei, and Sampawende Tapsoba. 2014. “China’s Monetary Policy and Interest Rate Liberalization: Lessons from International Experiences.” IMF Working Paper WP/14/75.

Nakamura, Emi, Jón Steinsson, and Miao Liu. 2014. “Are Chinese Growth and Inflation Too Smooth?” NBER Working Paper 19893.

Category: Think Tank


Quarantine David R. Kotok October 07, 2014   “The practice of quarantine, as we know it, began during the 14th century in an effort to protect coastal cities from plague epidemics. Ships arriving in Venice from infected ports were required to sit at anchor for 40 days before landing. This practice, called quarantine, was derived…Read More

Category: Science, Think Tank

Income Inequality and Income-Class Consumption Patterns

Economic Commentary Income Inequality and Income-Class Consumption Patterns LaVaughn M. Henry Federal Reserve Bank of Cleveland, 10.06.2014   As income inequality has increased in the United States, researchers have rightfully asked whether it has also led to inequality in relative consumption. This is an important question because consumption is clearly a better measure of an…Read More

Category: Think Tank, Wages & Income


Volatility David R. Kotok October 5, 2014     An era is ending: for over half a decade, nearly worldwide, zero interest rates suppressed volatilities. That is over. The first sign of this evolution came over a year ago when the bond market experienced the “taper tantrum” as then Fed Chairman Ben Bernanke alluded to…Read More

Category: Think Tank, Trading

The Wayback Machine Birthday Tour

The Wayback Machine Birthday Tour
By John Mauldin
October 3, 2014




“That men do not learn very much from the lessons of history is the most important of all the lessons that history has to teach.”
Aldous Huxley, Collected Essays

“Would you tell me, please, which way I ought to go from here?”
“That depends a good deal on where you want to get to,” said the Cat.
“I don’t much care where –” said Alice.
“Then it doesn’t matter which way you go,” said the Cat.
“– so long as I get somewhere,” Alice added as an explanation.
“Oh, you’re sure to do that,” said the Cat, “if you only walk long enough.”
– Lewis Carroll, Alice in Wonderland, 1865


Today, in the spirit of the wisdom the Cheshire Cat offers Alice, I would ask how you can know where you are now and where you’re going if you don’t know where you came from. You and I have lived through the first nearly 14 years of this topsy-turvy new century together, and many of its details as well as its overarching themes deserve to be recalled. But rather than offering you a dry, plodding recap of recent history, I’ve come up with a different and hopefully more fun way to revisit the past decade and a half.

I’ve been writing this letter for some 15 birthdays now, well over 10,000 pages of collected work. Every word is still at my website – a history, if you will, of what I was thinking at the time. I asked my longtime (and long-suffering) editor, Charley Sweet, to go back over this past decade and a half and give us a review of what I was saying my birthday week. When I perused what he came up with, a few things leapt out at me.

First, it turns out to be quite lucky that I was born in October, because when we assembled all the letters for the first week of that month, it turned out we hit on most of the big issues that came along in the first 15 years of the century: the tech-bubble collapse and ensuing recession; the actions of the Fed in the early ’00s, especially with regard to the housing bubble; the fundamental challenge – and promise – of accelerating change; the subprime collapse and Great Recession (including “the bailout”); the problems with Keynesian excesses at the Fed and other major central banks; the crisis in the Eurozone; and the healthcare crisis (and Obamacare).

Second, I could see my own thought process evolving and realized again how truly important it is to continually test your ideas in the marketplace.

The plan was to take a short stroll through the history of my letters to get a feel for how our world and my thinking about it have changed over time. As it developed, Charley presented me with a rather voluminous package of excerpts, one far too long to send out as a Thoughts from the Frontline letter. So I will have to viciously edit myself to make the retrospective more consumer-friendly for TFTF readers. But for those who are interested, we are posting the entire summary here (and it will remain available there).

As you read the entry for each year, think back on your own thought process and actions at the time. Surprisingly, as I did the same, it appeared to me that, more often than not, I “got it right” (even if I got it early). So let’s climb into the Wayback Machine and take a spin through the last 15 tumultuous years. We will begin with my call in October 2000 for a recession in 2001.

[Note: comments in brackets were written as we edited this. Everything else is verbatim from the original letters.]

The Probability of a Recession Grows
October 20, 2000

I get lots of mail from readers asking me to tell them if I think we will have a recession next year. I think I can say with some authority that making predictions can get you out on a limb. There are scores of variables that affect our economy. At any given time you can find trends that will seem to be pointing us to one conclusion, and other trends that might yield the opposite conclusion. It is only in hindsight that the pundits will tell us that we should have seen the most important trend all along. So instead of predicting a flat yes or no, I am going to assign some probability to the potential for a recession, and then as we go along I will either increase the probability or decrease it….

[If the yield curve is functioning as an accurate predictor of recession] we should be looking to see a recession next summer at the earliest and probably next fall. As I think back over the last few recessions, there were very few signs one year ahead that a recession was coming. For most economists and analysts, the recession was a surprise even one quarter out!…

Read More

Category: Think Tank

More Amateurs/Professionals

AMATEURS Ask permission. PROFESSIONALS Do. Amateurs are afraid they’re going to ruffle feathers, they’re afraid they won’t have success, they want everyone to feel good about them. Professionals know this is an impossibility. Sure, there are amateurs who don’t ask and do heinous things, but they usually don’t even see the landscape to begin with….Read More

Category: Music, Think Tank

Kiron Sarkar’s Weekly Report 10.4.14

The outlook components of the Japanese Tankan survey declined materially and may imply that the economy contracted in Q3 this year. Furthermore, the weak August output data also suggests that Japan could be facing a recession. As the data continues to worsen, further monetary and fiscal stimulus becomes more likely, which will result in a…Read More

Category: Think Tank

Deindustrialization Redeploys Workers to Growing Service Sector

Category: Think Tank

Why the Fed Is So Wimpy

Why the Fed Is So Wimpy John Mauldin October 1, 2014     Another in what seems to be a small parade of scandals involving secretly recorded tapes of Federal Reserve regulators emerged last week. What a number of writers (including me) have written about regulatory capture over the past decade was brought out into…Read More

Category: Federal Reserve, Think Tank

Category: Real Estate, Think Tank