Economic Openness, Financial Openness and Policy Tools Combination of Two-Pillar Adjustment
MA Yong, Jiang Yiqing, Guo Rui
School of Finance/China Financial Policy Research Center, Renmin University of China; School of Finance, Renmin University of China; Institute of Chinese Finance Studies, Southwestern University of Finance and Economics
Summary:
Since the commencement of 18th National Congress of the Communist Party of China, the country has undergone a gradual transformation of economic structure and accelerated the market-oriented reform of the financial system. This has deepened the integration of finance and the real economy, making financial stability an integral component of macroeconomic stability. However, as economic structural reforms progress, some issues from the early stages of rapid development have emerged, making potential economic and financial risks non-negligible. In response to this, the 19th National Congress of the Communist Party outlined a strategic deployment to establish a “two-pillar regulatory framework” of monetary policy and macro-prudential policy. The aim is to ensure the bottom line against the occurrence of systemic financial risks through the coordinated implementation of the policies under the “two-pillar” regulatory framework. Within this framework, how should the central bank utilize monetary policy and macro-prudential policy to mitigate the economic and financial volatility caused by external financial shocks？ Concurrently, the external environment for China's economic development has grown more complex. China has not only continuously achieved new breakthroughs in economic openness but has also made significant progress in financial openness by simultaneously promoting the financial industry's internationalization, improving the formation mechanism of the RMB exchange rate, and decreasing capital controls. From an economic perspective, at a higher level of openness, domestic economy and financial markets are more closely connected with the world. As more foreign agents participate in domestic economic and financial activities, mutual influence and linkages between domestic and international macro economy and finance intensify. The spillover effects of policies become more evident, and the comprehensive regulation of macro economy and financial system becomes more intricate. In this context, a pertinent question is how economic and financial openness impact the policy effectiveness of the central bank's macroeconomic regulation. In an attempt to address the aforementioned questions, this study, based on the model of Funke and Paetz (2013), introduces an incomplete open financial market and a banking sector subject to foreign exchange control, providing a theoretical framework for analyzing the transmission of exogenous shocks and the policy responses of the central bank under open conditions. By calibrating and estimating the model parameters using actual economic data from China over the period of 2014Q1 to 2022Q4, we examine the effects of different combinations of policy tools within the “two-pillar” framework. The findings suggest that, considering China's current levels of economic and financial openness, the central bank can better balance the goals of economic and financial stability and reduce policy loss levels by judiciously combining an expanded monetary policy that incorporates financial stability objectives, dynamic Loan-to-Value (LTV) regulation, and dynamic capital adequacy ratio requirements. However, the specific policy combinations and corresponding target adjustments need to be determined based on the nature of exogenous shocks. For instance, in the case of a depositor housing preference shock, a combination of an expanded monetary policy targeting loan volume, along with the other two macro-prudential policy tools, is deemed appropriate. In the context of a foreign house price shock, a traditional monetary policy combined with the other two macro-prudential policy tools is a relatively optimal policy arrangement. Further analysis reveals that changes in economic and financial openness affect the effects of the optimal policy combinations on economic and financial stability to varying degrees. Therefore, the central bank needs to consider the actual status of economic and financial openness when implementing the “two-pillar” policy regulation. Based on the previously stated conclusions, we propose three policy recommendations: First, given the importance of the real estate industry in the Chinese economy and the complexity of related issues under open conditions, policymakers should comprehensively utilize monetary policy and macro-prudential policy for regulation. Currently, a policy combination of an expanded monetary policy incorporating financial stability goals, dynamic LTV regulation, and dynamic capital adequacy ratio requirements could more effectively achieve economic and financial stability objectives. Second, in the regulation, policymakers need to judiciously select the target and intensity of pertinent policies based on the specific nature of exogenous shocks to mitigate policy losses resulting from conflicts between policies. Third, as high-level opening advances, and as economic and financial openness undergo changes, potential connections between macroeconomic and financial variables will evolve. This necessitates policymakers to closely monitor economic and financial dynamics and promptly update the policy toolkit, flexibly employing diverse macroeconomic policies to further enhance their adjustment capability over the overall economic and financial conditions.
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