A Monetary Conditions Index for Mainland China

Economic and financial developments on the Mainland have important implications for Hong Kong. This paper presents an empirical framework for assessing monetary and financial conditions on the Mainland by estimating a monetary conditions index (MCI). An MCI is usually defined as a weighted sum of some measures of real interest rate and the real effective exchange rate (REER). Because bank credit is an important channel of monetary policy transmission mechanism in Mainland China, this study extends the conventional MCI by including a quantity variable to capture the credit availability effect. Estimates suggest that, in terms of the effect on real GDP growth, a rise in real interest rates by 1 percentage point is equivalent to an increase in REER appreciation by about 4 percentage points or a fall in real credit growth by 2.5 percentage points. The estimated MCI suggests a sharp easing in monetary conditions in 2002-2003, reflecting a weaker US dollar, relaxed credit stance of banks, and easing of deflation which reduced real interest rates. The fall in the MCI is equivalent to a decline of about 10 percentage points in real interest rates during the period. Easy monetary conditions have contributed to an acceleration in economic growth since 2002. Fears of overheating pressures prompted the authorities to implement administrative measures in early 2004 to curb credit supply to selected sectors and raise interest rates in late October 2004. The estimated MCI suggests that the tightening of monetary conditions is equivalent to a rise in real interest rates by about 4.6 percentage points.