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What Monetary Policy Does China Need?

China’s remarkable growth has been financed recently by a rapid expansion of money and bank credit that is producing an increasingly unsustainable investment boom. This renews concerns that the country may not be able to avert a replay of the painful boom–and-bust cycle such as the one it endured in the mid-1990’s.

Monetary policy is usually the first line of defense in such situations. But China’s monetary policy has been hamstrung by the tightly managed exchange-rate regime. This regime prevents the central bank – the People’s Bank of China (PBC) – from taking appropriate policy decisions to manage domestic demand, because interest-rate hikes could encourage capital inflows and put further pressure on the exchange rate.