Enodo Untangled
- Investors should watch who calls the shots – and it’s not the PBoC
- China watchers can overcome lack of transparency with careful analysis
- As China’s financial system opens up, PBoC edges towards market rates
- China’s monetary transmission mechanism is still evolving
- Communication of monetary policy has limited impact on interest rates
Introduction
China presides over the world’s largest yet still underdeveloped financial system. Over the past few years, Beijing has finally thrown the doors of its financial fortress open to the rest of the world.
This warrants a much closer look at how monetary policy is set and communicated to investors, and the impact it has on interest rates.
In this Enodo Untangled report we start by discussing the findings of our empirical study of how monetary policy communication in China affects financial variables. Then we outline China’s unique policy framework and how it differs from that in the West. We look at who sets monetary policy – a question most investors surprisingly get wrong – and how monetary policy works, including China’s alphabet soup of tools.
We end by listing the key institutions and persons you need to keep an eye on to understand China’s monetary policy direction and by spelling out how these bodies operate and communicate - a practical guide to help you stay abreast of monetary policy in China.
China’s stunted monetary transmission mechanism
Our empirical analysis suggests that monetary policy communication remains largely underdeveloped in China and, to the extent that it conveys any information about interest rates, it does so mainly for short-term market rates.
You can find the method and results of our statistical analysis in the Appendix. Here we summarise the main findings. Central banks across the globe have been increasingly relying, rightly or wrongly, on managing expectations through communication. As China has now opened up its financial market to the rest of the world, it needs to make considerable efforts to improve its communication.
Investors often liken China’s policymaking to a black box, an indication of the long road the authorities need to travel before they can gain the confidence of global markets.
The overwhelming conclusion from our regression work is that the various channels of China’s monetary policy communication have limited impact on interest rates. We examine three key channels: State Council communiques, PBoC statements on policy instrument changes and PBoC open market operation (OMO) notices.
We have investigated the effects on communication on the following market interest rates: the Shanghai Interbank Offered Rate (Overnight and 7-day SHIBOR); the 7-day collateralised interbank repo rate between depository financial institutions (DR007); the 7-day collateralised interbank repo rate between all financial institutions (R007); Treasury bond yields (1m, 3m, 6m, 12m); commercial paper (AAA+); and yields on the interbank market (1m, 3m, 6m, 12m CP).
Of the three main channels of communication we examine, OMO notices have the greatest impact and all three channels mostly affect SHIBOR and R007.
But overall, the effectiveness of monetary policy communication by the State Council and the PBoC is limited. Communication tends to calm the markets but does not move them much.
The introduction of PBoC OMO notices with additional short explanations since March 2016 has enhanced the efficiency of the monetary policy transmission mechanism, but our analysis suggests that its development remains stunted. We need to see much bigger improvements before investors can be confident of reading China’s policy leaves sufficiently well to be willing to invest in its capital markets.
Unique Policy Framework
Co-ordinated but Complex Overall Policymaking
The institutional design of China’s policy setting in the context of the Party-state is distinctly different from that of developed economies. First, it is important to realise that China tends to pull all its policy levers at the same time – and the command aspect of its hybrid economy means there are a lot of them.
On the one hand, this allows the authorities to adjust policy in a timely, co-ordinated manner. One policy change reinforces another.
On the other hand, the authorities often don’t or can’t consider or anticipate the cumulative impact of tugging lots of different levers simultaneously for different purposes.
It makes the job of analysing China hard, as there is a lot of information to process in order to figure out the combined effect and the force that will dominate and to anticipate unintended consequences.
Lack of Transparency
Second, policymaking is shrouded in secrecy. The Party-state conducts its deliberations behind closed doors, so it is always hard to know how decisions are reached. But while Beijing is harder to read than capitals with more open systems of government, it is possible to infer what is on the minds of the leadership by a careful analysis of state media and journals such as the Party’s theoretical journal, Qiushi.
In many ways the Party-state is quite open about what it plans to do: it is perhaps unfortunate that Western policymakers and investors have all too often paid insufficient attention to such statements or have failed to take them at face value.
These communications are important: after all, the leadership needs to pass the word down through the ranks to mobilise the enormous apparatus at its disposal.
Consensus-Driven Process
The Party determines overall strategy and priorities, and these are then developed into detailed plans of action through a process of extensive consultation and repeated redrafting.
In practice, this process has tended to produce outcomes that amount to a lowest common denominator consensus designed to iron out disputes and differences. The results are subject to proforma debate, but the real work has been done by then.
While the institutions of the Chinese state have executive authority, they exercise it on behalf of the Party, which is the real power in China.
In effect China has a dual system of government in which the state institutions are front-facing while the Party wields the real power behind the scenes.
All ministers and most other high-ranking functionaries of the state are also Party members, and their primary allegiance is to the Party.
Who Sets Monetary Policy
State Council and PBoC
Unlike in the US, China’s central bank – the People’s Bank of China (PBoC) - does not set monetary policy and cannot as such speak most authoritatively on the direction of travel.
The institution that has ultimate authority to determine China’s exchange rate and interest rate policy is the State Council, or cabinet. The PBoC executes monetary policy but, unlike Western central banks, it’s not independent.
The PBoC Law states that ‘The People’s Bank of China shall report its decisions to the State Council for approval concerning the annual money supply, interest rates, foreign exchange rates and other important matters specified by the State Council before they are implemented.’
The State Council and the PBoC have a mutual understanding as to how this arrangement works, but these details are not made public. So the PBoC is the conduit for monetary policy, but doesn’t determine it. As the central bank, it does, of course, have more influence on the State Council than other organs of state on monetary matters.
The Monetary Policy Committee at the PBoC is also a different beast than the MPC of a typical Western central bank. Its powers are much more constrained, and it functions more like a consultative body. This also means that changes to monetary policy can and do take place outside of quarterly MPC meetings.
The governor of the PBoC is also not necessarily the person who will have the final say when it comes to decisions that are within the remit of the central bank.
While Yi Gang is the current governor, the PBoC’s Communist Party secretary, Guo Shuqing, outranks him.
Since the inception of the PBoC, seven individuals have served as governor. Each was officially appointed by China’s premier but was truly chosen by the CCP’s Politburo Standing Committee or by the Party’s top leader. Zhou Xiaochuan has been the longest-serving governor and still holds significant sway.
Financial Stability and Development Committee
At the same time that the PBoC’s responsibilities were expanded (see next section), its authority was challenged by the creation in 2017 of a new super-regulator, the Financial Stability and Development Committee (FSDC).
The FSDC was set up to strengthen the myriad of financial overseers, including the PBoC, and to put an end to the endless turf wars that have characterised China’s fragmented financial regulatory system.
Headed by Vice Premier Liu He, the FSDC has its offices in the central bank’s building and brings together the country’s most senior regulatory officials. Like the PBoC, the committee comes under the State Council but sits above the central bank in the Chinese government hierarchy. The majority of the FDSC’s current members also hold seats on the PBoC’s monetary policy committee.
Central Comprehensive Deepening Reform Committee
When Chinese Party leaders need to get things done, their preferred mechanism is the Leading Small Group. There are dozens of such groups, some headed by state officials and others – the ones that matter – by the Party. These Leading Small Groups are intended to drive forward the implementation of policy through inter-departmental co-ordination.
Since Xi Jinping came to power, he has consolidated control and taken over the overall policy agenda through the creation of a multitude of small leading groups he now chairs. In late 2013 the Politburo set up the Leading Small Group for Comprehensively Deepening Reform, later renamed to Central Comprehensive Deepening Reform Committee (CCDRC).
The CCDRC is tasked with "designing reform on an overall basis, arranging and co-ordinating reform, pushing forward reform as a whole, and supervising the implementation of reform plans".
Xi’s leadership of the committee represents a challenge to the authority of the State Council and its National Development and Reform Commission, the state planning body. The CCDRC meets the least regularly and has a wide remit, but in the highly inter-related policy landscape of China, it is important to include it in analysing communication in relation to monetary policy.
How Monetary Policy Works
Objectives
The high-level objectives of monetary policy in China are set out in the founding legislation of the PBoC, ratified by the National People’s Congress. The PBoC Law clearly prescribes that the ‘aim of monetary policies shall be to maintain the stability of the value of the currency and thereby promote economic growth’.
As Yi Gang, the current governor of the PBoC, explains, “To maintain currency stability has two meanings – internally, to keep prices stable and externally, to keep the exchange rate stable, at an adaptive and equilibrium level.“
But that’s certainly not the only mandate of monetary policy. The PBoC has multiple objectives – including full employment, sustainable growth, financial stability – that change over time. And the changes are not necessarily announced as they happen.
The most significant shift since Xi came to power is the significant expansion of the PBoC’s responsibilities. Xi first spoke about the need to enlarge the PBoC’s remit in 2017. In October 2020 China’s bank law was revised for the first time in 17 years to enshrine a “dual pillar” policy function, adding to its standard monetary policy objectives macro-prudential management and the supervision of systemically important financial institutions.
When analysing monetary policy it is also important to bear in mind that because the State Council sets the overall direction of macroeconomic policy, monetary, fiscal and regulatory policy are co-ordinated and enmeshed more closely than is usual in the West.
Framework
China’s current monetary policy framework, like its overall economy, could be best described as hybrid - a hybrid quantity and price system, but one in which administrative guidance also remains key.
No single policy target or tool in China captures the overall stance of monetary policy. However, our analysis indicates that the best barometer of this stance is broad money, as measured by Enodo’s M3.
But China’s authorities use M2 – a less broad money aggregate – as the intermediate target for monetary policy and total social financing (TSF), introduced in 2012, as their reference target. TSF measures the financing offered by the financial sector to the real economy, covering loans, bonds, stocks and other sources of funds. It’s important to note here that TSF combines the creation of money and the use of money. As such, in our view it is actually not a useful target.
China’s monetary policy framework has been increasingly moving from using quantitative targets to regulating price indicators.
In 2018, the government signalled that the emphasis on quantitative targets had declined by not projecting a goal for M2 or TSF in its annual work report to the National People’s Congress, China’s rubberstamp parliament.
Instead, the language was more vague: “Our prudent monetary policy will remain neutral, with easing or tightening as appropriate. We need to make sure that the value of M2 money supply, credit, and aggregate financing ensure a reasonable, stable level of liquidity.”
Meanwhile, China has gone through successive bouts of interest rate liberalisation, starting with money market rates and bond yields and culminating in 2015 with the removal of the ceiling on deposit rates. There have been three defining features of this process: long-term interest rate controls were scrapped before those on short-term rates, restrictions on lending rates were lifted before those on deposit rates, and offshore rates were liberalised before domestic ones.
| Year | Events |
| 1996 | Removed the ceiling on interbank lending rate |
| 1997 | Introduced market-based repurchase agreements (repo) |
| 1998-1999 | Introduced auction to policy bank and treasury bonds issuance |
| 2000 | Removed restrictions on FX lending rates and large-account FX deposit rates |
| 2003 | Removed interest rate floors on small-account FX deposits |
| 2004 | Removed the ceilings on lending rates; |
| Expanded the floating floors for lending rates to 90% of the benchmark rate; | |
| Removed the floors on deposit rates; | |
| Removed interest rate ceilings on small-account FX deposits with maturity above 1 year | |
| 2012 | Expanded the floating range for lending rates to 70% of the benchmark rate; |
| Expanded the floating range for deposit rates to 110% of the benchmark rate | |
| 2013 | Removed the lending rate floors on all loan facilities except for mortgages |
| 2014 | Expanded the floating range for deposit rates to 120% of the benchmark rate |
| 2015 | Launched the bank deposit insurance scheme; |
| Expanded the floating range for deposit rates to 150% of the benchmark; | |
| Removed the ceiling for deposit rates | |
| 2019 | Linked loan prime rates (LPR) to medium-term lending facility (MLF); |
| Required banks to price outstanding loans based on LPR | |
| Source: PBoC |
In 2018, the PBoC indicated its intention to move to a unified interest rate framework. “In some aspects, the interest rates are ‘running on two tracks’, that is, there are benchmark interest rates for deposits and loans, while the money market rates are fully liberalised…The best tactic is for us to gradually unify the two tracks of interest rates, and we are doing just that in the market-based reforms.”
Although interest rates were nominally liberalised in 2015, commercial banks based their own rates on these benchmarks. But in August 2019, the PBoC duly took a step in unifying these two tracks. Unsurprisingly, it started with long-term interest rates. It replaced the lending benchmark with the Loan Prime Rate (LPR). This is the average rate charged by 18 of the biggest banks in China.
It linked the LPR to its medium-term lending facility (MLF) with banks submitting their rate to the PBoC expressed as a spread over the MLF rate.
In this way the central bank aims to improve the transmission mechanism from a “semi-official policy rate” to banks’ lending rates, although the MLF rate has not yet been officially recognised or designated as the policy rate.
Monetary Policy Tools
Just as monetary policy has multiple objectives, the authorities have multiple instruments – both quantity-based and price-based – to execute it. The alphabet soup of tools with varying importance for markets makes it hard to assess the overall impact on monetary conditions.
The PBoC still publishes its benchmark 1-year lending rate, although this has now been superseded by the linkage between the LPR and rates on its MLF. The deposit rate is fully liberalised on paper, but in practice, the authorities exercise significant control, and the scrapping of the benchmark deposit rate is not on the cards for some time yet.
| Tool | Features | Data | Type |
| OMO | Regular open market operations (OMO) include PBoC bill issuance, repos and reverse repos | 2002 | Liquidity management |
| SLO | Short-term OMOs conducted in place of regular a OMOs | 2013 | Liquidity management |
| SLF | Liquidity (7 days to 3 months) extended to a specific institution against high-quality collateral | 2013 | Liquidity management |
| MLF | The medium-term version of SLF | 2014 | Liquidity management |
| RRR | Required reserves ratio set by the PBoC | 1985 | Liquidity management |
| ERR | Rate on excess reserves. Seen as the lower bound of the interest rate corridor | 1989 | Liquidity management |
| TMLF | Providing relatively cheaper funding for banks that lend to small and private business | 2018 | Targeted lending |
| PSL | Long-term loans against collateral directed towards specific sectors; PSL interest rates are used as medium-term interest rate guidance | 2014 | Targeted lending |
| Relending | Loans to specific banks; precursor to the PSL and relending against bank loans as collateral | 1985 | Targeted Lending |
Source: PBoC, Enodo Economics
China’s monetary stance is reflected in a number of money market rates. The markets see the seven-day repo and three-month SHIBOR rates as the best indicators of interbank market liquidity and benchmarks for pricing other financial instruments. The interbank repo rate DR007, which is traded only by depository institutions in the interbank market using bonds as collateral, is the most important short-term money market rate.
In recent years the PBoC has started operating an interest rate corridor to anchor the seven-day repo as a quasi-policy rate, using the remuneration on banks’ excess reserves as the lower bound and rates on its Special Lending Facility (SLF) as the upper bound.
Although the authorities are progressing towards increased use of price-based instruments, they continue to rely heavily on quantitative policy tools, window guidance, administrative control and macro-prudential measures to manage the quantity of base money and direct credit.
The PBoC can alter the supply of base money either by purchasing or selling foreign exchange reserves or domestic assets from commercial banks, or by changing the required amount of deposits that banks hold at the central bank (reserve requirement) or using other liquidity facilities.
Communication Channels
See below a description of the membership, where known, of each of the four key bodies which could communicate monetary policy decisions, their meeting frequency, release calendar and information release channels.
State Council
Members:
Li Keqiang (李克强) Premier
Han Zheng(韩正) Vice-Premier
Sun Chunlan (孙春兰) Vice-Premier
Hu Chunhua (胡春华) Vice-Premier
Liu He (刘鹤) Vice-Premier
Wei Fenghe (魏凤和) State Councillor
Wang Yong (王勇) State Councillor
Wang Yi (王毅) State Councillor
Xiao Jie (肖捷) State Councillor; Secretary-General
Zhao Kezhi (赵克志) State Councillor
If needed, heads of relevant departments and units may attend the meetings as non-voting delegates.
Meeting Frequency:
According to Clause 40 in Chapter 8 of the Working Rules of the State Council, the body usually meets once a week. Judging by the actual number of meetings held since January 2019, the frequency varies from two to five times a month. The gap between meetings is usually seven days, but sometimes it as long as 14 days (e.g. during the Chinese Spring Festival) or as little as three days.
Calendar:
There is a calendar of meetings already held but not one of scheduled future meetings. You can find the historical information on http://www.gov.cn/guowuyuan/cwhy/20210714c22/index.htm
Information Release Channel:
The CCTV news broadcast at 7.00pm each day on CCTV Channel 1 is the first place where information on the State Council meeting is released.
PBoC
MPC members:
Yi Gang (易刚) Governor of the People's Bank of China
Ding Xuedong (丁学东) Deputy Secretary-General of the State Council
Lian Weiliang (连维良) Vice-Chairman of the NDRC
Zou Jiayi (邹加怡) Vice-Minister of the Ministry of Finance
Chen Yulu (陈雨露) Deputy Governor of the People’s Bank of China
Liu Guoqiang (刘国强) Deputy Governor of the People’s Bank of China
Ning Jizhe (宁吉喆) Commissioner of the National Bureau of Statistics
Guo Shuqing (郭树清) Chairman of the CBIRC
Yi Huiman (易会满) Chairman of the China Securities Regulatory Commission
Pan Gongsheng (潘功胜) Administrator of SAFE
Tian Guoli (田国立) Chairman of China Banking Association
Liu Shijin (刘世锦) Vice-President of the Development Research Centre of the State Council
Cai Fang (蔡昉) Chief Expert of the Chinese Academy of Social Sciences' National Institute for Global Strategy
Wang Yiming (王一鸣) Vice-President of the China Centre for International Economic Exchanges
Meeting Frequency:
The MPC meets at the end of each quarter. Since 2009 it has published a press release one or two days afterwards, but the PBoC can act at any moment and first notifies the market through its website. News conferences are usually scheduled after policy announcements to explain the rationale for decisions.
Since 2016 the bank has published daily open market operation notices to explain the rationale for its OMOs. Increasingly, these notices provide contextual information about the liquidity stance.
The PBoC also publishes a monetary policy report each quarter that tends to be backward-looking and explanatory, but recent reports have contained more forward-looking information.
Finally, the PBoC governor and other MPC members give public speeches at conferences and international meetings of central bank chiefs. The PBoC holds a Work Conference once a year, usually at the start of January or February.
There are three other important economic meetings: the Central Economic Work Conference takes place once a year, usually in December; the Political Bureau of the Central Committee of the CPC Conference, once a quarter; and the National Financial Work Conference, once every five years. The Lujiazui Forum and the Boao Forum are also key events in the calendar.
Calendar:
There is a historical calendar listing the meetings already held and monetary policy action taken but there is no future meetings calendar. You can find the historical information on
http://www.pbc.gov.cn/zhengcehuobisi/125207/125213/index.html
You can find the daily OMO notices on
http://www.pbc.gov.cn/zhengcehuobisi/125207/125213/125431/125475/index.html
Information Release Channel:
The PBoC first notifies the market about any monetary policy action through the news channel on its website.
Financial Stability and Development Committee
Members:
Liu, He (刘鹤) Vice-Premier; FSDC chair
Yi Gang (易纲) Governor of the PBoC, as vice-chair of the FSDC
Ding Xuedong (丁学东) Deputy Secretary-General of the State Council as vice-chair
Guo Shuqing (郭树清) Chairman of the China Banking and Insurance Regulatory Commission
Pan Gongsheng (潘功胜) Vice-chair of the PBoC and head of the State Administration of Foreign Exchange
Han Wenxiu (韩文秀) Vice-chair of the Central Leading Group on Financial and Economic Affairs
Lian Weiliang (连维良) Vice-chair of the National Development and Reform Commission
Liu Wei (刘伟) Vice-Finance Minister
Meeting Frequency:
The committee usually meets once a month, but in the past it has convened as frequently as eight times in two months. Not every meeting is reported to the media, so we can only guess at the frequency by the number of the meeting mentioned in official communications. There could also be special sessions.
Calendar:
There is a calendar of meetings already held but not one of scheduled future meetings. You can find the historical information on
Information Release Channel:
Whereas the premier chairs the State Council, the vice-premier heads the FSDC, which focuses only on monetary and financial issues. The outcome of FSDC meetings is usually not reported on the 7.00pm CCTV news. The earliest information we can find about an FSDC meeting is on the central government website.
Central Comprehensive Deepening Reform Committee
Members:
Xi Jinping (习近平) Chair; President
Li, Keqiang (李克强) Vice-chair; Premier
Wang, Huning (王沪宁) Office chair
Han, Zheng (韩正) Vice-premier
The rest of its membership is not made public, but the core group has 23 members while the entire group including the sub-groups has at least 43. Perhaps even more significantly, although the group’s six work offices each has a Politburo-level director, meetings are usually chaired by Xi Jinping himself.
Meeting Frequency:
Meetings are usually held every two months.
Calendar:
There is a calendar of meetings already held but not one of scheduled future meetings. You can find the historical information on
https://www.12371.cn/special/zyqmshggldxzhy19/
Information Release Channel:
The CCTV news broadcast at 7.00pm each day on CCTV Channel 1 is the first place where information on CCDRC meetings is released.
Conclusion
The formulation of monetary policy in China is still a work in progress. As China opens up its financial system to international investors, the PBoC continues to gradually liberalise interest rates. But the monetary policy framework remains fundamentally different from that of Western central banks.
That is because the PBoC, as a servant of the Chinese Communist Party, executes monetary policy but does not set it. That responsibility lies with the CCP leadership and the State Council.
Reflecting the PBoC’s lack of independence and the secretive nature of all policymaking in China, communication of the central bank’s monetary stance and signalling of its future intentions is underdeveloped.
But investors can partly overcome this absence of transparency by carefully tracking the institutions and senior officials calling the monetary policy shots.
Appendix
Statistical Analysis of the Effects of Monetary Policy Communication on Interest Rates
This empirical event study provides econometric evidence on whether PBoC/State Council communications contain news for financial market variables. We are interested in the effect of communication and changes in policy rates on the interest rates at the short and long end of the yield curve.
The first step is to construct variables that capture PBoC/State Council communication events. We are focused on the impact of PBoC informative OMO notices on interest rates and therefore we create a dummy variable which takes one for each release of OMO notices and 0 otherwise (d_omo).
We also investigate the impact of monetary policy-related statements by the State Council on market interest rates and thus we create a dummy variable taking one when such statements were made and 0 otherwise (d_state_council).
To control for other factors that may affect market interest rate movements, we include (1) a dummy variable d_gdp_release to indicate the release of GDP data, (2) a dummy variable d_pboc to indicate the date of changes in key PBC monetary policy instruments. The latter variable incorporates changes in the benchmark interest rate, required reserve ratio, OMO, and other instrument rates, that is, the standing lending liquidity facility (SLF), short-term liquidity operations (SLO), medium-term lending facility (MLF), and the pledged supplementary lending (PSL).
The event-study analysis covers trading days during 2017–2021.
Baseline Results: OLS Analysis of Communication News
First, we conduct an ordinary least squares (OLS) analysis by estimating the following equations:
|∆r_t |=α+β*d_omo+γ_1 〖*d〗_(gdp release)+γ_1 〖*d〗_pboc+ε_t
and
|∆r_t |=α+β*d_(state council)+γ_1 〖*d〗_(gdp release)+γ_1 〖*d〗_pboc+ε_t
These regressions, as in other event studies, identify the average reaction of market prices to the different types of communication events; the identifying assumption is that any systematic reaction on communication days is driven by the communication event. The dependent variable is the daily absolute change in market rates.
The advantage of using the absolute value is that we measure the market reaction to the communication irrespective of the direction of that reaction. The key test concerns the sign of the communication event dummy variable. When communication is associated with news, it would cause a market adjustment and thus positive β coefficient. If, however, a communication event systematically reduced the noise in the market, it would be associated with less market adjustment than on other trading days and our estimated β coefficient would be negative.
The key estimation results, correcting the standard errors using the Huber-White sandwich estimators, are presented visually in Figure 1A, 1B and 1C; the full regression results are presented in Table 1.
Figure 1A:
Figure 1B:
Figure 1C:
Effect on Volatility and the Timing of Communication
Even if there is no systematic effect on the average price in the market, another possibility is that communication events are associated with greater market volatility. OLS regressions do not separately model the volatility of the residuals; the regressions analysis above did correct the standard errors on coefficients for heteroskedasticity and auto-correlation.
General Autoregressive Conditional Heteroscedastic (GARCH) models will allow us to address the possibility that time-series models may violate homoscedasticity (constant variance of errors). These models are used extensively in financial econometrics as higher frequency data tend to have periods of higher and lower volatility.
Specifically, we follow Nelson (1991), and explore the volatility effects of communication using an EGARCH methodology (a particular class of GARCH model). The advantage of an EGARCH model over a GARCH model is that it ensures that the conditional variance is positive and allows for the asymmetric response of the volatility to good and bad news.
Our EGARCH(1,1) specification features a conditional mean equation in which it is necessary to control for all the relevant variables that drive the mean to minimize the size and variance of residuals:
|∆r_t |=γ_0+γ_1 〖*x〗_t+ε_t
where ε_t~N(0,σ_t^2) and x_t contains any controls in the conditional mean equation. The conditional volatility equation, which measures the drivers of σ_t^2, is:
〖log σ〗_t^2=α_0+θ_1 d_(state council)+θ_2 d_omo+α_1 (ε_(t-1)/σ_(t-1) )+μ(|ε_(t-1)/σ_(t-1) |-√(2/π))+φ〖log σ〗_(t-1)^2
To study the volatility effects while also ensuring that the dependent variables are stationary, we use the daily change of interest rates as the main dependent variable (∆r_t). (Earlier, we focused on the market news given by the absolute value of the change in the interest rate). Given that the communication variables are dummy variables which could have a positive or negative effect on the level of the interest rate (depending on the message in the communication), in the mean equation we control for the lag of the dependent variable (∆r_t) and the change in the 7-day repo rate, but not for the communication event dummies.
An average State Council communication is associated with higher volatility of short-term market rates (DR007). However, one needs to be cautious with the interpretation of these findings. Especially for ad hoc events - it could be that the volatility in the market leads the State Council to introduce measures/comment current economic developments.
Even if the comment is calming, volatility could remain higher than usual and so the event is associated with high volatility. The EGARCH attempts to control for this by modelling volatility as dependent on the volatility from the previous trading day as well as other covariates.
The alternative interpretation of these results is that the event causes this higher volatility.
When the State Council initiates ad hoc communication, the markets get the message of the communication and that the situation was severe or worrying enough to warrant communication. The same can be said for OMO notices as can be seen in Table 2, where coefficient c(9) is significantly positive.
Table 2:
EGARCH (1, 1) model
