China's Easily Overlooked Monetary Mechanism: Monetary Reservoir

One explanation for the counter-cyclical boom in real estate is that real estate sector absorbs over-issued money. In China, local government officials have promoted the boom in the real estate sector by increasing government debt to indirectly finance economic growth, which we call the monetary reservoir mechanism. The monetary reservoir mechanism replaces the traditional monetary transmission mechanism from the central bank to commercial banks, and the fiscal expansion of local governments becomes the main monetary transmission channel. This paper first establishes a theoretical framework to analyze loan contracts, financial intermediaries, fiscal investment, and also financing and then investigates the pathway and long-term equilibrium of this special monetary transmission mechanism using cities-level panel data from 2003 to 2019. The results show that the Monetary reservoir mechanism strengthens the effectiveness of price- based monetary policy through mediating and interaction effects, but reduces the effectiveness of the quantity-based monetary policy. Land finance and financing platforms are policy instruments by local governments that independently influence the effectiveness of the monetary policy. Land finance and autonomous fiscal expansion are important factors driving China’s economic growth and aggregate demand recovery after the financial crisis. However, the concern is that the monetary reservoir mechanism necessarily ends with large-scale monetization of fiscal deficits, for which we name it as the monetary reservoir mechanism.