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Tuesday, January 3, 2012

China's Reserve Ratio Tactic

As last year drew to a close, the Peoples Bank of China cut the reserve requirement for local banks in an effort to swiftly ease funding liquidity conditions in the country.

In this post, we look at this tactic and why the central bank is doing this.

On 5th of December Peoples Bank of China cut the reserve requirement by 50 basis points to add an expected CNY 350 billion into the local financial system. The policy move happened only hours before the US Federal Reserve and the European Central Bank stated that they were cutting the cost for emergency funding in their markets respectively. All these efforts are targeting the same problem; funding liquidity and money supply.

Interestingly, only a year earlier China was doing the opposite. In fact in December 2010 it raised the reserve ratio three times in a matter of weeks alone to mop excess cash in the economy and in the end, it finished up with a final reserve that required local banks to hold 18.5% depositor cash in its own coffers. By directly changing the bank's loan to deposit ratios will have swift impacts on borrowing but 18.5% is extremely high, actually a record high for China. So that was last year, this year however, things are moving the other way.

Controlling & Driving Inflation
Central banks have several ways to influence inflation, economic expansion and contraction. The most obvious method is to reduce the interest rate or equivalent "risk free like" rate in which banks can borrow directly from the central bank itself. Nearly all countries will use this monetary policy instrument to stimulate lending in the economy and they fuel expansion by dropping the base interest rate appropriately. However, in China's case interest rates were raised 5 times between October 2010 and August 2011 to deflate concerns with price growth in the economy but as 2012 turns on the calendar, the central bank has shifted the gear into reverse when it comes to interest rates.
  
  Figure 1 | China's Interest Rates, Trading Economics
  
So why does China focus on reserve requirements rather than interest rates to control inflation?

The simple answer is to target foreign investment and capital flows. Before the European markets started to unwind in August 2011, China's economy was beginning to form its own asset price bubble and higher interest rates were aimed at having a dampening effect on this growth. As the calamity in Europe spread from one sovereign nation to another, Asia's role became even more embedded as the investor haven for the global economy and Asia very much appeared to be resilient in some respects to the debt woes of Europe. Capital continued to enter China and trade surplus was diminishing but when the crisis deepened, these cross boarder capital flows switched and they did this flip quite rapidly.
  

The last time this happened, the world economy was in severe shock from the collapse of Lehman Brothers. We must keep that point in mind.

Central Bank Policy
China's strategy here is a smart move if you are believer in the use of reserve requirement ratios for controlling money supply but some economists are not. Going along with the story here, if China leaves its interest rate high and relaxes the reserve requirement ratio, there are several potential outcomes it might benefit from.
  
Figure 3 | Policies for stimulating and dampening lending (click to enlarge)

Firstly capital outflows should slow as investors would remain in positive yield territory by leaving their funds in China. Secondly, moving the reserve requirement has a quick response to economic liquidity without banks being immediately impacted from duration gaps between their funding and lending lines. Changing interest rates creates the same response but has a broad impact across all risk weighted asset classes, new and old. Then, if the European crisis is resolved quickly the reserve ratio can be lifted again if need be and finally this is a step, a reinforcing step. Dropping interest rates signals to the market that growth is retracting, while opening up the flood gates to immediate money supply via reserve requirements increases cash velocity directly in the market place. If the policy is not effective then interest rates will be dropped as a second weapon for smoothing the downward economic cycle.     

Figure 4 | Bank for International Settlements on Reserve Requirement Ratios

Reserve requirement ratios aren't used by all central banks and the structuring of them can differ substantially between nations when they are actually entertained. In the emerging markets particularly, they are a popular tool that is designed to work alongside a standard monetary policy of interest rate setting, some analysts on the other hand; simply don't believe they are effective. Stiglitz and Greenwald fall into this camp and they wrote a paper on the problems of reserve requirement ratios.
Banks will attempt to maximize their utility by minimizing their risks and in doing so, they will be willing to find a combination of interest rate charged on loans and expenditure screening through which they can reach a maximum level of utility.
Causes and Cures for Credit Rationing Stiglitz and Greenwald
All this aside, China is actively using this strategy and it will be interesting to see how it all pans out. So here we are in 2012 and while the calendar date has changed the global economy hasn't and, it is starting to become evident that we could be in for more economic shocks as we move through the first part of this year.

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