China’s evolving reserve requirements

Abstract

We examine the role of reserve requirements as a cheaper substitute for the open market operations of the People’s Bank of China (PBC) to sterilise foreign exchange interventions in recent years. China’s reserve requirements have also been used to address a range of other policy objectives, not least macroeconomic management, financial stability and credit policy. The preference for reserve requirements reflects the size of sterilisation and the associated costs, in a quantity-oriented monetary policy framework faced with policy dilemmas. The PBC often finds it easier to make reserve requirement adjustments than interest rate decisions and enjoys greater discretion in applying this tool. The monetary effects of reserve requirements need to be explored not in isolation but in conjunction with other policy actions. Depending on the policy mix, higher reserve requirements tend to signal a tightening bias, to squeeze excess reserves of banks, to push market interest rates higher and to help widen net interest spreads, thus tightening domestic monetary conditions. Reserve requirements, however, impose an implicit tax burden on Chinese banks, albeit the latter seem to pass through a large but incomplete portion of these costs to their customers.

Keywords:

• reserve requirements
• sterilisation tools
• monetary policy
• net interest margin and spread
• tax incidence
• Chinese economy

JEL Classifications:

• E40
• E50
• E52
• E58
• E60
• H22

Acknowledgements

The views expressed here are those of the authors and do not necessarily reflect those of the BIS or the PBC. We wish to thank J Anderson, V Chan, Chen Hongyi, J Chen, Chen Qingying, Cui Li, A Filardo, M Hyvonen, R McCauley, R Moreno, C Montoro, Shu Chang, Wang Honglin, Wang Tao, D Wu and May Yan for their comments and Lillie Lam and Majorie Santos for their excellent assistance. Any remaining errors are ours.

Notes

1. For a discussion of the evolving Chinese monetary and financial system, see Yi (2009), Conway, Herd, and Chalaux (2010), Wang (2011), Chen, Chen and Gerlach (2011), and He and Wang 2011.

2. The decline in the average interest cost on deposits in 2010 may also relate to two other factors. First, the maturity composition of deposits shortened as inflation rose, owing to lags in deposit rate hikes. Second, some interest expenses could be included in other bank expense categories to circumvent the official ceiling on deposit rates.