Are PBOC Reserve Ratio Cuts Better for Liquidity Management Than OMO?

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One of China’s leading economists and monetary policy experts believes that adjustments to  the required reserve ratio of Chinese banks could prove more effective than open market operations for the precision management of liquidity in the economy.

The People’s Bank of China recently announced that a range of Chinese banks would receive a one hundred basis point reduction in their required reserve ratios starting from 25 April, including large-scale commercial banks, joint-stock banks, municipal commercial banks, non-county village commercial banks and foreign-invested banks.

The reduction is expected to unleash 1.3 trillion yuan in liquidity, of which 900 billion yuan will be used to repay the medium-term lending facilities (MLF)  borrowed by lenders from PBOC as part of the latter’s open market operations.

Yu Xuejun (于学军), an economist and veteran regulator of both PBOC and the China Banking Regulatory Commission, believes that reductions in the required reserve ratio may prove to be more effective than open market operations when it comes to channelling funds to the real economy.

During the first half of 2017 Yu delivered a series of public speeches calling for regulators to “restore warped Chinese-style monetary policy to a normal state,” via “appropriate reductions” in the usage of monetary tools such as medium-term lending facilities, pledged supplementary lending and reverse repos, and their gradual replacement with reductions in required reserve ratios.

Observers such as chief economist for UBS China Wang Tao, as well as Yu Xuejun himself, are now pointing out that the Chinese central bank’s recent actions appear to have followed his prescriptions

“I have researched macro-economics and monetary policy for more than 30 years,” said Yu to 21st Century Business Herald. “This reduction in the required reserve ratio and my opinions from the past year and half are completely consistent.”

With respect to the use of reserve ratio reductions to release funds for repaying MLF, PBOC has said that it can “increase the long-term supply of funds and reduce bank funding costs.

“Swapping out MLF will enable commercial banks to reduce their interest payment costs, and be of benefit to reducing enterprise financing costs.”

Yu Xuegang also contends that the use of reserve ratio reductions instead of open market operations will prove more effective at directly channeling funds to China’s real economy.

“The loans funds released by adjustments to reserve ratios and the use of new policy tools such as MLF appear the same superficially, but are in fact greatly different,” said Yu.

According to Yu the funds released by reserve ratio reductions are derived from the base deposits of China’s depository financial institutions, which are primarily funds from the market that under normal conditions would return to commercial banks for investment in the economy.

New monetary tools such as MLF instead involve operations on financial markets, where in Yu’s opinion funds are often wont to “float” between financial institutions.

Many of these funds will eventually flow towards policy, trust or securities financial institutions, and be primarily directed towards government-led infrastructure investment or the real estate market, instead of “real enterprises.”

Yu further points out that the Chinese central bank has ample room to manoeuvre when it comes to reserve ratio cuts, given that China’s levels are still comparatively high at 14 – 16%, as compared to the historic and international standards of 6 – 8%.

“With regard to China’s current and future macro-economic controls, reductions in required reserve ratios are definitely the correct direction, and I expect that there is still a long path to follow”

 

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