Reserve requirement a tool to prop up rigged exchange rate

PUBLISHED : Thursday, 06 May, 2010, 12:00am
UPDATED : Thursday, 06 May, 2010, 12:00am

The mainland's central bank has ordered commercial lenders to set aside more deposits they must keep in reserve instead of lending out, in a surprise move amid the three-day Labour Day holiday to rein in an explosion of new loans.

South China Morning Post, May 3

Surprise move? It was as predictable as the sunrise and, where reining in explosions (or defusing horses) is concerned, as likely to stimulate as restrain lending growth.

Let's go back to basics here. In the good old days, monetary discipline was a simple matter. The king would have a bad likeness of himself stamped on a gold disc of a standard weight and decree that anyone who monkeyed with this coin would be burned alive, boiled to death and then clapped in a dungeon for the rest of his days. It generally worked if the king did not himself monkey with the coin. He generally did.

Things are more complex these days. You still have to believe that the king, now Federal Reserve board chairman Ben Bernanke, won't monkey with the currency but he needs different tools to make sure the monetary system works properly.

He has three such tools. They are: (1) the statutory reserve requirement, (2) open market operations and (3) the discount rate.

You can look up yourself how (2) and (3) work. They are the shorter-term fine-tuning tools. Our subject matter today is (1) the statutory reserve requirement, which is the longer-term basic mechanism.

What a central bank does here is order all commercial banks under its authority to put aside a fixed percentage of customer deposits and keep that money out of circulation.

Thus, in simple terms, if you deposit $100 with ABC Bank and the statutory reserve requirement is 6 per cent, ABC Bank will keep $6 cold in its vaults and put only $94 out to work as loans. If the borrower of this $94 subsequently deposits it, ABC Bank will keep $5.64 (6 per cent of $94) cold in its vaults and put only $88.36 to work as loans and so on.

Get the figure for the reserve requirement right and your financial system will generate just the right amount of liquidity to keep things running smoothly. For finer adjustments, the fine-tuning tools can be brought in.

Two fundamental characteristics of the statutory requirement need emphasis, however. The first is that the percentage reserve figure should only very infrequently be changed. Once you get the right figure, you stick with it.

I now refer you to the chart. The People's Bank of China seems to have forgotten this entirely at some point over the past 10 years.

The second fundamental characteristic is that these reserves must be kept cold to have any monetary effect. If you take the money out of the vault to put it back in circulation, then you may as well not bother with statutory reserves at all.

And now guess what mainland banks do.

Yes indeed, the money does not go into the vaults. It goes directly to the PBOC, which then puts it directly to work again.

Let's not be too harsh on the PBOC for breaking the rules, however, as it is under great pressure. The bosses in Beijing want to go softly, softly on any appreciation of the yuan but money continues to flow in from big trade surpluses.

Currency speculators are also putting on bets that the yuan will soon have to strengthen again.

To hold the line against this pressure, the PBOC has to mop up the inflows by finding enough yuan to give all these foreign-currency holders in exchange for their foreign currency. Here follows a quiz.

Question: Why do bank robbers rob banks?

Answer: Because that's where the money is, stupid.

Question: Why do governments rob banks?

Answer: For the same reason, stupid.

So what the PBOC likes to bill as a measure undertaken for responsible monetary management turns out to be nothing more than the propping up of a rigged exchange rate with ever more frantic grabs for money.

My colleague Tom Holland has already pointed out in the Monitor column on Tuesday how ineffective this misuse of a monetary tool has been in restraining credit growth.

I can only add that it is probably worse than useless because the tinkering with the yuan exchange rate is done at the expense of real monetary discipline.

And I wonder whether high-ups in the central bank have not themselves been fooled by this pretence of monetary responsibility. That would be sad.

Howler. In Tuesday's column, I confused China's 40 per cent personal tax rate with the corporate tax rate, which has now come down to 25 per cent. Several people also wrote me to say that they pay Hong Kong tax on exports from China that passed through Hong Kong. Really? Why?