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A nice idea Mr Yam, but it will be a long time before it can fly

Ex-Monetary Authority chief's call for an end to PBOC's use of reserve requirements is unworkable as long as China maintains capital controls

PUBLISHED : Wednesday, 19 February, 2014, 1:27am
UPDATED : Wednesday, 19 February, 2014, 1:27am

Former Hong Kong Monetary Authority boss Joseph Yam Chi-kwong may have retired from his position as the world's most generously paid central banker, but he is still eager to dispense his advice to anyone who will listen.

In 2012 he called on Hong Kong to scrap its currency peg to the US dollar - the very same peg that Yam spent much of his career defending.

Replacing the link to the US dollar with a Singapore-style managed float, he argued, would lead to greater price stability and boost Hong Kong's role as an international financial centre.

Few took his advice seriously, which was just as well because neither of Yam's claims stood up well to examination.

For one thing, Singapore's managed float has done little for local price stability. Historically its inflation rate has hardly differed from Hong Kong's.

And for another thing, it makes good sense for Hong Kong as a financial centre to link its currency to the US dollar, given that the world's financial flows are overwhelmingly US dollar-denominated.

The central bank imposes a high reserve requirement for one overriding reason: it’s cheap

Clearly, however, Yam was undismayed at the lukewarm response generated by his 2012 recommendation, because now he's at it again.

This week he published a paper calling on the People's Bank of China to ditch its reliance on reserve requirements for managing monetary policy, and to adopt a Western-style policy interest rate instead.

Constraining monetary growth by forcing commercial banks to set aside 20 per cent of deposits at the PBOC as required reserves is not only inefficient, argued Yam, it "is in effect a tax on the banking system" which has encouraged the growth of China's shadow markets.

Yam does have a point here. The PBOC would dearly like to move to a policy rate. And using reserve requirements is indeed an inefficient way to direct monetary policy, although the tax falls on ordinary depositors rather than on the banks.

But the central bank imposes a punitively high reserve requirement for one overriding reason: it's cheap.

China runs a sizeable trade surplus with the rest of the world. It also welcomes inward investment while imposing strict controls on capital outflows. As a result, the country's financial system gets enormous net inflows of foreign money.

Normally all that cash pouring in would push the yuan sharply higher on the foreign exchange market. However, to prevent runaway appreciation, the PBOC intervenes heavily in the market, buying foreign currency and selling yuan.

Selling all that yuan would naturally tend to boost China's money supply, threatening both asset price and consumer inflation. So to keep a grip on prices, the central bank must mop up - or sterilise, in the jargon - the floods of yuan it releases into the domestic financial system.

There are two ways it can mop up. Firstly, it can borrow the money back again by selling vast quantities of central bank bills to China's banks.

Unfortunately such heavy issuance would tend to push up interest rates, which would only attract more inflows, compounding the problem.

What's more, it also would inflict heavy losses on the central bank, which would earn less on its foreign currency assets than it would have to pay on its domestic liabilities.

So instead the PBOC relies on the second method. It simply orders China's banks to lodge a sizeable proportion of their deposits at the central bank as required reserves - reserves on which it pays only a stingy 1.62 per cent interest rate.

In a nutshell, as long as China maintains its capital controls, it is obliged to rely on reserve requirements to manage domestic monetary conditions.

And as even Yam concedes in his new paper, China's financial system is too fragile for Beijing to allow free capital flows just yet.

For the time being, at least, his latest hobby horse will remain a non-starter.

tom.holland@scmp.com