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  • Apr 17, 2014
  • Updated: 12:43pm
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Time for PBOC to switch to policy rate system, Yam says

Yam says the existing reserve ratio mechanism is not efficient enough in managing money supply

PUBLISHED : Monday, 17 February, 2014, 5:38pm
UPDATED : Tuesday, 18 February, 2014, 2:18am

Beijing should adopt a Western-style interest rate policy mechanism to make capital allocation in the banking system more efficient, said Joseph Yam Chi-kwong, the former chief of the Hong Kong Monetary Authority.

Yam, who headed the city's de facto central bank from 1993 to 2011, wrote in a new research paper that making the change could help Beijing better manage liquidity in the financial system.

"It is time that China's central bank adopts a clearer system to manage money supply," Yam, now a professor at the Chinese University of Hong Kong, said in a media briefing yesterday.

Mainland authorities have historically conducted monetary policy mainly through the use of the required reserve ratio, which effectively rations the availability of credit in the system by setting the proportion of deposits banks must maintain as reserves. The higher the ratio, the fewer loans a bank can make. The mainland's reserve ratio currently stands at 20 per cent for the biggest banks.

But over the past 18 months, the People's Bank of China, which is actively pursuing a policy of liberalisation to let market forces play a greater role in setting the price of credit, has been letting the Shanghai interbank offered rate act as the key indicator of the availability of credit in the system.

"The introduction of a policy rate can send a clearer message from the PBOC on monetary policy and reduce the volatility of Shibor," Yam said.

If Shibor moves too dramatically in one direction, the central bank is in theory able to adjust money supply through the issue or repurchase of government bonds to nudge market rates towards the level that policymakers believe to be appropriate for the prevailing economic outlook.

The United States Federal Reserve, for example, conducts so-called open-market operations to adjust the supply of reserve balances maintained by banks to keep market interest rates roughly in line with the target it sets at its policy meetings.

The PBOC has been under steady criticism since the middle of last year for failing to provide banks with clear enough signals of its intentions regarding money supply and its concerns about the availability of credit.

A jump in Shibor in June last year, followed by similarly sudden surges in interbank rates in successive quarters since, has been blamed on the central bank's failure to communicate its policy intentions clearly.

The PBOC said the surges were a consequence of its actions to curb rampant lending outside the formal banking system.

Yam said the emergence of the huge shadow banking sector was evidence that the mainland's existing banking system was not functioning well.


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So the real value of the reserves hasn’t changed at all --- just the accounting value in yuan,
but this simply recognizes losses that were already taken long ago when the trade was made, and that should be a largely irrelevant number.
Of course after the revaluation there are a whole set of winners and losers in China, given the different balance sheets (net long dollars or net short dollars) of individuals and companies.
(From ‘Avoiding the Fall’)
Mr. Yam also said in his article [ IV. Foreign Exchange Market (3) Other Questions, point 40. ] that last year, the 3% revaluation of the yuan against the US dollar, given China’s US$3.5 trillion average reserves, means a loss of US$105 billion suffered by China.
Well, it’s just an accounting loss, not real loss.
All China (or any other country) can do with foreign exchange reserves is to pay for foreign imports or repay foreign obligations.
Foreign reserves cannot be spent at home for obvious reasons, and the real value of foreign reserves is the value of what it can do with the reserves abroad.
But the value of things it can purchase or pay for abroad is unaffected by the exchange value of the currency.
If the value of the reserves drops 10 per cent in yuan terms when PBoC revalues the yuan, so does the value of all those foreign payments --- by definition they must go down by exactly the same amount in yuan terms.
China takes no loss on the dollars it has in its foreign currency reserves. It can buy and pay for just as much “stuff” after the revaluation as it could before the revaluation --- the real value of money is what you can buy with it.
The Chinese authorities also view the yuan exchange rate as a tool to curb inflation.
Revaluing the yuan against the US dollar helps alleviate substantial external cost-push pressures.
But even massive nominal appreciation of the yuan vis-a-vis the US dollar won't greatly reduce China's trade surplus in the foreseeable future, since the current account surplus is dictated by China's massive excess savings.
And given the relatively high interest rates in China relative to other countries, carry trade is still profitable and is a one-way bet.
Which means capital will keep on flowing into China, either legally or illegally, in addition to those FDI inflows.
To avoid currency appreciation and high domestic inflation (overheated economy), the authorities have to keep on performing sterilization to neutralize the impacts of capital inflows.
With US interest rates at near zero,
and the yuan revaluing relatively slightly against the US dollar,
PBoC's sterilising the still huge foreign exchange interventions (given China's still massive exports earnings, and the FDIs) has become costlier,
because the central bank cannot sell its bills to the banks at zero rate internally.
The authorities could no longer ensure easily that the return on their foreign exchange reserves is greater than the rates the PBoC pays on the bills it sells to the banks.
But PBoC pays a much lower rate on banks' required reserves than on central bank bills.
Hence it has preferred to mop up liquidity by hiking the required reserve ratio (RRR).
Replacing the RRR by a policy rate may increase the central bank's cost to maintain a relatively steady yuan exchange rate against the US dollar.
(Adapted from 'The American Phoenix')


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