Reserve ratio to play bigger role in China's monetary policy

Beijing will rely more on adjusting the ratio to counter a slowdown, with rate controls in flux

PUBLISHED : Saturday, 26 April, 2014, 1:21am
UPDATED : Saturday, 26 April, 2014, 1:21am

Beijing's relaxation of interest rate controls has left cutting banks' required reserves as the chief monetary tool to counter a slowdown, focusing attention on an option used in the past decade only during financial crises.

Premier Li Keqiang's insistence that the mainland would not implement more powerful stimulus than faster spending on railways and reserve ratio cuts for rural banks has failed to sway economists, who predict the central bank will lower the ratio nationwide this year. The tool unleashes about US$80 billion of liquidity into the system for every half-percentage-point cut.

The mainland has put its interest rate system in flux with last year's removal of limits on borrowing costs and a shift towards interbank market rates. That has left officials reliant on the reserve ratio tool if they need to call on monetary policy to support growth even as they seek to give markets a greater role and rein in surging debt.

"The changing regime means the reserve ratio has a more material impact because it impacts liquidity in the interbank market," said Yao Wei, China economist at Societe Generale. "That changes the interest rates that actually matter."

Beijing last lowered reserve ratios during the depths of the European debt turmoil, when three cuts were made from November 2011 to May 2012. Reductions had also coincided with periods when capital had flowed out of the country, said Michael Pettis, a finance professor at Peking University in Beijing.

The government had used increases in the ratio as an "industrial-sized vacuum cleaner" to soak up liquidity when the nation faced a balance-of-payments surplus or was buying US dollars to prevent the yuan from appreciating, said David Loevinger, former US Treasury Department senior co-ordinator for China affairs and now an analyst at TCW.

Mainland authorities are transitioning from a system of state-directed credit to one where markets play a "decisive" role in pricing capital. A floor was removed from lending rates in July and People's Bank of China governor Zhou Xiaochuan said deposit rates would be liberalised in one to two years.

Beijing has increasingly used tools including repurchase agreements to manage liquidity in the financial system and influence interbank rates.

"The PBOC is struggling to find a new framework for monetary policy and what's the best rate to target," said Shen Minggao, head of China research at Citigroup.

Xu Gao, chief economist at Everbright Securities, said policymakers would prefer to cut the reserve ratio over interest rates because reducing the ratio could release money into the system while influencing expectations.