20 October 2018
Rather than tinker with interest rates, China prefers to adjust the reserve ratio for commercial banks because of its immediate effect in managing liquidity. Photo: Bloomberg
Rather than tinker with interest rates, China prefers to adjust the reserve ratio for commercial banks because of its immediate effect in managing liquidity. Photo: Bloomberg

Why China likes to tinker with bank reserve ratio

As more indicators show the Chinese economy is facing rising pressure to slow down, calls grow for a cut in the reserve requirement ratio (RRR) for commercial lenders.

Whether the government should heed these calls remains a question for debate, but it is clear China prefers to adjust RRR rather than tinker with interest rates when it wants to change monetary policy.

In fact, since the end of the 2008 global financial crisis, every one of the monetary turnabouts in China started with RRR adjustment.

Last time China adjusted the reserve ratio was in May 2012 when it raised it to 20 percent, a very high level that is rare in the world.

The reserve ratio and interest rates are two common tools the world’s central banks use to manage liquidity and overall monetary situation.

By comparison, other major economies seldom change their RRRs and they keep the ratio very low. For example, the eurozone set the ratio at 2 percent in 1999 and lowered it to 1 percent in 2012. The ratio has remained unchanged till now.

The United States tends to change its interest rates but keeps RRR stable and low. Some other countries including the United Kingdom, Canada and Australia do not even have a required reserve.

This shows major economies are not big fans of RRR adjustments. So, why is China in the habit of using it?

The root cause is that China’s financial market is underdeveloped so that interest rate moves may not achieve the goal of adjusting liquidity as quickly as RRR adjustments do.

The depth and breadth of China’s financial market are smaller than those in developed countries. The variety of China’s financial products remains limited and their coverage economic spectrum is also narrow.

In addition, China’s interest rate regime is not fully liberalized. The market does not decide the rate by itself, so financial products are not priced on interest rates or market-oriented yields.

All these factors determine that market response to interest rate changes is not as highly sensitive as in other major economies. Because of the difference, the effect of interest rate adjustments could take time and can be discounted.

By comparison, RRR adjustments can immediately change liquidity in the banking system and quickly help achieve the money management goals of the central bank.

Also, China can comfortably resort to RRR changes to control money supply because of its high saving rate.

To be specific, Chinese are the world’s most saving people. The country’s saving rate is more than 50 percent. A large amount of money are parked in banks in the form of deposits, a situation that allows the central bank to control liquidity by aptly manipulating the amount of money banks can lend.

By the end of April, renminbi deposits were 108.45 trillion yuan (US$17.34 trillion) which means a change of 25 basis point in RRR can translate into  a difference of 271 billion yuan in the money supply.

The amount is equal to more than one-third of monthly new loans, which means that adjusting the reserve ratio can quickly achieve the goal of changing market liquidity.

China’s investment structure has helped the central bank develop the habit of using RRR adjustments in managing liquidity.

Chinese like to invest by their own instead of entrusting their money investment agencies. In stocks, properties, bonds, funds and precious metals, it is retail investors that dominate the market. Individual investors account for 70 percent of the stock market.

Retail investors are less sensitive to interest rate changes, especially when the change is small, but institutional investors would actively adjust their investment portfolio in response to the slightest change in interest rates.

Because of the difference between retail and institutional investors, economies such as the US and the eurozone, where institutional investors manage most of the capital, tend to adjust interest rates to guide the market.

China has a different story. Since retail investors manage a huge bulk of the money, their slow response will greatly reduce the effect of interest rate changes. That also prompts the central bank to lean toward RRR changes, a direct and swift way of adjusting money supply.

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The writer is an economic commentator. He writes mostly on business issues in Greater China.

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