Readers may be aware of the use by central banks of a policy instrument called "reserve requirements", or the "Deposit Reserve Requirement Ratio" in the case of the Mainland, as one of the tools to regulate the loanable funds of banks. With effect from 15 August, for example, the Deposit Reserve Requirement Ratio of deposit-taking financial institutions on the Mainland was raised by 0.5% to 8.5%. Other things being equal, an increase in the Deposit Reserve Requirement Ratio, which is measured as a percentage of deposit liabilities and used partly for the supervisory purpose of ensuring that deposit-taking institutions have liquid funds to repay depositors if necessary, has a restraining effect on the ability of deposit-taking institutions to create credit.

But the assumption of other things being equal is unlikely to be realistic. In the case of the Mainland, which is running a large current account surplus and is rapidly accumulating foreign reserves, the sum of balances in the clearing accounts with the central bank, what we call here in Hong Kong the Aggregate Balance, keeps increasing. Although the People's Bank of China has been issuing quite a lot of short-term paper to "sterilise" the capital inflow, in other words to try to slow down the increase in the Aggregate Balance, or prevent it from increasing, the banks must have still found themselves holding increasing amounts of money in their clearing accounts with the People's Bank, to the extent of being able to accommodate rapid increases in loan demand. This is perhaps why the Deposit Reserve Requirement Ratio has been raised twice in recent months.

Increasingly, central banks in other parts of the world focus more on the control of the price of money (interest rates) than on the supply of money in conducting monetary policy. While changes in reserve requirements can affect short-term interest rates by changing banks' demand for reserves, these actions can have disruptive effects on banks since banks need time to adjust their portfolios to accommodate the changed requirements, especially if the financial markets are not fully developed and the distribution of excess reserves among banks is uneven. For example, the Federal Reserve of the United States determines a Fed funds target rate, through the deliberations of its Federal Open Market Committee, and conducts open market operations to ensure that at least the short-term interest rates in the money market remain close to the target and leaves the banks to perform their role of credit allocation. This is similarly the case in other major economies. While a reserve requirement is not a flexible tool for fine-tuning monetary operations, we need to bear in mind that it is a powerful tool to deal with a structural surplus in liquidity, which is the situation the People's Bank is facing given the current policies of exchange rate and capital account controls.

Another reservation in the use of reserve requirements for monetary or supervisory purposes is the cost being imposed on banks. A reserve requirement higher, for whatever purpose, than a prudent liquidity ratio means that banks are forced to hold an excess amount of low-yield assets. Reserve money (or deposit reserves) held with central banks is usually paid quite low interest rates. In any case, even for the purposes of ensuring adequate liquidity to repay deposits, there may be higher-yield and equally liquid assets than the reserve money that banks are required to hold. Readers may be aware that there is no reserve requirements for banks in Hong Kong, although our Banking Ordinance specifies a clearly defined statutory liquidity ratio for authorized institutions.

The required deposit reserves held with the People’s Bank currently earn interest at 1.89% a year and any amount in excess of that earn 0.99%. These interest rates are significantly lower than the one-year time deposit rate of 2.25%, although demand deposits are paying only 0.72%. And reserve money constituted around 11% of total assets of the deposit money banks at the end of 2005. On top of this, another 11% or so of assets was in the form of central bank bills and treasury bonds currently earning around 2.5% on average, which is only slightly higher than the one-year time deposit rate. In order to make money, banks need to keep the lending rates high to compensate for the reduced earnings arising from the Deposit Reserve Requirement Ratio. Although higher lending rates may suit current macroeconomic conditions, a required deposit reserves forming a significant proportion of the total assets of banks does mean a bigger-than-usual gap between deposit and lending rates, implying a loss for depositors (because of a relatively low deposit interest rate) and borrowers (in terms of relatively high interest rate on bank credit). From a macro perspective, when banks are forced to place a significant amount of deposits with the central bank earning relatively low yields, the financial intermediation by banks will become less efficient.

Capital inflow and the reluctance of the private sector to hold the very limited choice of foreign currency assets on the Mainland (partly as a result of exchange rate expectation and foreign exchange control) will continue to influence monetary developments on the Mainland. Perhaps greater freedom for the private sector directly or indirectly to invest their foreign currency holdings in a much greater variety of foreign currency assets overseas would help.

Joseph Yam

17 August 2006

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