Understanding Chinese QE

Advertisement

From Capital Economics via FTAlphaville:

Screen-Shot-2015-05-06-at-2.50.42-PM1The level of reserves is unaffected by changes to the RRR. It also doesn’t change when new deposits are created through the issuance of bank loans. When a bank credits a borrower with a new deposit, it doesn’t have to “lock” anything up. Instead, the relationship runs in the other direction. The level of reserves, in conjunction with the required reserve ratio, puts an upper limit on the amount of deposits that can exist in the banking system. This is equivalent to putting a cap on the amount that banks can lend since the majority of deposits are created by bank lending (the exceptions are those deposits created through asset purchases by the central bank). If, for example, the level of reserves is RMB1trn and the reserve requirement ratio 20%, the maximum amount of deposits in the banking system is capped at RMB5trn.

…One reason reserve requirements are prone to being misunderstood is that until recently such quantitative monetary tools had fallen out of favour in much of the rest of the world. The textbook central bank instead targeted a desired level of interbank rates and provided whatever quantity of reserves was demanded to meet it.

China is different. The People’s Bank does not have a fixed target for interbank rates. It still relies heavily on adjusting the quantity of reserves or the RRR (or a combination of both) to control the pace of lending. This explains the volatility in China’s interbank market, where rates can swing wildly depending on how scarce or abundant excess reserves are.

The key point is that the RRR remains a constraint on the capacity of banks to expand lending. The 100bp RRR cut that came into effect on 20th April will at a stroke have increased the excess reserve ratio. As long as banks have profitable lending opportunities and no other constraints apply then, other things being equal, banks will respond by increasing lending.

…Of course, the qualification that other things are equal doesn’t always hold. Many recently have expressed concerns over capital outflows and how they affect monetary policy. Outflows don’t, in themselves, directly affect banks’ ability to lend. But if the PBOC responds by selling foreign exchange, these FX sales reduce the quantity of reserves, which tightens monetary conditions. The PBOC can offset this tightening either by cutting the RRR or increasing the quantity of reserves using other monetary policy tools (open market operations but also, for example, the re-lending programmes under discussion in recent days).

The implication is that a portion of the loosening provided by the last two RRR cuts was needed to offset the tightening impact of the PBOC’s recent FX sales. As a result, the overall policy stance won’t have eased by as much it might initially have seemed. Crucially though, this does not mean that RRR cuts have become less effective. Their impact on bank lending constraints is unchanged, even in the face of capital outflows. It is simply that they are now being used partly as a tool to offset tightening elsewhere.

Exactly right. QE ain’t new in China!

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.