Reforms in China’s Monetary Policy Reforms in China’s Monetary

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Reforms in China’s Monetary Policy
the scale of their lending, which simultaneously increases their deposits and 
thus the required reserves. Therefore, reserves demand brought about by 
the required reserves will increase continuously and rigidly, and the reserve 
demand-to-supply ratio of the banking system will at all times reflect a liquid-
ity deficit. The situation whereby the central bank artificially creates liquidity 
deficit in the banking system by establishing a required deposit reserves sys-
tem is called the “structural liquidity deficit.” The central bank is always the 
lender and commercial banks are borrowers, and the latter has to frequently 
borrow from the central bank in the market to meet requirements. 
Under the institutional arrangement of the structural liquidity deficit, 
commercial banks must obtain reserves to meet rigid reserves demand. For 
banks as a whole, reserves can be obtained only by trading with the cen-
tral bank.
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Regardless of whether they borrow from the central bank or 
sell bonds to the central bank, commercial banks have to lose their inter-
est income, and the reserves they obtain will barely bring them any interest 
income. The commercial banks therefore need to pay the cost of obtaining 
reserves. From another perspective, creating reserves brings income to the 
central bank. Commercial banks pays for reserves while at the same time, 
they have the franchise to create an unlimited amount of money. The central 
bank conducts liquidity management operations to stabilize the value of the 
currency, which can be regarded as a tax levied on commercial banks. 
The central bank uses the institutional arrangement of the required reserve 
ratio to create a structural liquidity deficit, which is power given by laws. The 
central bank imposes compulsory measures on commercial banks to manage 
reserves and money and establishes an exogenous digital connection between 
deposits (the major constituent of money) and reserves (by which the cen-
tral bank can control its own liabilities) to control the money supply and the 
interest rate. The key to this digital connection lies in the central bank creat-
ing a structural liquidity deficit by setting the required deposit reserves ratio 
at a level slightly higher than the supply of reserves. Commercial banks in 
developed countries have a very low level of demand for excess reserves, and 
the demand for required reserves basically represents total reserves demand. 
The main function of the required reserve ratio is liquidity management, and 
if the required reserve ratio is significantly lower than the level of reserves 
held by commercial banks, making total reserves demand lower than the sup-
ply of reserves and ensuring the banking system has a liquidity surplus, then 
the central bank is required to reduce the supply of liquidity to balance the 
demand and supply of reserves. In this case, the compulsory digital connection 
between reserves and deposits of the required reserve ratio no longer exists. 
The function of the required reserves system not only lies in creating 
liquidity deficit, but also lies in stabilizing the demand for reserves. The 

Monetary Theory
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required reserves systems of developed countries usually assess the reserve 
ratio requirements according to the average value or the value at the end of a 
prescribed period. Thus, within the assessment period, the required reserves 
of commercial banks may briefly fall below the prescribed level and may be 
used for clearing and cash withdrawal. In this way, at any time other than 
the end of the assessment period, the required reserve ratio may basically 
cover the total reserves ratio of commercial banks, and the central bank may 
accurately calculate and predict the liquidity demand according to the quan-
tity of deposits as the basis for assessing required reserves and may therefore 
effectively control the reserve demand-to-supply ratio. Hence, the required 
reserves system plays a role similar to that of a “cushion” that absorbs fluc-
tuations in liquidity demand for clearing and cash withdrawal and stabilizes 
total liquidity demand. If required reserves fall below the average level held by 
commercial banks, they will not be able to stabilize liquidity demand. 
According to in-depth research conducted by many economists on the 
relationship between the demand for reserves and money market interest 
rates (Poole, 1968; Feinman, 1993; Strongin, 1995; Hamilton, 1996, 1997; 
Bernanke and Mihov, 1998; Furfine, 2000; Woodford, 2000; Meulendyke, 
1998), provided that an effective required reserves system is implemented, 
the central bank can accurately control short-term money market interest 
rates through short-term trading, and a liquidity management framework of 
the structural liquidity deficit has been proven to be effective. 
In China, there is a deep seated misunderstanding about the role of the 
required reserve ratio and the mechanism by which it has an influence. People 
believe that when commercial banks absorb deposits from the public, they pay 
the required reserves, which guarantee the liquidity for payments. According 
to this understanding, an increase in deposits will lead to an increase in the 
supply of reserves, and there will be a liquidity surplus in the banking system. 
However, in practice, reserves held by commercial banks (including required 
reserves and excess reserves) originate from asset increases in the central bank 
and are offered and controlled by the central bank (Sun, 2001). An increase 
in deposits represents an increase in liabilities of commercial banks, leading 
to an increase in demand for reserves, and there will be a liquidity deficit in 
the banking system. This is why central banks of developed countries estab-
lish a required reserve ratio to create a structural liquidity deficit.
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