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

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Reforms in China’s Monetary Policy
three types of instruments at the edge of the central bank liabilities spectrum 
will be maintained: required reserves at the point of origin, excess reserves 
and cash at the high end of the liquidity scale, and central bank bonds at 
the high end of the liquidity and marketization scales. When it is neces-
sary to withdraw liquidity, the central bank either raises the required reserve 
ratio or adopts the market-based method to issue bonds, and other liabilities 
instruments in-between can be substituted by central bank bonds. These two 
operation methods precisely embody the dual identities of the central bank 
as the administrative department and market participant. 
Based on comparison of these two operation methods above, we can clearly 
see their advantages and disadvantages. The major advantages of increasing 
the required reserve ratio to hedge foreign exchange intervention are a strong 
degree of exogeneity and low cost. But its shortcomings are as follows: 
(1) Reduce the competitiveness of commercial banks, and therefore the 
scope of any increase of the required reserve ratio is very limited. As noted 
earlier, the required reserve ratio is actually a type of taxation. High required 
reserve ratio will obviously reduce the competitiveness of commercial banks, 
especially in international competition with the participation of foreign 
banks. The decline of the competitiveness of China’s commercial banks would 
constitute a long-term threat for the banking industry. Therefore, raising the 
required reserve ratio has its limitations and cannot be used for increasing the 
demand for liquidity. In the late 1980s, large amounts of foreign exchange 
flowed into Korea, and the Bank of Korea had to increase the required reserve 
ratio from 4.5 percent to 7 percent in November 1987 and kept raising the 
ratio even higher to 11.5 percent in February 1990. As a result, commercial 
banks and nonbanking financial institutions competed fiercely. Commercial 
banks were in great difficulty, and at the same time foreign exchange kept 
flowing in. Therefore, the Bank of Korea came to the conclusion that it was 
very difficult to use required reserves as monetary policy instruments to hedge 
capital inflows. 
(2) Frequent changes in the required reserve ratio interfere with the opera-
tions and expectations of commercial banks. The required reserve ratio is 
increased to influence the demand for reserves by changing the parameters 
of the reserves demand function, which is the inverse of the money supply 
function. Frequent changes in its parameters mean radical fluctuations in the 
parameters of money supply function of the commercial bank, which will 
seriously interfere with the normal operation of commercial banks, deprive 
commercial banks of stable expectation, and influence the sound operation 
of the banking system. 
(3) Decrease the efficiency of the banking system and the monetary con-
trol system. The quantity of reserves is an important indicator reflecting the 

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efficiency of the banking system and the monetary control system. A smaller 
amount of reserves means higher efficiency, while a larger amount of reserves 
means lower efficiency and the society as a whole has to pay too much for 
monetary control. Thus, the international trend is to continuously lower the 
required reserve ratio, and an important issue faced by central banks in devel-
oped countries is how to balance between lowering the required reserve ratio 
and maintaining a structural liquidity deficit. 
(4) The allocation method for reserves is not market-oriented. If the 
central bank measures and increases the required reserve ratio to eliminate 
liquidity surplus, some commercial banks will still have liquidity surplus, 
while some others may face severe liquidity shortage. Even in a highly effi-
cient money market, rebalancing such surpluses and deficits will bring about 
violent fluctuations in the money market interest rates. In particular, when 
foreign exchange hedging intervention is conducted, the central bank’s coun-
terparties for foreign exchange intervention are limited, and therefore the 
liquidity injected by the central bank via foreign exchange hedging interven-
tion is not distributed evenly across the banking system. The increased level 
of reserves can be redistributed via money market trading, but if the sales of 
foreign exchange to the central bank are concentrated in a few commercial 
banks, the problem of uneven distribution of surplus reserves in the banking 
system will still exist, which will correspondingly cause fluctuations in money 
market interest rates. 
Because of the market-oriented auction-based issuance, central bank 
bonds have avoided the shortcomings of raising required reserve ratio. First, 
commercial banks purchase central bank bonds based solely on their own 
needs, and the quantity purchased reflects the demand for reserves in each 
commercial bank, a matter of which the central bank has no knowledge. 
Thus, the issuance of central bank bonds can realize the allocation of reserves 
changes in the banking system very well without causing a large-scale transfer 
of reserves in the banking system and corresponding fluctuation of money 
market interest rates. Second, central bank bond issuance does not reduce 
the competitiveness of commercial banks but their efficiency. The character-
istic of market trading is that both sides trade according to their own will. 
Commercial banks purchase central bank bonds to certainly improve them-
selves so as to enhance their efficiency. Third, large-scale foreign exchange 
intervention by the central bank will not last forever, and once things get bet-
ter, the central bank can come back to the normal status through the gradual 
maturity of central bank bonds without causing fluctuations in the financial 
system as the adjustment of the required reserve ratio would have done. 
However, the main drawback of issuing central bank bonds to hedge for-
eign exchange intervention is that issuing central bank bonds will increase 

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the supply of bonds while reducing the supply of reserves. There will be no 
change in the amount of funds available in the bond market and the money 
market, but the increased supply of bonds will lead to a rise in the domestic 
interest rate. If the domestic interest rate rises to a certain threshold, which is 
obviously higher than the yield of foreign exchange reserves held by the cen-
tral bank, this will lead to two results: (i) increase the central bank’s interest 
cost expenditure, and because the interest cost is ultimately borne by the lim-
ited fiscal expenditure, continuous rise of interest rate will eventually over-
burden the fiscal authority; and (ii) because interest expenditure for central 
bank bonds increases the supply of reserves, over-high interest expenditure 
will greatly impede the efforts made to issue central bank bonds and reduce 
the supply of reserves.

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