VI. Features and Influence of the PBC Liquidity

Monetary Theory
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63
(1) The liquidity surplus puts the monetary policy operations of the cen-
tral bank in disadvantaged position. Since 2000, the PBC has conducted 
proactive monetary policies via open market operations mainly to reduce the 
supply of reserves. The PBC is the lender in the liquidity withdrawal transac-
tions of repos and central bank bills issuance, that is, it is a fund provider, 
which reduce its ability to regulate and control money market interest rates. 
Because commercial banks are not subject to a mandatory requirement to 
reduce reserves, the interest rate for the central bank’s open market opera-
tions to withdraw liquidity is not the marginal interest rate in the market 
and has no decisive influence on market interest rates. The central bank has 
to effectively influence money market interest rate levels through large scale 
operations with high operating costs. In addition, due to no upward rigid 
demand for reserves, when the central bank reduces the supply of reserves to 
bring the demand and supply of reserves toward an equilibrium level, inter-
est rates will rise sharply, and therefore it is difficult for the central bank to 
accurately control money market interest rates. This means that under liquid-
ity surplus, the central bank cannot easily and accurately realize the balance 
between the demand and supply of reserves. This leads to an important dif-
ference between the central bank’s operations in a liquidity surplus condition 
and those in a liquidity deficit condition: under a structural liquidity deficit 
framework, the central bank has to inject liquidity; otherwise, the imbalance 
between the demand and supply of reserves will lead to a situation that com-
mercial banks will violate the required reserves rule. Under liquidity surplus, 
the central bank absorbs liquidity mainly depending on its macro-level assess-
ments, but not daily market pressure. 
(2) The central bank’s monetary policy operations are poorly transmit-
ted in the banking system. Because demand for reserves is only rigid on the 
downward side as stated above, under circumstances where there is a consid-
erable liquidity surplus and the quantity of reserves is reduced unintention-
ally through monetary policies, commercial banks are inclined to adopt a 
“tolerance” method in reaction, in which they change the parameters of the 
reserves demand function to digest the unintentional reserves change to strike 
a balance between demand and supply of the reserves. As a result, neither 
credit activity nor the quantity of money is changed. This means that it is 
difficult for the central bank’s monetary policy to be transmitted within the 
banking system. 
(3) Considerable liquidity surplus forces the central bank to pay interest 
on reserves, which therefore limits the signaling function of money market 
interest rates. The source of the supply of reserves is the central bank, and 
the central bank is the reason for considerable liquidity surplus. Therefore, 
before eliminating the liquidity surplus, if the central bank pays no interest 

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Reforms in China’s Monetary Policy
on reserves, then commercial banks have to absorb the huge loss, which is 
the major reason why the central bank is asked to pay interest on reserves. 
Practices in developed countries show that excess reserves serving as a clear-
ing instrument and preparation for cash withdrawal have the highest degree 
of liquidity. The function of excess reserves is similar to that of cash, thus 
requiring no interest to be paid. The PBC’s current practice of paying inter-
est on excess reserves has actually enabled excess reserves to have a clearing 
and investment function. Based on this, we can theoretically break down 
excess reserves into real interest-free excess reserves plus an automatic deposit 
facility. This automatic deposit facility is similar to the deposit facility of 
the ECB. The difference between them is that the former does not require 
commercial banks to apply for it; instead, it is assumed to be automatically 
transferred at the end of each business day. In 2002, the annual average excess 
reserves ratio of China’s banking system was 6.28 percent, with the average 
level of excess reserves being 900 billion yuan. This means there was the same 
amount of money market instruments with deposit facility. Due to the fact 
that the automatic deposit facility is not subject to market-oriented alloca-
tion requirements but is ancillary to excess reserves and cannot be traded, it 
exerts a strong substitution effect on other money market and bond market 
products and restricts development of the money market. Moreover, interest 
rates with automatic deposit facility have weakened the signaling function 
of money market interest rates. The ECB adopts deposit facility mainly to 
set a lower limit for the short-term interest rate corridor and reduce fluctua-
tions in short-term interest rates. However, interest rates for the ECB deposit 
facility and marginal loan facility are determined based on the short-term 
interest rate target of monetary policy operations, and are subject to changes 
of the central bank interest rate target. In China, the interest rate level of the 
automatic deposit facility attached to excess reserves is fixed, so it is difficult 
for the automatic deposit facility to play a policy role. On the contrary, the 
facility distorts short-term interest rate signals and reduces the efficiency of 
liquidity management.
The payment of interest on excess reserves has established a lower limit 
for money market interest rates (see Figure 1.7 ), and the reserves demand 
curve to the right of “R0” is a horizontal straight line. If the reserves demand 
curve is at the “Rs1” position in the diagram, the equilibrium money market 
interest rate will be “r.” However, because the reserves demand curve having 
a horizontal part, the real money market interest rate is “r0,” which does not 
reflect the actual reserve demand-to-supply ratio. If the central bank reduces 
the supply of reserves to make the reserves supply curve shift toward the left 
to the “Rs2” position, the equilibrium interest rate will increase from “r1” to 
“r2” to reflect the change in the reserve demand-to-supply ratio. However, 

Monetary Theory
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65
due to the restriction on the excess reserves interest rate, the real money mar-
ket interest rate is still “r0.” Thus, the central bank and commercial banks 
cannot assess the change in demand and supply of the reserves from the 
money market interest rate level. Only after the central bank reduces the 
supply of reserves and enables the reserves supply curve to shift to the left of 
the critical position (R0) will the real money market interest rate recover its 
normal flexibility.
Due to the long-term liquidity surplus, interest rates in China’s money mar-
ket have consistently been close to the reserves interest rates
27
(see Figure 1.8 ). 
After the PBC reduces the supply of reserves via open market operations, 
because the supply of reserves does not exceed the critical position, a strange 
n occurs. Sharp reduction in the supply of reserves does not change the 
money market interest rate until the supply of reserves exceeds the critical 
position when the money market interest rates begin to move along with the 
reduction in the supply of reserves. At the same time, when the central bank 
reduces the supply of reserves to bring it toward equilibrium, the money mar-
ket interest rate will rise significantly with obvious fluctuation.

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