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

Monetary Theory
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increases the supply of bonds on a large scale to improve the bond market. 
In particular, short-term central bank bills currently being issued by the PBC 
have filled in the blank in money market instruments and promoted devel-
opment of the money market. 
Moreover, as regards the special central bank assets and liabilities structure 
currently in place whereby interest is paid on reserves, the large-scale issu-
ance of central bank bills is in effect a substitute for the automatic deposit 
facility for excess reserves, and converts such automatic deposit facility into a 
real money market instrument for market-oriented issuance and circulation, 
creating the conditions for reducing or cancelling interest payments for excess 
reserves. 
The PBC has witnessed positive results of its bond issuance. From April to 
August 2003, it issued central bank bills valued at 455 billion yuan, hedging 
a large amount of the increase in foreign exchange reserves. The interest rate 
at which central bank bonds issued has been stable, and the secondary mar-
ket has seen active trading, with average daily turnover accounting for about 
50 percent of that of the interbank bond market.
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Faced with dual liquidity surpluses, the central bank will be better off if it 
issues central bank bonds to deal with large-scale mid- and long-term liquid-
ity surplus, which is especially effective in absorbing excess reserves generated 
by the spontaneous factors of ongoing large-scale foreign exchange interven-
tion. However, central bank bonds issuance should not be a normal measure 
within the liquidity management framework. When absorbing liquidity, the 
PBC may study how to convert the structural liquidity surplus into structural 
liquidity deficit, thereby establishing a structural deficit liquidity manage-
ment framework under the deposit reserve ratio system. 
With the development of the money market and the construction of the 
PBC Real Time Gross Settlement system, the declining trend of demand 
for excess reserves among commercial banks will continue. However, too 
much reserve supply has accumulated in the past, and the central bank has 
to face the structural liquidity surplus situation for a certain period. In the 
meantime, the central bank’s foreign exchange intervention may remain at a 
relatively high level in the short run, and the liquidity supply brought about 
by exogenous shocks may continue to exist. In circumstances where China’s 
money market and bond market instruments remain inadequate, the central 
bank may continue to issue short-term central bank bills to absorb liquidity. 
In the mid- and long term, the central bank can gradually redeem central 
bank bills and increase the required reserve ratio appropriately according to 
the weakening trend of exogenous shocks and the reserve demand-to-supply 
ratio, thereby increasing the total demand for reserves, putting greater pres-
sure on the money market and forming a liquidity management framework 

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Reforms in China’s Monetary Policy
in which the demand and supply of reserves are basically in balance with a 
small structural liquidity deficit. After such a framework is formed, the cen-
tral bank should maintain an appropriate required reserve ratio that enables 
an increase in banking system deposits to automatically bring about increased 
demand for required reserves, continuously increasing total demand for 
reserves, maintaining pressure on the money market, and ultimately setting 
up a structural deficit liquidity management framework. Under this frame-
work, the central bank is in a proactive position, and open market opera-
tions are transformed from absorbing liquidity to daily liquidity injection 
through bond trading so as to effectively realize monetary policy objectives. 
Subsequently, based on the premise of continuous structural liquidity deficit, 
the central bank may periodically and gradually lower the required reserve 
ratio according to the pace of the increase in demand for required reserves 
brought about by increased deposits, thereby realizing a structural deficit 
liquidity management framework at a low reserve ratio.

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