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

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are debts of third parties other than the central bank and commercial banks. 
Thus, the central bank is more active in trading. Therefore the central bank is 
inclined to adjust reserves via bond open market operations, which reduces the 
extent to which relending, rediscount, and other instruments are used. 
With the slowdown of the global economy, central banks in developed 
countries have come under considerable pressure to increase the money sup-
ply continuously and commonly regard bond purchase in the open market 
as their major method of monetary policy operations. One good example 
is that the Bank of Japan has set a target for monthly purchase of treasury 
bonds. The Federal Reserve has intensified its efforts to purchase bonds in 
the open market in recent years and purchased USD68.5 billion bonds in 
2001 while the bond repo balance totaled only USD19 billion. It can be seen 
that bond purchase transactions have become an important policy measure 
for the open market operations of the Federal Reserve. Recently, to cope with 
a potential deflationary trend, the Federal Reserve has proactively studied 
the operational possibility of purchasing large amounts of long-term treasury 
bonds in the market to inject liquidity and lower the long-term part of the 
yield curve. In addition to its exogenous advantage in enhancing the supply 
of reserves, bond trading may directly influence the term structure of market 
interest rates and the yield curve, which will therefore enhance the effects of 
monetary policy operations and increase operational flexibility. 
Moreover, bond purchases can increase central bank’s regulatory capac-
ity, in addition to increasing its assets. Especially when open market opera-
tions in which bonds are used as the instrument of choice become the most 
important monetary policy instrument of the central bank, the central bank 
having sufficient bonds becomes a precondition for the realization of effective 
regulation. An important gauge of the effectiveness of open market opera-
tions is the amount of bonds held by the central bank as a percentage of the 
whole bond market; thus, it is very important for the central bank to seize 
the moment to accumulate bond assets and inject liquidity. For example, the 
Federal Reserve has been increasing its bond holdings since 1957.
22
Since 
1986, treasury bonds held by the Federal Reserve as a percentage of the trea-
sury bond market has been larger than the sum of those held by all commer-
cial banks, and this difference has expanded since 1994. Treasury bonds held 
by the Federal Reserve as a percentage of the market has exceeded 12 per-
cent since 2001, and the Federal Reserve has become the top holder of US 
T-bonds, with an amount triple of that of treasury bonds held by commercial 
banks as a whole, thus ensuring the capacity of the Federal Reserve to regulate 
and control through open market operations. 
In addition to choosing the exogeneity of the trading instruments, the 
Federal Reserve chooses investment banks as its trading counterparties, 

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achieving success in its liquidity management. This has inspired us that the 
indirectness of choosing nonbanks as trading counterparties of the central 
bank open market operations is conducive to enhancing the exogeneity of 
the supply of reserves. 
The 22 primary dealers for the open market operations of the Federal 
Reserve are all investment banks, while in other developed countries, central 
banks’ trading counterparties are usually commercial banks. The structure of 
the United States financial market is different from those of other countries. 
Investment banks have more power in the US bond market, while commer-
cial banks have less power, which is why the Federal Reserve chooses invest-
ment banks as its trading counterparties. By contrast, commercial banks have 
more power in the Euro zone, and therefore the European Central Bank 
(hereinafter referred to as the “ECB”) mainly trades with commercial banks. 
Differences between financial markets are reasons for central banks to choose 
their trading counterparties and may to some extent explain the effects of 
controlling the supply of reserves. However, the author believes that this is 
not the whole picture and that the indirectness among trading counterpar-
ties enhances the degree of proactivity in open market operations, that is, it 
enhances the exogeneity of liquidity. 
The investment banks, trading counterparties of the Federal Reserve, clear 
their funds with the Federal Reserve via commercial bank clearing accounts at 
the central bank, and their trading activities change the reserves of commercial 
banks at the central bank. Therefore, the influences on reserves respectively 
exerted by the central bank, investment banks, and commercial banks are the 
same. However, the Federal Reserve chooses investment banks as its trading 
counterparties, which prevents the trading activities from being influenced 
by liquidity demand among commercial banks and ensures that changes in 
reserves resulting from open market operations are completely passive as far 
as commercial banks are concerned, thus resolving an important weakness in 
the traditional implementation of monetary policy. Under traditional chan-
nels for the implementation of monetary policy, where the central bank needs 
to change its own liabilities, mutual cooperation between the reserves supply 
function of the central bank and the reserves demand function of commercial 
banks is required. Though the central bank may adjust the interest rate to 
influence the reserves demand function of commercial banks, completing the 
deals requires the consent of commercial banks. For example, if the central 
bank wants to withdraw liquidity and sells bonds to commercial banks in 
open market operations, but commercial banks are not willing to purchase 
because they want to maintain their lending capacity, then the central bank 
can only reduce the bond price continuously to increase the yield to a level 
similar to banks’ lending yield after taking risk factors into account. Such 

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yield level will encourage commercial banks to purchase bonds and thus 
achieve the objective of withdrawing liquidity. This operation will lead to 
great fluctuations in the market interest rate level, which the central bank will 
find difficult to accept. If the central bank trades with nonbanking institu-
tions, nonbanking institutions will only compare the yield of the bonds sold 
by the central bank and the yields of other bonds sold in the market when 
considering any adjustment to their asset portfolios, which avoids the direct 
link with loan interest rates and therefore greatly enhances the efficiency of 
the central bank’s operations. Under this trading counterparty system, non-
banking institutions use the liabilities of commercial banks to trade with the 
central bank and change reserves via clearing activities of commercial banks. 
Commercial banks merely play the role as clearing parties in transactions that 
change reserves. In this way, even if commercial banks are unwilling to change 
their reserves, they can do nothing but accept the operating activities of the 
central bank. Hence, the design of this system has strengthened the exoge-
neity of reserves. As for the result of such operations, the Federal Reserve is 
more efficient in its open market operations than that of the central banks in 
other developed countries, and this indirect trading counterparty system rep-
resents the development direction of open market operations in the future. 
When the central bank trades with the primary dealers of noncommercial 
banks, there is no need to make a direct comparison between the central 
bank interest rate and the loan interest rates of commercial banks. Therefore, 
commercial banks have weak control over their own liquidity. In China, due 
to the relative weakness of investment banks, the major bond market partici-
pants are commercial banks, and most of the central bank’s counterparties in 
open market operations are commercial banks. The exogeneity of liquidity 
is therefore relatively weak. When commercial bank lending grows too fast 
and the central bank seeks to withdraw bank liquidity by issuing central bank 
bills, commercial banks acting as primary dealers can refuse to purchase cen-
tral bank bills. This occurs not only when the interest rate of the central bank 
bills is lower than the loan interest rate excluding the risk premium factor 
but also when the interest rate of the central bank bills is equal to or higher 
than the loan interest rate excluding the risk premium factor due to nonprice 
factors such as market share expansion. Then the central bank’s liquidity tar-
get may become difficult to realize or may be realized at a high cost. This 
problem becomes more acute under circumstances whereby China currently 
regulates the loan interest rate. 
Under a structural liquidity deficit framework and faced with continu-
ous growth in the demand for reserves, the central bank purchases bonds 
directly to meet long-term demand for reserves and injects a small amount of 
liquidity into the banking system on a daily basis to meet short-term reserve 

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requirements and thereby control money market interest rates. This can be 
seen in Figure 1.5 .
As illustrated Figure 1.5 , in the United States, Europe, Japan, the United 
Kingdom, and other developed countries, the daily open market operations 
of the central banks are mainly carried out to inject liquidity into the market 
via small short-term repurchase transactions. Due to the very short-term of 
repurchase transactions, within the short terms illustrated by the many tri-
angles in Figure 1.5 , the central bank ensures the reserves demand curve is 
basically identical to the reserves supply curve via short-term repurchases. At 
the same time, the central bank increases the supply of reserves via periodic 
purchases of bonds, thus ensuring the difference between demand and sup-
ply of the reserves remains small, which allows the central bank to maintain 
balance between demand and supply of the reserves via small daily repurchase 
transactions. Hence, under an effective liquidity management and monetary 
policy operating framework, the central bank creates demand for reserves via 
required reserves system before providing liquidity via open market opera-
tions, and it realizes effective control of reserves and money market interest 
rates through this institutional arrangement of demand and supply of the 
reserves. 
From a theoretical perspective, reserves demand can be reduced if the cen-
tral bank reduces the required reserve ratio and the reserve demand-to- supply 
ratio, creating buffer stock reserves. In reality, however, central banks in 
developed countries seldom do so. The very reason is that the required reserve 
ratio is precisely the institutional arrangement used to create structural defi-
cit, and lowering the required reserve ratio is not conducive to establishing 
RRR is Required Reserve Ratio
Reserves
Deposit
Liquidity
Supply 
RRR 
Reserves
Demand 
Temporary Purchases of Bonds under Repo Agreements
Outright Purchases of Bonds

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