China: Reserve Requirements, GFC

Although the PBOC has had reserve requirements since 1984, it only began regularly using them as a policy tool in 2007 (Ma, Xiandong, and Xi 2013). In its second-quarter 2006 Monetary Policy Report, the PBOC explained that reserve requirements were initially used to ensure commercial banks had sufficient liquidity to cover unexpected payments, but over time had become a tool for the PBOC to manage banking sector liquidity (PBOC 2006b).

Between 2006 and early 2008, the PBOC hiked the RRR several times to support its tight monetary policy and sterilize its foreign-exchange interventions.^FLeading up to the GFC, the PBOC used required reserves to sterilize an estimated 70% of foreign-exchange inflows (PBOC 2008i; Wang and Hu 2011). The PBOC combined RRR hikes with open market operations to absorb extra liquidity in the banking system and restrain bank lending (PBOC 2008f). In a 2007 speech, Deputy Governor Wu explained that raising reserve requirements was preferable to CBB issuance when the PBOC wanted to reduce liquidity while maintaining market interest rates (Wu 2007).

When the GFC threatened China, the PBOC cut the RRR to ensure a healthy supply of liquidity and reinforce financial institutions as the PBOC guided lending to priority and weak sectors of the economy (PBOC 2008h). The PBOC claimed these RRR cuts released USD 117 billion of liquidity into the system (PBOC 2008i). When initiating this RRR easing cycle, the PBOC adopted a formal two-tier reserve requirement system that applied a reserve requirement ratio to the largest commercial banks that averaged 200 bps above the rate applied to smaller commercial banks and 600–800 bps above urban and rural credit cooperatives (Ma, Xiandong, and Xi 2013). Ma et al. note that the purpose of the two-tier requirement was to ease liquidity pressures on small banks during the GFC, while increasing the costs of RRRs for larger banks.

The PBOC hiked the RRR three times in early 2010 without adjusting benchmark interest rates. Later that year, the PBOC switched to an overall tight monetary policy, supported by many hikes to the RRR that continued into 2011. The PBOC used the adjustment of the differentiated deposit reserve requirement ratio to support the role of conventional monetary policy instruments. This policy stance continued through 2010, and the PBOC reiterated that the use of required reserves in combination with open market operations allowed the PBOC to manage liquidity, facilitate efforts to normalize money and credit growth, and handle inflationary expectations (PBOC 2010d).

China regularly combined RRR with open market operations and other monetary policy tools (Fungáčová, Nuutilaine, and Weill 2015; Ma, Xiandong, and Xi 2013).

The PBOC took several measures to promote liquidity during the GFC. In October 2008, the PBOC established a term auction facility for financial institutions in need of short-term liquidity (PBOC 2009b; PBOC 2010e). In November 2008, the government announced a two-part response to the international financial crisis. First, the central government approved an economic stimulus package totaling USD 586 billion, or 12.5% of GDP, which would be spent over two years on infrastructure projects and social welfare policies. Second, the central government sought to expand credit supply to the real economy by ordering the PBOC to cut reserve requirements from 17% to 15.5% (or 13.5% at small and rural banks), lower benchmark lending rates, and eliminate credit quotas (Cong et al. 2018; PBOC 2008i; Wong 2011). The State Council also called for banks to facilitate consumer credit and support car purchases and mortgages for first-time buyers, even establishing a quantitative target for new lending of USD 586 billion in 2008 and 17% growth in the money supply (Wong 2011).

In December 2008, the State Council announced a partial liberalization of the financial system, injected USD 14.6 billion into China’s policy banks and USD 17.6 billion into investment funds, and urged commercial banks to lend to solvent firms and those in distaster-sticken areas (PBOC 2008i; Wong 2011). The State Council also announced new credit mechanisms for small to medium-size enterprises (SMEs), broader eligibility for corporate bond issuance, and new regulations expanding the range of real estate investment trust funds (REITs) and private equity (PE) funds (Wong 2011).  

Because the State Council directed many of the PBOC’s activities, the PBOC was expected to align its monetary policy with the government’s stimulus measures.^FIn announcing its monetary easing in 2008, the PBOC called for its staff to “further integrate their thinking and action with the central government’s judgment on [the] economic situation and its policy responses” (PBOC 2008d).

The Law of the People’s Republic of China on the PBOC (PBOC’s enabling law) permits the central bank to require financial institutions to place deposits with the central bank at a prescribed ratio (Tenth NPC 2003b, ch. 4, article 23(1)).

Article 32 of the PBOC law empowers the PBOC to govern the rules and regulations on reserves (Tenth NPC 2003b Article 32(1)). The PBOC needed State Council approval before adjusting bank deposit and lending rates, but the PBOC may have had greater control over changes in the RRR (Fungáčová, Nuutilaine, and Weill 2015; Ma, Xiandong, and Xi 2013).

The PBOC may redefine the reservable deposit base to include different types of deposits in order to adjust the effective reserve requirements without altering headline RRR (Ma, Xiandong, and Xi 2013).

Commercial banks are bound by the Chinese Commercial Bank Law, which stipulates that banks must place deposits with the PBOC and maintain sufficient provision for payment in accordance with the PBOC’s regulations^FChapter VIII, Article 77(3) of the Commercial Bank Law identifies the penalties for noncompliant commercial banks. (Tenth NPC 2003a, ch. III, article 32).

The PBOC Law states that the goal of China’s monetary policy is to maintain currency stability and facilitate economic growth (Gang 2019; Tenth NPC 2003b, ch. 1, article 3). In practice, this meant that PBOC policy was also directed toward other policy goals, such as providing affordable financing to economic sectors or geographical areas (Fungáčová, Nuutilaine, and Weill 2015).

The PBOC administered all changes to the RRR.

Since August 2007, the PBOC had required commercial banks to deposit reserves in the form of foreign exchange, which were considered external assets on the PBOC’s balance sheet because they were managed by the State Administration of Foreign Exchange (SAFE), which is part of, but distinct from, the PBOC (Setser and Pandey n.d., 4).

Article 7 of the PBOC Law states that the PBOC forms monetary policy under the leadership of the State Council, the highest government body in China,^FHowever, the highest decision-making body in the country is the Standing Committee of the Politburo (Elliott and Yan 2013). See Figure 8 for a hierarchy of the Chinese financial system. and independent from the influence of other government offices or individuals (Tenth NPC 2003b). The State Council determined the functions, responsibilities, composition, and procedures of the PBOC’s Monetary Policy Committee (Tenth NPC 2003b, ch. 2, article 12).

According to Article 5 of the PBOC Law, the central bank submitted all decisions related to China’s money supply, interest rates, and exchange rates, among other issues, to the State Council (Tenth NPC 2003b). In practice, many regulatory and financial sector agencies were involved in setting the exchange rate and interest rate limits, but the State Council had the ultimate decision (Elliott and Yan 2013; Wang and Hu 2011).

The law required the PBOC to submit work reports to the Standing Committee of the NPC on the conduct of monetary policy and the operations of the financial sector, and record its monetary policy decisions and procedures for the State Council (Tenth NPC 2003b, ch. 1, articles 5-6; ch. 2, article 12).

The PBOC announced RRR adjustments in press releases, and they typically became effective one week after announcement. In its 2009 Annual Report, the PBOC cited a requirement by the State Council to increase publicity and education around its crisis response and measures to grow the Chinese economy (PBOC 2010a).

In explaining its cuts to the RRR and benchmark interest rates, the PBOC claimed it was signaling that it would secure economic growth and stabilize market expectations (PBOC 2008h). Throughout the crisis, the PBOC characterized RRR adjustments as a supplement to “conventional” monetary policy instruments (flexible open market operations) to manage liquidity, facilitate efforts to normalize money and credit growth, and manage inflationary expectations (PBOC 2010d).

Throughout the response to the GFC, the PBOC’s communications cited State Council communications and decisions made at Central Economic Work Conferences, annual meetings that determined China’s economic agenda and banking and regulation priorities.

The PBOC ordered banks to hold all required reserves as deposits at the PBOC; they could use those reserves for intraday settlements. (Ma, Xiandong, and Xi 2013).

Shortly after its introduction in 1984, the PBOC’s RRR regime differentiated by deposit type, including corporate deposits, savings deposits, or demand deposits. During the GFC, the PBOC’s reserve requirement covered most deposits, but the PBOC did not specify these deposit types and likely differentiated the RRR based on financial institution type only (Ma, Xiandong, and Xi 2013).^FMa et al. note that the reservable deposit base was expanded in September 2011 to include some margin deposits; this expansion effectively hiked the RRR by 125 bps (Ma, Xiandong, and Xi 2013).

Since the PBOC began adjusting the RRR more regularly in 2007, the PBOC used a “time-point” assessment. Chinese banks generally relied on deposit funding. Thus, given the low remuneration rate on required reserves, a high RRR imposed a large opportunity cost^FBecause a policy rate hike, intended to be contractionary, might have attracted foreign-capital inflows and offset the monetary tightening, an increase in unremunerated (or partially remunerated) reserves effectively “taxed” banks by raising the lender’s cost of capital and the cost of credit in the economy, and may have widened the loan deposit rate spread (within the state-mandated deposit rate cap) (Ma, Xiandong, and Xi 2013). on banks. Under the time-point framework, banks had to meet the RRR on a daily basis (based on a 10-day rolling average of the stock of deposits) and therefore tended to hold excess reserves as a buffer, averaging 1.5% of deposits in 2011 (Ma, Xiandong, and Xi 2013; Turner, Tan, and Sadeghian 2012).

Chinese banks generally relied on deposit funding (Turner, Tan, and Sadeghian 2012). Thus, given the low remuneration rate on required reserves, a high RRR imposed a large opportunity cost^FBecause a policy rate hike, intended to be contractionary, might have attracted foreign capital inflows and offset the monetary tightening, an increase in unremunerated (or partially remunerated) reserves effectively “taxed” banks by raising the lender’s cost of capital and the cost of credit in the economy, and may have widened the loan deposit rate spread (within the state-mandated deposit rate cap) (Ma, Xiandong, and Xi 2013). on banks. Banks had to meet the RRR on a daily basis (based on a 10-day rolling average of the stock of deposits) and therefore tended to hold excess reserves as a buffer, averaging 1.5% of deposits in 2011 (Turner, Tan, and Sadeghian 2012). The IMF stated that this daily requirement of reserves meant the RRR was mainly a tool to manage aggregate liquidity rather than a prudential buffer for banks (IMF 2011).

Required reserves generally applied to all Chinese-domiciled financial institutions. The PBOC Law defines financial institutions as Chinese-domiciled policy banks,^FThe “policy banks,” which were formerly state-owned, included the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China, the China Construction Bank, and the Bank of Communications (PBOC 2009a). In 2005, all five banks were converted to joint-stock companies. Together, they accounted for 52% of total banking assets in 2008 (Fungáčová, Nuutilaine, and Weill 2015). commercial banks, urban credit cooperatives, rural credit cooperatives, and other deposit-taking institutions (Tenth NPC 2003b, Ch. 8, Article 52).

The PBOC began to differentiate between small and large financial institutions in July 2006, when it applied a 50 bps RRR hike to all institutions except rural cooperatives (PBOC 2006a). It also applied differentiated RRR based on capital adequacy levels and nonperforming loan ratios (PBOC 2007). Rural cooperative banks and credit cooperatives constituted only 0.02% of deposits in the banking system (see the Appendix for more information on the Chinese financial system) (Lardy 2008).

The PBOC continued to differentiate between small and large financial institutions as it lowered RRRs during the GFC. In the last quarter of 2008, the PBOC cut the RRR for large banks three times, from 17.5% to 15.5%, and cut the RRR for small and medium-size banks four times, from 17.5% to 13.5%.^FA standard definition of medium- and small-size commercial banks included 12 joint-equity commercial banks (excluding the major policy banks), urban and rural commercial banks, and urban and rural credit unions (Cong et al. 2018). Rural credit cooperatives, who were the primary originators of agricultural loans to populations adversely affected by natural disasters in 2008, were also subject to the lower RRR (Ma, Xiandong, and Xi 2013).

On September 16, the PBOC’s Monetary Policy Committee met and, under the orders of the central government, cut benchmark interest rates and the RRR for small and medium-size institutions by 100 bps (PBOC 2008a; PBOC 2008h). It cut the RRR for institutions in disaster-stricken areas by 200 bps (PBOC 2008a).

The MPC met three more times in the final quarter of 2008, and cut the RRR for all institutions on each occasion: October 8, October 29, and November 26 (PBOC 2008b; PBOC 2008c; PBOC 2008e). Shortly after its October 29 announcement of RRR cuts, the PBOC announced a moderately loose approach to its monetary policy (PBOC 2008d).

RRR adjustments took effect roughly one week after their announcement, which the PBOC believed gave financial institutions a sufficient amount of time to adjust their reserves (PBOC 2006b).

As the crisis spread to China in the second half of 2008, the PBOC lowered the RRR in three steps to 15.5% for large banks, and in four steps to 13.5% for small banks and rural credit cooperatives (PBOC 2009a). The PBOC maintained this headline RRR level throughout 2009 (see Figure 6; see Figure 11 for an overview of reserve requirement changes between 1984 and 2011).

The PBOC intended these RRR cuts to maintain “stable, sustained, and relatively fast growth of the national economy” (PBOC 2008a). The PBOC stated that the first required reserve regime change in 2008—to differentiate RRR based on the size of financial institutions—was part of a broader principle of “differentiated treatment to different sectors,” including credit allocation to agricultural sectors and preferential treatment to credit institutions in rural areas affected by the natural disasters (PBOC 2008i, 51).  

Since it was established in February 2002, the PBOC’s remuneration rate on required local currency deposit reserves remained fixed at 1.89% (Lardy 2008; Ma, Xiandong, and Xi 2013). In late 2008, the PBOC cut the remuneration rate on required reserves of local currency deposits to 1.62% (Ma, Xiandong, and Xi 2013). Excess reserves were remunerated at 0.72% (BOC 2015). By comparison, commercial banks earned an average of 8.72% in March 2008 on loans with terms of six months to one year (Lardy 2008). Thus, the reserve tax burden—the spread between the interest banks receive on central bank reserves and the returns banks could earn on loans—was relatively high in China.

In 2011, the remuneration rate was 1.62% per annum on required reserves, compared to an average auction yield of 2.72% for one-year CBBs (Ma, Xiandong, and Xi 2013; Wang and Hu 2011). The relative “cost” of CBBs was due to the (normally) lower remuneration rate paid on required reserves and the potential for net negative sterilization. In the event that the short-term rate paid on these domestic debt instruments exceeded the average interest rates received on the PBOC’s foreign asset holdings (such as US Treasuries), the PBOC could have realized significant net losses on its foreign-exchange interventions (Wang and Hu 2011). However, these “cost savings” to the PBOC are passed on to banks, who potentially passed them on to their customers (Ma, Xiandong, and Xi 2013).

In 2007, the interest rate paid on CBBs rose by 90 bps for three-month bills, 126 bps for one-year bills, and 155 bps for three-year bills, meaning the implicit tax on required reserves, which were mandatory, was greater than the implicit tax on holding CBBs, which was voluntary (Lardy 2008). According to Ma et al. (2013), the burden that required reserves imposed on banks was estimated at 0.3% of GDP in 2010, which banks appeared to pass on to their depositors (Ma, Xiandong, and Xi 2013).

The PBOC generally remunerated reserves at a below-market rate—lower than the rate paid on CBBs or government bonds (see Figure 7). The remuneration rate on required reserves typically served as a floor to the overnight interbank rate (Ma, Xiandong, and Xi 2013; Wang and Hu 2011).

Foreign currency deposits were not remunerated (Ma, Xiandong, and Xi 2013).

Source: Elliott and Yan 2013.

The PBOC did not attach other conditions to its reserve requirement adjustments.

China’s monetary policy consisted of quantity-based tools—including required reserves, as well as “window guidance,” credit quotas, and other administrative measures—and price-based tools, such as benchmark rates (and other policy interest rates) and open market operations (Fungáčová, Nuutilaine, and Weill 2015). PBOC Governor Yi Gang stated that the central bank managed liquidity with open market operations and required reserves and adjusted the money supply with central bank lending and discounts (Gang 2019). Given China’s carefully controlled exchange rate regime and regulated interest rate policy, the PBOC’s monetary policy framework relied more on RRR adjustments than open market operations (Ma, Xiandong, and Xi 2013). Often, the PBOC coordinated benchmark interest rate cuts and decreased CBB issuance with RRR cuts (PBOC 2008h).

Initially, the PBOC could manage liquidity with RRR adjustments without signaling policy rates,^FSince 2007, the PBOC had guided the auction yield toward the one-year bank deposit rate and used CBB auctions to signal potential changes to policy rates (Ma, Xiandong, and Xi 2013). Over time, however, RRR adjustments began to signal other interest rate changes, and the RRR was adjusted in line with benchmark interest rates (Fungáčová, Nuutilaine, and Weill 2015). In a 2007 speech, Deputy Governor Wu explained that raising reserve requirements was preferable to CBB issuance when the PBOC wanted to reduce liquidity while maintaining market interest rates (Wu 2007). but over time RRR adjustments began to signal the PBOC’s posture on bank lending and management of the money supply (BOC 2015; Ma, Xiandong, and Xi 2013; Martin 2012).

The PBOC eased the RRR beginning on September 16, 2008 (for small banks) and made its last cut on December 22, 2008 (for all banks). The PBOC did not preannounce an end date for the easing, nor state publicly the criteria under which it would discontinue its easing.