Recently, a report issued by China's central bank has sparked a wave of attention in the financial market, particularly regarding the regulations surrounding the reserve requirements for depositsThis discussion centers on the significance of deposit reserves and their evolution, as well as the implications they hold for the banking sector and economy.

The Evolution of the Reserve Requirement System

Deposit reserves serve as a buffer, ensuring that financial institutions have adequate funds to satisfy customer withdrawal requests and to facilitate fund settlementsThese reserves consist of funds that banks must maintain and are deposited with the central bank, known as statutory reservesThe proportion of total deposits that these reserves constitute is referred to as the reserve requirement ratio.

By adjusting the reserve requirement ratio, the central bank can effectively impact the amount of credit that financial institutions can extend, indirectly influencing the money supply within the economyThis mechanism provides the bank with a powerful tool for managing liquidity and stabilizing the economy.

The reserve requirement system in China has undergone significant reforms through the years

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In 1998, for instance, the central bank amalgamated two different accounts—“reserve deposits” and “required reserves”—into a single “reserve deposit” accountThis simplification was part of broader reforms to streamline operations and enhance efficiency in the banking system.

Beginning in 2004, the People's Bank of China implemented a differentiated reserve requirement systemThis approach tied the reserve rate applicable to financial institutions to indicators like their capital adequacy and asset qualityFurther developments in 2011 introduced a dynamic adjustment mechanism for reserve requirements, allowing for greater flexibility in monetary policy.

In May 2019, China embraced the “three-tier, two-benefit” reserve requirement frameworkThis classification divides financial institutions into three tiers based on their size and systemic importance, establishing different reserve rates for large, medium, and small banksAdditionally, institutions meeting specific criteria can enjoy reduced reserve rates as incentives to stimulate lending and support economic growth.

The central bank's primary role in regulating these reserve requirements is to help achieve monetary policy goals by ensuring stability in the financial system and the economy at large.

Breaking the Implicit “Floor” of 5%

In recent years, the market has viewed the 5% reserve requirement ratio as an implicit “floor.” This viewpoint arises partly because when the central bank announced cuts to reserve requirements, it stated that such reductions would not apply to institutions already operating at the 5% standard

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Additionally, international practices suggest that 5% is a significant threshold in the realm of statutory reserve ratios.

Despite this perception, many market analysts believe that the 5% threshold is not insurmountableBetween September 2003 and June 2011, the central bank raised reserve requirements 32 times, effectively increasing the average rate from 6% to 20.1%. Following 2013, a series of 29 reductions brought the average down to 6.6%, which brings it precariously close to the 5% mark, especially for small banks that are already at this level.

Industry experts note that for a long time, the central bank has effectively utilized a trio of traditional tools: deposit reserves, re-lending, and open market operations to create a conducive financial environmentThese tools have not remained static and have evolved alongside the changing economic landscape and macroeconomic requirementsOver the years, especially with ongoing financial reforms, the criteria for evaluating deposit reserves have shifted from fixed point assessments to average metrics, which help smooth out fluctuations in financial institutions' deposits and stabilize the money market.

Prominent economist Lu Zhengwei argues that while 5% is considered an implicit limit, there are no formal regulations preventing a drop below this thresholdThus, if these changes are sensible, there are no institutional barriers to executing such reforms.

Moreover, Li Peijia, head of the financial research team at the Bank of China, points out that reserve requirements have long been a significant monetary policy tool in China, primarily due to factors like the persistent balance of payments surplus and the consequent growth in foreign exchange reserves

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He also emphasizes the urgent need to accelerate the reform of reserve requirements.

In light of rising uncertainties posed by external trade frictions and tightening surpluses, the supply of base money in China may face adverse effectsHence, cutting reserve requirements can be essential to increasing the availability of low-cost, long-term fundsAs a comparison, many countries have lowered their statutory reserve ratios to lower levels or even established zero reserve requirements, while China's ratios remain relatively high in a global context, imposing a significant cost burden on banking operationsThere remains considerable scope and necessity for further reductions in reserve requirements.

Nevertheless, Lu Zhengwei contends that within the framework of the Basel III liquidity regulations and the increasingly sophisticated monetary policy toolbox, some traditional roles of statutory reserve ratios can be supplantedHowever, breaking the 5% reserve requirement will necessitate a series of coordinated policy initiatives.

Further Adjustments and Optimization

The dynamic adjustments and optimization of the deposit reserve system signify a shift in the central bank’s regulatory approach, indicating more flexibility in the implementation of monetary policy tools

The People's Bank of China continues to expand its toolkit, enhancing the functions of monetary policy.

As experts suggest, decreasing the statutory reserve ratio is a step in retaining ample liquidity levels within the banking systemThis approach makes it possible to shift focus from rigid total quantity targets to more adaptive interest rate controls.

Market analyses reveal viable avenues for reforming the deposit reserve systemAn important consideration is the potential to abolish the 5% floor or lower it to 3%. Tsinghua University's National Financial Research Institute director Tian Xuan posits that such a change could promote greater liquidity among banks and align China's practices more closely with international trends in reserve management.

In a landscape where the capacity for further reductions is limited, Citic Securities chief economist Ming Ming advocates for trial initiatives that could see small and medium banks’ reserve requirements lowered from 5% to 3%. This pilot program would observe impacts on liquidity and broader financial markets, eventually expanding the practice across the industry based on outcomes.

Moreover, Dong Ximiao emphasizes that reducing reserve requirements can significantly lower banks' funding costsIf the 5% floor is crossed, every bank stands to benefit, particularly rural banks that already face tighter margins, thus stabilizing their interest margins which can be transformative for their operations.

Incorporating medium- to short-term treasury bonds into the range of assets considered for reserve requirements also presents a feasible option

Tian Xuan argues these bonds typically exhibit strong liquidity and creditworthiness, making them well-suited as qualified reserve assetsBroadening the asset base for reserves improves the quality of banks' holdings, enhances liquidity management tools available to financial institutions, and stabilizes the treasury bond market.

The advantages of such reforms, according to Ming Ming, include optimizing the structure of bank assets by converting “non-interest” cash reserves into “interest-bearing” treasury bonds, alleviating pressure on net interest spreadsAdditionally, this could reinforce the yield curve's steepening and normalizing interest rates, aligning with central bank objectives of achieving a more upward inclined yield curve.

We advocate for the exploration of incorporating treasury bonds into reserve requirementsInitially, there could be a cap on the proportion of bonds included (for instance, a range of 0.5% to 1%) and restrictions on their remaining maturity (e.g., within five years) to manage interest rate risksCoupling this approach with existing open market operations can provide more flexible liquidity management for commercial banks.

Furthermore, Li Peijia suggests that alongside lowering reserve ratios, there should also be an enhancement of collateral management systems linked to monetary policy to fortify effectiveness and agility.

Currently, under the implementation of new structural monetary policy tools, the central bank mandates banks provide high-grade collateral like treasury bonds

Although stringent, this practice considerably reduces banks' liquid asset availability and subsequently depresses their liquidity coverage ratios, constraining lending activities and affecting overall fund accessibility across the economy.

In contrast, central banks globally have adopted a more flexible approach; for instance, the European Central Bank has incorporated green bonds into its collateral framework to encourage eco-friendly investmentsThe Bank of Japan accepts securities linked to small and medium enterprise loans as collateralSimilarly, the Federal Reserve has made allowances during the pandemic for municipal bonds and high-yield ETFs as acceptable collateral, temporarily easing credit rating requirementsChina could glean valuable insights from these practices.

Optimizing the assessment methods for targeted reserve requirement reductions is another key propositionCurrently, such assessments largely focus on supporting small and micro enterprises along with the agricultural sectorTian Xuan posits that future evaluations may favor criteria reflecting real impacts on economic restructuring and upgrading, ensuring the targeted reserve reduction policies remain relevant and effective.

Ultimately, discussions surrounding adjustments to the deposit reserve requirement system underscore its broader implications for enhancing the efficacy and flexibility of monetary policy, stabilizing financial markets, supporting economic structural shifts, and achieving sustainable economic growth.

The insights from Tian Xuan indicate that adjusting reserve requirements dynamically can lead to better control over the money supply, bolster banking institutions’ ability to extend credit, and enhance the flexibility of monetary policy

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