How does Chinas Higher Bank Reserve Requirement Impact the E

June 11, 2008 The Bank of China again raised the amount of cash that banks must keep on hand. The reserve requirement limits the amount that a bank can on-lend. At its current level of 16.5%, a bank can lend out approximately six times the deposit base. Until mid-2003, the level was only 6%, allowing the banks to lend out 16 times the deposits. The authorities are trying to limit money supply (M1) growth and this rapid increase in the reserve requirements has done that. Interest rates (both lending and deposit) are up about 100 basis points although inflation remains a concern, particularly in the wake of skyrocketing prices for crude oil and other commodities. Usually Central Banks regard changing reserve requirements as a sledgehammer approach to controlling inflation. Why did China pick this policy? The basic answer is that the continuing trade and current account surpluses are creating challenges in controlling the money supply. When a dollar comes in from an exporter, the Bank of China is required to convert it into yuan, thus increasing M1. With such a large and continuing surplus, the normal monetary policy controls (buying and selling of treasury notes) are overwhelmed. China has also been reluctant to use the other instrument of a major revaluation of the currency. (Note: the Peoples Bank of China has put the Yuan on a 15% percent annual appreciation course; nevertheless most observers believe that the currency continues to remain undervalued.)The change in reserve requirements is a much more blunt instrument and has effects of tightening credit, taking some wind out of the overheated economy. As noted in previous posts, watch out for major economic contractionary measures after the Olympics.