As a seminar focusing on China’s monetary policy, we’ve always been interested in the use of monetary instruments by People’s Bank of China (PBoC). In this posting, we’d like to wrap up the core elements of our past discussions on PBoC instruments.
To begin with, we need to understand that one of PBoC’s critical roles is to sterilize the "passive money supply" caused by increase in FX reserves, in order to prevent inflation or overheating. It has three instruments at hand to fulfill the role: reserve requirement rate (RRR), open market operations, and Ministry of Finance (MoF) deposits at PBoC. In other words, PBoC could preemptively withdraw liquidity from market through each of the following ways: 1) raise RRR; 2) issue PBoC bills, or repos which are excluded here as they are short-term instruments; 3) increase MoF deposits frozen at PBoC or auction less to commercial banks. However, the cost for each monetary instrument is quite different: 1.62% for RRR (interest paid for reserves by PBoC), around 3% for PBoC bills, and 0.5% for MoF deposits.
Next we would separately analyze the three instruments. Firstly, RRR has been the dominate instrument utilized by PBoC to withdraw liquidity in these years, as it increased gradually from 10% in 2007 to 21.5% now. And it’s widely regarded as the most direct and effective instrument in China.
Secondly, open market operations are another key instrument, and together with RRR they could sterilize about 80% of FX reserve increase. Actually, before 2007, this instrument was the major force in sterilization, as shown in Figure 1, but gradually lost PBoC’s favor afterwards. Moreover, if we look at PBoC bills’ cumulative withdrawal amount alone in Figure 2, we may be a little surprised to find that PBoC bills are not withdrawing but injecting liquidity recently. The current cumulative amount stands at same level as Nov. 2005, which means there’s no net withdrawal since then. In addition, we could notice that, starting from Q4 2010, when PBoC intended to tighten according to Governor Zhou Xiaochuan, it has injected as much as 2.3 trillion RMB through bills.
Why did PBoC stop using bills to withdraw liquidity? One possibility was, PBoC did it involuntarily. As it was unwilling to raise PBoC bills’ rate in primary market, which was below secondary market rate for quite a long time, banks didn’t have much motivation to buy; thus issuance has been in a quite limited amount since Q4 2010, if not suspended. Another possible reason could be the high cost of bills. Let’s consider PBoC balance sheet. If we compare US Treasuries on the assets side with PBoC bills on the liabilities side, there are two mismatches: currency and interest rate. 5% RMB appreciation, plus 3% interest rate difference, would mean a sterilization cost of 8% for PBoC. Given bills’ high cost, it’s reasonable for PBoC to prefer “cheap” instruments, i.e., RRR hike.
Thirdly, MoF deposits are a more passive instrument in liquidity withdrawal. The total deposits amount is significantly seasonal, as a result of tax collection and accrual of expense. Most of the deposits are frozen in PBoC, earning an interest rate of 0.36%; only a small fraction are auctioned monthly by PBoC.
Finally, we put together all PBoC instruments and check the overall effect. Since Q4 2010, PBoC bills have injected 2.3 trillion RMB, while RRR hike has withdrawn twice as much in order to roughly offset surging FX reserve; MoF deposits act as a disturbance term. This broad picture of PBoC instruments is quite important to us, as it’s one of the foundations for our analysis in China’s monetary policy.
Central Banking Seminar
