Chinese FX reserves have reached $3.2 trillion. The majority of the FX reserves are accumulated through financial institutions, such as commercial banks, purchases of dollars from corporations and households. As an article in September 26th edition of the South China Morning Post puts it:
Let's look at one of these assets "left on bank balance sheets", an item obscurely classified in the official statistics as "financial institutions position for forex purchases". This category of assets now amounts to 25.3 trillion yuan.
Figure 1: Commercial Banks Bear the Sterilization Costs
The commercial banks, however, don't benefit from the FX purchases; rather, they incur a negative interest margin on those transactions. Commercial banks convert dollars into RMB for exporters, who deposit the money into banks. Recall that the PBoC controls the credit quota, and that commercial banks have to keep a required reserve with the central bank. So banks are paid the reserve rate by the PBoC, and pay the deposit rate which is higher than the reserve rate, incurring the sterilization costs.
To illustrate, suppose that an exporter is doing a trade settlement of $100 million with BOC, a commercial bank in China. BOC gives the corporation 638 million RMB for the dollars, and the corporation deposits the 638 million RMB with BOC. Since the PBoC imposes a required reserve ratio of 21%, BOC could only consider lending the remaining 79% (and with the deposit-to-loan ratio requirement of 75% from China Banking Regulatory Commission, the money available for lending is even less). On the 21% required reserves with PBoC, BOC receives 1.65% from PBoC and pays the exporter 3.85% for 1Y deposits, thus facing a negative interest margin. In this case, this PBoC reserve requirement decreased BOC’s interest margin on the 638 million RMB by 0.462%. It is a significant cost for a commercial bank.
We argue that the sterilization cost that should be borne by the PBoC. The high required reserve ratio is due to the PBoC's efforts to sterilize the money injected into the domestic economy as a result of FX reserve accumulation and mandatory currency-exchange policy. Thus, the negative interest margin for commercial bank is the cost of sterilization.
This simple analysis again reminds us of the costs of colossal FX reserves. Monetary policy freedom is not free, and even though the PBoC seems to earn a positive return on sterilization, as long-term Treasury yields are higher than short-term PBoC bill yields, costs are nevertheless being incurred, and it is the Chinese commercial banks that are bearing a large part of them.
Central Banking Seminar