China Bumps Bank Reserves Ratio Again, Sixth Time This Year

The People’s Bank of China has announced another 50 basis points increase in the country’s required reserves ratio for China’s banks. This is the sixth such increase in a year, and the third in a month. The PBoC did not raise benchmark interest rate, which currently stands at 5.56%.

The rise in the reserve ratio means the country’s largest banks will have to hold on to 19% of their deposits as a reserve. The new requirement is expected to force the banks to hold another $53 billion in reserves, according to Bloomberg.

China’s trade surplus, some $22.9 billion in November, continues to add liquidity to a financial system that can’t seem to deal with it. The trade surplus has added about 20% to the country’s money supply in 2010, and the government is having some trouble figuring out what to do with all of it.

The main problem the country faces, of course, is inflation. The government raises the required reserve ratio to take money out of circulation. This is one of several measures the government takes to sterilize the $2.6 trillion of China foreign exchange reserves. The government also issues central bank bills that have soaked up about 6% of liquidity, but purchases of these bills is voluntary.

The PBoC has also tried to limit lending, setting a ceiling for 2010 of 7.5 trillion yuan. So far this year, bank loans total 7.44 trillion yuan, indicating that the limit is sure to be surpassed.

According to Chinese economist Fan Gang, approximately one-quarter of China’s total monetary base is illiquid because the government requires its banks to sit on the money. Banks are paid a “reasonable” interest rate on the required reserves.

The PBoC did not raise interest rates, very likely because that makes the country’s banks more attractive to cash inflows seeking high rates of return. And if there’s one thing the economy can do without right now, it’s more cash.

The one course that China has not taken is the obvious one of revaluing its currency. Professor Gang admits that further exchange rate appreciation is necessary to reduce surpluses in China’s current and capital accounts. Reducing these accounts is really the only way to reduce the country’s foreign exchange holdings.

So far, though, the government has refused to let the yuan appreciate by more than a few percent. The government is set to try a number of fiscal approaches to try to cool inflation, but none is likely to have as much effect as an appreciation of the currency would have.

So China keeps growing its foreign reserves and stuffing more than 40% of the cash into a mattress. That is cash that a revaluation of the yuan could set free into the world economy, at the same time that it puts a damper on China’s inflation.

Much of China’s current dilemma is a result of the second round of quantitative easing by the US Federal Reserve. As the US dollar weakens, China will be forced either to hike interest rates (threatening more hot money flows to the country) or to revalue the yuan. Neither path is one that China wants to follow.

Paul Ausick