Thursday, March 10, 2016

Changing The Reserve Ratio ≠ Changing Monetary Policy

Or, Part Three of Why I Feel Snarky This Week

A few weeks back, Bank Negara cut the Malaysian statutory reserve ratio by 0.50%, and the People’s Bank of China did the same thing last week. Most of the commentary was along the lines of “easing monetary policy” and “adding to stimulus” and “boosting lending and investment”.

That’s a load of bull.

I’ve had to explain this multiple times over the past few weeks, so rather than having to do it all again, I thought I might as well write it out.

First of all, what are reserves? Technically, reserves are the deposits placed by the banking system at central banks. They are intended to cover the banking system’s short term obligations – money for paying off what banks owe to other banks or to customers. Much of bank reserves are built up by customer deposits, part of the proceeds of which are parked at the central bank to ensure that there’s enough liquid resources in the system to handle payment flows.

Central banks set reserve ratios as a form of discipline, to make sure that banks always have sufficient funds for the payments system to function smoothly. In countries where the financial system is sufficiently developed, reserve ratios aren’t used at all.

The reserve ratio is a hard floor, below which banks cannot allow their reserves to drop. If that happens, banks will need to borrow from their central bank, usually at a rate above the prevailing interbank market rate. However, most of the time, banks which are short of cash typically borrow from banks that are long, i.e. those who have deposits or reserves in excess of their requirements.

Bank treasury departments would err on the safe side, and keep a safe buffer between day to day cash requirements and their liquid assets. So bank deposits at the central bank also typically exceed  the required reserve ratio – sometimes, many multiples more. Fact of that matter is, if the reserve ratio is low enough, changes in the ratio actually mean very little as banks will keep a prudential level of central bank deposits in any case.

There is thus an intimate though occasionally indeterminate relationship between the reserves in the system and interbank and money markets. On the other hand, there is very little relationship between reserves and bank lending to customers.

Lending is determined almost purely by the demand for loans and the willingness of banks to supply loans. Note that in an endogenous money system as we have today, banks don’t need reserves to give out loans. The whole idea of releasing reserves so that banks can “lend it out to customers” is bunkum. The only direct link between reserves and lending is the cost difference between the level of desired reserves by the banking system, and their actual availability. To put it more succinctly, its all about liquidity.

In modern monetary policy practice (at least those that use interest rates as the primary intermediate policy target), central banks set a target rate at the very shortest end of the interbank market, typically overnight deposit rates. This target is achieved by the central bank placing deposits or offering securities to the market for overnight money, such that the overnight rate stays at or near the target.

Interest rates for longer dated deposits are set mostly by the market, but “anchored” on the overnight rate (compounded interest + liquidity risk premium + term risk premium). Debt securities, which extend even further into the future (with some overlap), would in turn be anchored on interbank deposit rates. If the markets are functioning well, shifts in the overnight rate will move the whole term structure of interbank and money market rates up or down.

That’s the theory anyway.

When financial systems are under stress however, strange things can happen. Yield curves could become overly steep or overly flat, or you could get kinks and bumps in the curve, all without any change to the policy target. To put it another way, monetary conditions could become tighter or looser, all without any change to the “official” policy stance. One way for central banks to react to such undesirable changes is to change the reserve ratio.

So, let’s now turn to BNM’s and PBOC’s reserve ratio cuts.

Lowering the reserve ratio shifts funds from the required reserves account (which banks can’t touch), to their ordinary deposit accounts (which they can use for payments). How that affects the markets depends on whether the extra money exceeds the desire for banks for reserves. If there is an excess, then some will get placed out in the interbank markets, and if there isn’t, you’re whistling in the wind and there will be zero impact (except maybe bankers with lower blood pressure).

The effect on customer borrowing basically boils down to whether interbank rates come down, which would reduce bank cost of funds, and allow them to offer loans at cheaper rates. In practice, the impact is very subtle – we’re talking 1-2 basis point moves in interbank rates for every 50 basis point cut in reserve ratios in Malaysia’s case. That won’t budge bank lending rates much, if at all. What it does do is allow banks to have a bigger buffer in terms of their ability to meet payment obligations. Another effect is to generally lower the liquidity premium across the whole interbank yield curve, which would have the effect of flattening the curve.

Ergo, it’s about liquidity.

In Malaysia’s case, the run-up to Basle III implementation had caused some liquidity issues with some banks, which manifested itself in a competition for customer deposits. Short term FD rates were being offered that were higher than the yield on long term Malaysian Government Securities. Despite the fact that overall liquidity remained adequate, the regulatory requirements were causing serious price distortions in the market.

Hence the release of liquidity via the SRR cut. It was to address a temporary yet troublesome market distortion.

In China’s case, the rationale is even simpler. The use of foreign exchange reserves to defend the Yuan against capital outflows was reducing liquidity in the interbank market, despite the easing bias in monetary policy. China lost USD100b in reserves in January 2016 alone, the equivalent of pulling out RMB650b from domestic liquidity. In other words, despite attempting to loosen monetary policy, the requirement to keep the Yuan exchange rate “stable” was actually creating the opposite conditions.

This had to be sterilised somehow and the usual option is to print money and buy debt securities in the money market. But despite it’s size, China’s money markets aren’t that well developed which is why it uses a high reserve ratio in the first place. Cutting the reserve ratio was thus a no-brainer – it released something like RMB650b-RMB700b into the interbank market, only a little larger than reduction of liquidity created by the PBOC’s defense of the Yuan. It was simply an offsetting (sterilisation) move to maintain monetary conditions at the desired status quo. In fact, one could argue that because the outflow of capital and reduction in FX reserves have been so large and acute (over USD1 trillion in the past year), the PBOC is actually tightening policy and liquidity, despite cutting both policy rates and reserve ratios multiple times.

In any case, neither BNM's or the PBOC's moves signal an “easing” of policy, a desire to increase “customer borrowing and investment”, or “adding to stimulus”. It’s about liquidity. QED.


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    1. @Ujang

      At 3.1% GDP, our fiscal deficit is pretty small, not very large.

      In any case, I'm not in favour of reducing the deficit under the current circumstances. Better to increase it instead.

  2. Great analysis that is not found in mainstream media.

  3. I am kinda confuse here. If PBOC depletes USD100b to defend their yuan, they would have obtain the yuan being bought out with their USD reserve. So where does the yuan goes to?
    Since you said it reduces liquidlity.

    1. @anon

      It goes on the PBOC's balance sheet.

      The central bank does have the option of placing out the Yuan it has gained, but that increases domestic money supply (money in the banking system) and puts downward pressure on the exchange rate i.e. right back where they started from.

      The key point here is that the Yuan proceeds from central bank USD sales are effectively removed from the banking system.

    2. Got it! thanks

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