Why RRR is a better policy tool,HSBC China Monetary Conditions Indicator
Since late-2016, the PBoC has been tightening liquidity in the interbank market. Themarket-traded 7-day repo rate increased to an average of 2.9% in September, from 2.5%in January. This happened against the backdrop of gradually tightening liquidity andslower base money growth over the past years. Despite slower capital inflows, the PBoChas refrained from cutting the reserve requirement ratio, and instead relied on short-termliquidity injections in the interbank market.。
These developments have increased the effectiveness of monetary policy. There isevidence, for example, that suggests a markedly higher sensitivity of liquidity instrumentsin the banking sector to short-dated interest rates. There have been side effects as well.。
The most notable one is the sharp divergence between the interest rates for banks andthat for the wider financial institutions. Reflecting the inherent liquidity hierarchy in thebanking system, this asymmetry is further exacerbated by the PBoC’s shift toward agreater reliance on open market operations (OMOs), which transmit liquidity from thelarge banks to smaller non-bank financial institutions. This happens against the backdropof an already large gap between the cost of borrowing from and lending to the PBoC.。
To prevent the gap from rising further, a broadly stable liquidity backdrop is needed. In themedium term, the system-wide Reserve Requirement Ratio (RRR) should be reduced,with the liquidity impact offset through sterilisation, if needed. Regulatory reforms toreduce market segmentations are also necessary.。