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The Role of Reserve Requirements: The Case of Contemporary China Compared to Postwar Germany

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Currency Cooperation in East Asia

Part of the book series: Financial and Monetary Policy Studies ((FMPS,volume 38))

Abstract

The role of reserve requirements has evolved significantly over time and differs across countries, though there are two broad trends. For central banks that operate in highly developed financial markets the role of reserve requirements as the primary instrument of monetary policy has been decreasing over the past few decades. The role of mandatory reserves is reduced to smoothing fluctuations of short-term interest rates, which helps to communicate the operational target of the central banks more clearly. For central banks operating in emerging market economies, however, tweaking reserve requirements has gained importance. Reserve requirements supplement a policy mix that aims at stabilizing the exchange rate and combating high and volatile capital inflows, especially as the low interest rate environment of advanced economies has accelerated a global search for higher yield. We offer a comparison of the experience at the People’s Bank of China (PBC) during the recent past and that of the Bundesbank from the post-war period until the start of the European monetary union. It presents a case study suitable for explaining the different functions of reserve requirements and how characteristic features and external conditions influence the feasibility of each function. Reserve requirements have been most actively used in China and Germany during shifts in exchange rate regimes that coincided with periods of high and volatile capital inflows. Economic theory, however, can additionally drive visions of what reserve requirements should perform. We conclude that some misconceptions of the role of money, credit and liquidity influence the bias between theory and practice.

The views expressed are those of the authors and do not necessarily reflect those of the Deutsche Bundesbank. We would like to thank Ulrich Daechert for helpful comments based on a long experience with minimum reserves at the Bundesbank.

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Notes

  1. 1.

    In Canada, for example, the discussion started fairly early, see Johnson (1976), while much later in Germany, see Kaven (1990).

  2. 2.

    This includes the Bundesbank in 1995a, see Meister and Hofmann (1994).

  3. 3.

    See Borio (1997) or Rich (1997).

  4. 4.

    Turkey implemented an unorthodox reserve requirement system in 2012 that triggered international interest; see O’ Byrne (2012), Talasli and Ozyildirim (2013). Tovar et al. (2012) discuss the current effectiveness of reserve requirements in Latin America.

  5. 5.

    As suggested by Gray (2011).

  6. 6.

    See Feinman (1993, pp. 572–573). Feinman, however, mentions that reserve requirements had a limited usefulness as a guarantor of liquidity in the U.S. as bank runs nevertheless continued periodically before the Federal Reserve Bank was established as a lender of last resort.

  7. 7.

    Andreae (1953, p. 224). In order to restrict circulation and ultimately inflation, the issuance of new banknotes was tied to an equivalent value of gold as a reserve. In contrast, the Banking School believed that the quantity of banknotes in circulation was normally adequately controlled by the credit business of competitive banking and that Peel’s Banking Act unnecessarily restricted the elastic supply of money provided for economic activity. In practice, the provisions of Peel’s Banking Act were hardly effective, because they were frequently overruled whenever financial and political crises occurred.

  8. 8.

    See Gilbert (1980) on the implications of lagged reserve requirements for monetary control and for general criticism of the money multiplier see, e.g., Goodhart (1989), Disyatat (2010) or Carpenter and Demiralp (2012).

  9. 9.

    In contrast higher capital adequacy ratios in principle do not restrict lending, though the argument that equity is more expensive than debt is often put forward. Admati and Hellwig (2013, pp. 100–114) point out the fallacies of this argument. First, required rates of return for debt and equity are not fixed but rather depend on the risk associated with the investments and second, the costs of debt and equity cannot be considered separately without referring to their structure in total funding (see also Miller 1995). A change in the funding mix, which only affects the division of risks and not the total returns from the investment, cannot have any effect on total funding costs. In practice, however, there are frictions, i.e., investors in a bank do not bear the risk of an investment, because, for example, the deposit insurance or government guarantees cover it partly. This can make borrowing cheaper for banks, but such cost savings are paid by others.

  10. 10.

    See Borio and Disyatat (2009, p. 2, 3).

  11. 11.

    The role of reserve requirements in the Eurosystem is a prominent example of this function.

  12. 12.

    When central banks buy foreign currency from commercial banks, they provide central bank reserve balances. If the provision is in excess of the usually required working balances of banks, surplus liquidity emerges. See Gray (2006) for a survey on the different sources of surplus liquidity and how it is managed.

  13. 13.

    This may indicate that the central bank aims to keep the exchange undervalued in order to support competitiveness, or to prevent an overvaluation from its fundamental value. Disentangling the two reasons is difficult, because the equilibrium value of the exchange rate is unobservable. The purchasing power parity concept is just one out of many concepts of the equilibrium value, see Driver and Peter (2005).

  14. 14.

    Andreae (1953, p. 228).

  15. 15.

    Spindler et al. (1957, p. 162).

  16. 16.

    Including (1) authorization requirements for selling selected domestic financial instruments to nonresidents, for residents’ borrowing abroad, for domestic banks accepting foreign funds, assigning domestic claims to non-residents and for payments of interest on foreign deposits with domestic banks (2) a cash deposit requirement for borrowing abroad and (3) a coupon tax on interest received by non-residents on domestic bonds.

  17. 17.

    The Big Four are Bank of China, China Construction Bank, Industrial and Commercial Bank of China, Agricultural Bank of China. Their origins can be traced back to the division of the Peoples Bank of China into “special banks” during the process of Reform and Opening in order to support different business sectors.

  18. 18.

    Begründung zum Gesetz der Deutschen Bundesbank, Sect. 3, in Spindler et al. (1957, p. 108).

  19. 19.

    Trade bills purchased by the Bundesbank, for example, were those drawn between enterprises and/or the self-employed on the basis of deliveries of goods and services. Furthermore, the specific business structure of the bank was taken into account when determining the total amount of rediscount quotas. This so called structural component was based on the share of short and medium-term lending to non-banks in the total volume of business.

  20. 20.

    Such as authorization requirements for nonresidents purchasing selected short- and medium term financial instruments.

  21. 21.

    Eichengreen (2011) argues that the economically and politically powerful manufacturing sector feared further appreciation and loss of competitiveness. According to Frieden (2000) the interests of the manufacturing sector were politically more powerful than the interests of the financial sector, which benefits from assets denominated in a strong currency and are more attractive to international investors. Another factor that may have influenced the Bundesbanks’ attitude towards the international role of the Deutsche Mark was the choice of monetary targeting as its monetary policy strategy. The circulation of domestic currency abroad triggered fears that controlling money and inflation becomes more complicated though these fears eventually were not confirmed (see Deutsche Bundesbank 1995, p. 71).

  22. 22.

    In the middle of the 1980s Germany dismantled the remaining restrictions on capital inflows and became a leader with respect to the free movement of capital compared to other European countries, many industrial countries and virtually all developing countries. (Deutsche Bundesbank 1985, pp. 13–23).

  23. 23.

    Since July 2006 there are no quotas on foreign exchange purchases for foreign direct investment. Since December 2002 qualified foreign institutional investors have been allowed to invest domestically in certain types of shares. The qualified domestic institutional investor’s scheme was introduced in 2004 and has been further developed.

  24. 24.

    Only since August 2007 can residents keep certain foreign exchange receipts, purchase foreign exchange or hold foreign exchange accounts under certain conditions.

  25. 25.

    The PBC has published a three step plan for loosening the governments’ strict capital control in February 2012. According to the report the PBC sees the widening of the renminbi’s trading band and liberalizing domestic interest rates not as “perequisites” for capital account liberalization, but as mutually conducive to each other. Furthermore, it supports the view that financial stability and capital account liberalization are not highly correlated in China (Jingu 2012), Report on “Basic conditions for speeding up capital account liberalization are basically mature” http://www.pbc.gov.cn/publish/diaochatongjisi/866/2012/20120523135503424585606/20120523135503424585606_.html

  26. 26.

    Spindler et al. (1957): Die Deutsche Bundesbank, Kohlhammer Verlag, Stuttgart 1957, p. 62.

  27. 27.

    Hauptabteilung Volkswirtschaft und Statistik (1948) Memorandum zur Frage der Mindestreserve vom 27. Oktober 1948, Historisches Archiv, B330/3182.

  28. 28.

    In their view reserve requirements influenced credit and money growth in at least two ways. Higher reserve requirements reduced freely available reserves for banks, which should react by curbing credit growth. Second, higher unremunerated reserve requirements should increase lending rates and thereby, reduce credit growth. Furthermore, cost considerations should not influence monetary policy decisions, Begründung zum Entwurf des Gesetzes der Deutschen Bundesbank vom 9. August 1956, Sect. 12, Historisches Archiv, B 330/3644.

  29. 29.

    Further evidence in favor of the dual character, however, was the fact, that banks held minimum reserves on normal current accounts of banks with the central bank and could count them as liquidity reserves according to the Banking Act. If the two functions were separated, the accounts would have needed to be separated as well. Spindler et al. (1957): Die Deutsche Bundesbank, Kohlhammer Verlag, Stuttgart 1957, p. 161; see also Begründung zum Entwurf des Gesetzes der Deutschen Bundesbank vom 9. August 1956, Sect. 12, Historisches Archiv, B 330/3644.

  30. 30.

    Which is only 10 days compared to the German case of 1 month.

  31. 31.

    The Patman-Enquête in the US already discussed this idea, which influenced thinking in Germany, see Multerer (1956, pp. 69–78).

  32. 32.

    See Donner (1952) Mindestreservenpolitik in den USA II, pp. 494–495.

  33. 33.

    Begründung zum Entwurf des Gesetzes der Deutschen Bundesbank vom 9. August 1956, Sect. 12, Historisches Archiv, B 330/3644.

  34. 34.

    Pleiderer (1973, pp. 88–92).

  35. 35.

    A bank extends a loan, which the borrower, for example, uses to pay for goods purchased from another client of the bank. In this case, the bank creates its own funding. Though the example, of course, does not necessarily hold for each bank, it explains, how the banking sector in general creates deposits in the lending process.

  36. 36.

    This view is reflected in discussions on whether minimum reserves should be imposed on savings deposits. Some members of the central bank justified exempting saving deposits from minimum reserves as they believed that savings deposits were not money created by credit, but true savings. The main argument supporting this view was based on the fact that savings deposits could only be withdrawn as cash and not be used for cashless payments. The proposal, however, was finally rejected. In the clarification of the draft law the Bundesbank considered this line of reasoning to be a mistake. It eventually imposed minimum reserves on savings deposits and argued instead that savings deposits cause an inflow of central bank money for a bank which it can use as a source of new loans. Begründung zum Entwurf des Gesetzes der Deutschen Bundesbank vom 9. August 1956, Sect. 12, Historisches Archiv, B 330/3644.

  37. 37.

    Wang and Sun (2013, p. 23).

  38. 38.

    For example, favoring higher growth of credit to S & M and the agricultural sector.

  39. 39.

    Required reserve ratios for deposits of non-residents, however, had no upper limits and incremental reserve ratios that were temporarily imposed, virtually reached the legally permissible maximum of 100 % (Deutsche Bundesbank 1994, p. 124).

  40. 40.

    Originally, the higher ratios were imposed on the total amount of liabilities. After revisions in 1977 they were progressively imposed, which implied that the average minimum reserve requirement steadily increased as the volume of deposits grew and asymptotically approached the reserve ratio of the third stage. Later on, the progressive stages gradually disappeared, initially in the case of time and savings deposits, since March 1994 a uniform reserve ratio also applied to sight deposits.

  41. 41.

    In fact, some banks with long-term business models were temporarily exempted from minimum reserves (Bundesbank 1995a, p. 120).

  42. 42.

    Bank of China (BoC), Industrial and Commercial Bank of China (ICBC), China Agricultural Bank (CAB) and China Construction Bank (CCB).

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Authors and Affiliations

  1. Deutsche Bundesbank, Frankfurt am Main, Germany

    Franziska Schobert

  2. Chengdu Stock Exchange Corp., Beijing, China

    Lijun Yu

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  1. Franziska Schobert
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Correspondence to Franziska Schobert .

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Editors and Affiliations

  1. East Asia Institute, Hochschule Ludwigshafen, Ludwigshafen, Germany

    Frank Rövekamp

  2. German Institute for Int. and Sec. Aff., Stiftung Wissenschaft und Politik (SWP), Berlin, Germany

    Hanns Günther Hilpert

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Schobert, F., Yu, L. (2014). The Role of Reserve Requirements: The Case of Contemporary China Compared to Postwar Germany. In: Rövekamp, F., Hilpert, H. (eds) Currency Cooperation in East Asia. Financial and Monetary Policy Studies, vol 38. Springer, Cham. https://doi.org/10.1007/978-3-319-03062-3_10

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