Reserve ratio has primary place in fight against inflation

The People’s Bank of China yesterday announced that it would raise the required reserve ratio for commercial banks in China to 16%, up another half a percent. This is the latest increase in a series of increases that has seen the ratio double from 8% in mid-2006. So far, China’s implementation of a “tight” monetary policy has not been focused on interest rate hikes. The other inflation fighting tool which China has used is a more rapid increase in the appreciation of the Renminbi. It remains to be seen whether larger changes in interest rates will be recruited in the fight against inflation.

China’s preference for raising the required reserve ratio suggests a desire to target inflation by controlling liquidity. Using large interest rate changes to target inflation could alter the consumption and investment patterns of individuals and businesses. As a result, changing interest rates by larger amounts could be seen as more likely to result in instability in the economy. The Red Cat Journal would turn more cautious on the outlook for China’s economy if large interest rate rises were to be announced.

As long as China continues to run large current account surpluses (foreign exchange reserves now stand at US$1.68 billion), we can expect increases in the required reserve ratio to continue. The increases help to offset the expansion in domestic liquidity that occurs when China buys up foreign currency using newly created Renminbi to keep it from rising too quickly.