Raising banking reserve ratio the best move now but big reforms needed

By Sun Lijian  |   2008-6-13  |     NEWSPAPER EDITION

THE central bank recently announced plans to raise the reserve requirement ratio by one percentage point by the end of this month.

This is contrary to the general expectation that China would loosen its macro controls after the Sichuan earthquake. Relaxation was expected given the need for reconstruction, revival of the stock market and economic prosperity as the Olympic Games approach.

The policy has, of course, both advantages and disadvantages here.

On the plus side, it may somewhat relieve the pressure of imported inflation.

Foreign reserve statistics show that although China's trade surplus has been decreasing, the problem of funds outstanding for foreign exchange, caused by the increase of foreign exchanges, continues to worsen.

Such excessive liquidity is likely to further push up the inflation of commodity prices or asset price levels triggered by imported inflation.

In such cases, adjusting the reserve requirement ratio is the most direct and effective way to control liquidity. The move expected to freeze bank loans to more than 450 billion yuan (US$64 billion).

As the central bank believes, strict monetary policies can control the investment scale of enterprises most effectively, thus reducing demand for the world's primary products and relieving the pressure of imported inflation.

Besides, the policy helps prevent the amplification effects of investments in the quake reconstruction.

At present, reconstruction is being carried out in good order under active fiscal policies. However, there might be departments that finance and enlarge their production scale in the name of disaster relief, causing more liquidity and overinvestment.

Besides, the reconstruction's effect on commodity price rise is yet to come.

Therefore, the central bank issued the policy in advance, with a warning.

The policy also clarifies China's stand on opening its capital market and the appreciation of yuan.

As the United States' subprime mortgage crisis continues to sway the world economy, China's further opening its capital market would be likely to worsen its excessive liquidity.

Therefore, raising the deposit reserve ratio is the best choice.

The cost of this choice, however, is becoming bigger and bigger.

If China does not readjust its economic development mode and deepen the reform of its financial industries and social security system, its ability to resist shocks (imported inflation, international hot money, etc) from outside will weaken (note Vietnam) as it opens more to the world.

In fact, some difficult problems already require solutions.

First, the negative interest of banks (when deposit interest rate falls below the inflation rate).

Second, raising the deposit reserve ratio may dampen the substantial economy's legitimate demand for capital for development.

Third, the inertia of a policy-dominant market remains the main theme in the Chinese economy.

The government will feel increased pressure from the market at a time when the trend toward economic and financial globalization is unstoppable.

As a result, the government can rarely get its real intention across to the market.

That's also why the government must readjust its deposit reserve ratio constantly and issue other administrative orders for macro controls.

(The author is professor of finance and deputy dean of the School of Economics at Fudan University.)