Under mounting speculation for the appreciation of the yuan in the past few years, foreign currencies flowed into China through various channels. In response, the central bank had to increase the monetary base to offset the liquidity. In doing so, the central bank raised the deposit reserve ratio. And it was raised so frequently that the ratio was distorted. However, in the second half of 2011, the speculation for the appreciation of the yuan weakened, so that the liquidity of foreign currencies coming into China lessened and even took on negative growth. As the funds outstanding for foreign exchange diminished, the opportunities for cuts on the deposit reserve ratio loomed large.

The central bank has a lot of room to trim the deposit reserve ratio to normalize it. Yet the adjustment depends on the pace of the yuan's appreciation and the liquidity of foreign currency markets. That's why Zhou said a lowered deposit reserve ratio doesn't indicate a loosened monetary policy. What's more, the fluctuation of the ratio is not the only reason for changes in monetary policy. For example, the buy-back of Open Market Operations (OMO) is also an important tool in the monetary policies to drain liquidity.

However, it is only because the deposit reserve ratio has been distorted that the influence it exerts on the monetary policies is insignificant. Once it returns to normality, its impact would hardly be neglected.

According to Zhou’s comments, the central bank will alter the deposit reserve ratio more frequently in 2012. Meanwhile, the yuan will not appreciate too much and the funds outstanding for foreign exchange would gradually ebb.

Yet the big question is: If the central bank cuts its deposit reserve ratio frequently, where would the liquidity released from the lowered ratio flow to? Based on Zhou's comments, it will filter into each sector of the country's economy. In other words, banks would increase their capitals for lending under the less squeezed liquidity position, but the money would be channeled in line with risk assessments into the sectors that are supported by the government. This takes the stock market out of the running, and some state-owned banks have already categorized real estate market as a high-risk industry.

Zhou's comments at the press conference forecast higher fluctuation in the deposit reserve ratio and lower rate change this year in the central bank's monetary policies. These policies would probably be implemented unless the consumer price index (CPI) drops quicker than expected. Moreover, the exchange rate between the yuan and the U.S. dollars will not fluctuate too much.

All in all, the growth of the credit loans from the banks is not dependant on the capitals that is eligible for lending, but rather on where the released liquidity would flow to.

The author is a researcher with the Institute of Finance and Banking under the Chinese Academy of Social Sciences.

(This post was published in Chinese and translated by Wu Jin.)

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