Monday, June 16, 2014

China Cuts "Required Reserve Ratio" to stimulate lending and Investment. What does that mean exactly?

One of the tools modern Central Banks around the world have to affect money supply, hence interest rates that money is saved or borrow at, is the "Required Reserve Ratio (RRR)".

To prevent banks from lending out (or otherwise use) all of a deposit made by a customer they are required to with-hold a certain  percentage of that deposit in an account with the Central Bank.  After they with-hold the required amount banks put the remaining balance in their "Excess Reserve" accounts from which they can make loans.
China’s largest banks are currently required to hold 20 per cent of deposits as reserves at the central bank, while medium-sized lenders must meet ratios of 18 per cent. Rural banks and other small lenders are subject to a rate of 16.5 per cent or less. (Source: Financial Times)
Simple example: I make a $100.00 cash deposit in my bank. If the RRR is 20% then the bank puts $20.00 of that in their Required Reserve account and $80.00 in Excess Reserves.  The bank may loan up to $80.00 to a borrower.

At least that is the story that is told.  For now, we will go with it since it is a BIG part of the AP Macroeconomics curriculum.

You can see the constraint on lending in this scenario is the RRR.  If the RRR is LOWERED than banks are required to with-hold LESS of a deposit and the Excess Reserves to be loaned out are HIGHER. Banks tend to make more loans.  More loans are made to businesses for projects and/or capital equipment purchases. Economy boosted. Key vocab term for AP--"Expansionary or Loose Monetary Policy" designed to stimulate Aggregate Demand ("Investment" (I) in C+I+G +N):
Zhang Zhiwei, China economist at Nomura, described the move as “significant”. By his calculations, the new cut will inject about Rmb95bn ($15bn) back into the banking system. When added to other measures, such as the April cut, Beijing will have added Rmb545bn of fresh liquidity into the economy by the end of this month, equivalent to a 50 basis point cut to reserve requirements for all banks.
China has taken a fresh step to boost flagging growth by cutting the amount of cash reserves some lenders must hold at the central bank in a bid to boost lending to small businesses and the rural economy. 
The People’s Bank of China said it would reduce the “required reserve ratio” by 0.5 per cent for banks that mainly lend to small businesses and rural borrowers.(Source: Financial Times)
 At least that is the story that is told. For now, we will go with it since...
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