News Analysis: China's tweak to reserve calculation helps smooth liquidity

The central bank's latest refinement of how the reserve requirement ratio (RRR) is calculated will help smooth liquidity and facilitate the offshore renminbi market.

The People's Bank of China announced Friday that, as of July 15, a bank's RRR calculation will be based on the average of its daily outstanding deposits, rather than the deposit level at the date of assessment.

Calculation of the RRR for offshore renminbi deposits held onshore will also be based on the average of the holdings during the previous quarter, not just holdings at the quarter's end.

The revision will help "improve the assessment of deposit reserve requirements, increase flexibility of financial institutions' liquidity management and smooth volatility in the currency market," the central bank said.

The new refinement will help smooth liquidity, because RRR as a potential source of liquidity shock will be weakened, said China International Capital Corp. (CICC) in a research note.

The central bank started monitoring the average reserve holdings of banks last September, but still assessed their adequacy relative to outstanding deposits at the assessment date. Liquidity shocks may come when commercial banks fight to meet the reserve requirement when the assessment date nears.

In the future, this assessment will be made against the average deposits, meaning that the volatility of deposits will not affect the required reserve level for banks, but the average will, the CICC said.

"The move suggests the central bank has a cautious attitude toward liquidity management approaching the quarter-end," it said.

The move will also help the offshore renminbi market function, according to the CICC.

To contain regulatory arbitrage, the central bank imposed the RRR on offshore renminbi deposits held onshore from Jan. 25. At the end of the first quarter, offshore banks rushed to offload their offshore renminbi funds in order to reduce the reserves they would be required to hold in the second quarter.

This type of shock is less likely to occur again, when the average of offshore renminbi deposits starts to matter, according to the note.

"Improving liquidity management is a key step to establish China's interest rate corridor system," the CICC added.

After removing bank rate controls, the PBOC has attempted to build a corridor system to guide key money market rates. Interest rate spikes caused by the RRR could impose serious challenges to the effectiveness of the corridor. The smooth functioning of the interbank market will allow the PBOC to implement its policy effectively in the future, it said.

Analysts with ANZ Research agreed, noting that China's RRR rule change reflects the authority's willingness to maintain the stability of the renminbi exchange rate.

"The rule change will raise the costs of shorting the Chinese yuan in an effort to stabilize the currency," said Li Huiyong, chief analyst at Shenwan Hongyuan Securities. Enditem