Why should we lower the foreign exchange reserve when the RMB is depreciating?

According to the official website of the People’s Bank of China, in order to improve financial institutions’ ability to use foreign exchange funds, the reserve requirement ratio for financial institutions will be lowered by 2 percentage points from the current 8% to 6% from September 15, 2022.

On the news, the value of the Yuan against the dollar reversed from falling:

Onshore Yuan exchange rate fell to 6.93 from the high of 6.94;

The offshore Yuan fell from a high of 6.95 to 6.93.

This is the second time this year that the People’s Bank of China has cut the reserve requirement ratio.

On April 25, 2022, the People’s Bank of China announced that it would lower the reserve requirement ratio for financial institutions’ foreign exchange deposits from 9% to 8% as of May 15.

The foreign exchange reserve ratio refers to the ratio of the foreign exchange reserve amount deposited with the People’s Bank of China by financial institutions to the amount of foreign exchange deposits they receive. It is one of the monetary policy tools used by the People’s Bank of China to manage foreign exchange.

For example, if a bank receives a 1,000 Yuan deposit and needs to pay 200 Yuan of it to the central bank, the reserve requirement ratio is 20%. If you hand in 100 Yuan for a 1,000 Yuan deposit, the reserve ratio is 10%.

The reserve requirement ratio for foreign exchange is managed by the central bank similarly to the reserve requirement ratio for renminbi.

If the deposit reserve ratio is raised, it means that commercial banks need to hand over more foreign exchange for the same deposit quota. If the banks do not have so much, they have to use RMB to buy foreign exchange from the market. As a result, the foreign exchange in the market becomes more expensive, and the RMB will naturally depreciate.

Furthermore, because bringing more of the foreign exchange deposits of financial institutions back to the central bank means that there are fewer foreign exchange deposits in the market, which would inhibit the derivation of foreign exchange deposits in China; it would also have the effect of raising the value of foreign exchange.

Of course, the same logic applies the other way around

Reducing the reserve requirement for foreign exchange deposits encourages derivations of foreign exchange deposits, providing more dollars to the market, which banks may also sell if they have excess deposits, thus causing the Yuan to appreciate.

China’s foreign exchange reserve system was established in 2004, when the People’s Bank of China wanted to implement the exchange rate reform and make the exchange rate of RMB more market-oriented. However, it still needed to have a grip on exchange rate management, so it formulated and issued the Regulations on the Management of Foreign Exchange Reserve Requirements of Financial Institutions, which came into effect on January 1, 2005.

The specific scope of application shall be financial institutions within the territory of the People’s Republic of China that accept foreign exchange deposits, including: Wholly state-owned commercial banks, joint-stock commercial banks, urban commercial banks, rural commercial (cooperative) banks, urban credit cooperatives, rural credit cooperatives and enterprise group finance companies, wholly foreign-funded banks, wholly foreign-funded banks, wholly foreign-funded finance companies, Sino-foreign joint venture finance companies, branches of foreign banks and other financial institutions that take foreign exchange deposits.

Moreover, there is a special stipulation that the People’s Bank of China does not calculate and pay interest on the foreign exchange reserve funds deposited by financial institutions.

The reserve requirement ratio was gradually raised from 3 percent to 5 percent in 2007, and has not been adjusted for about 14 years.

In June 2021, when China’s export surplus reached the highest level in history, the People’s Bank of China stepped in and raised the reserve requirement ratio for foreign exchange by 2 percentage points in response to the strong expectation of RMB appreciation.

In December 2021, the People’s Bank of China raised the reserve requirement ratio for foreign exchange by 2 percentage points again to promote a reasonable depreciation of the RMB.

Since 2022, with the Federal Reserve’s interest rate increase, the yield of US Treasury bonds has gradually risen, and the difference between the yields of Chinese and US Treasury bonds has gradually narrowed and even appeared upside down. The depreciation pressure of RMB has significantly increased. In particular, in April 2022, the difference between the yields of Chinese and US Treasury bonds basically disappeared and appeared upside down, and the RMB began to significantly depreciate.

At this time, the central bank lowered the reserve requirement ratio for foreign exchange in line with the trend to avoid the excessive amplification of RMB depreciation expectations.

Since April 2022, when US bond yields surpassed China’s, the Fed has remained on a path of aggressive interest rate hikes. In contrast, the People’s Bank of China has even led a round of small domestic interest rate cuts, further exacerbating the inversion of US and Chinese bond yields.

In the past five months, along with the strength of the US dollar, the RMB exchange rate gradually depreciated to near the key level of 7.0, so the central bank stepped in again, cutting the reserve requirement ratio for foreign exchange by 2 percentage points to prevent further depreciation expectations.

Overall, however, the reserve ratio cut is only temporary and not enough to affect the logic of the Yuan’s exchange rate.

From mid-2010 to April 2022, Chinese and U.S. government bond yields never inverted, a 12-year period in which the Yuan traded roughly between 6.1 and 7.1. But now, there is an inverted interest rate of Chinese and US government bonds, it should be said that the value of the RMB, to continue to maintain in this range, it is a certain degree of difficulty.

In the absence of big changes in the financial environment in China and the US, the underlying logic of the renminbi exchange rate still depends on what happens to the spread between Chinese and US Treasury yields. If the Fed does not stop the path of interest rate hike and the Chinese and US Treasury bond yields continue to reverse or even worsen, the RMB depreciation pressure will not be alleviated much just by lowering the reserve requirement ratio for foreign exchange.

Of course, RMB only depreciates against the US dollar. Compared with other major non-US currencies in the world, such as euro and yen, RMB exchange rate is a particularly “tenacious” currency. From the beginning of 2022 to now:

The dollar-yen exchange rates has fallen from 115 to 140 today, equivalent to 18% depreciation.

The euro-dollar exchange rates has gone from 1.13 to 1 now, equivalent to 12 percent depreciation.

The Yuan has depreciated 8 percent from 6.38 to 6.95.

 

 

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