China Continues To Tighten Monetary Policy....

A rate rise a couple of months ago, jawboning by government officials and the central bank and now a rise in reserve requirements as China is starting to get more serious about the economy overheating...

The People's Bank of China raised the required reserve ratio for commercial lenders by 0.5 percentage point, it said in a statement on its Web site today, bringing the required ratio to 8 percent. The move comes less than two months after the bank raised interest rates for the first time since October 2004.

Monetary policy is very blunt instrument and China's central bankers do not have all the monetary tools available to them to tighten credit when asset prices rise too quickly or the economy overheats. With the repo market being undeveloped, the central bank cannot effectively use open market operations to sop up excess liquidity in the banking system. So, by increasing reserve requirements, the central bank is attempting to reign in credit availability in the PRC.

For those not in the know, when money is deposited in banks, central banks require that a certain percentage of that money be deposited interest free as backing against these banking system liabilities. In the US, the reserve requirement is 10%. Adjusting these reserve requirements up or down, allows for contraction or expansion of availability of funds for loans, respectively.

And to make the idea even simpler, lets say that a bank has a deposit of $100....

Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As this fractional-reserve banking process continues, the banks can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

So, therefore, using a reserve requirement of 7.5%, the previous number, the banking system generated 1,333.33 Yuan of credit for each deposit of 100 Yuan. This figure falls to 1,250 Yuan by raising the reserve requirement to 8%, a decline of 6.2 % in available credit in China as a result of this most recent action.