Sheng Songcheng: China's reserve requirement ratio cut is better than interest rate cuts, but there is still room for interest rate cuts

On September 12, the "Bund Conference · Insight Forum" jointly organized by Ant Group and Caixin Media was held in Shanghai. The afternoon agenda of the forum focused on capital markets and technological innovation. Sheng Songcheng, a professor at China Europe International Business School, senior academic advisor at the China Europe Lujiazui International Financial Research Institute, and director of the China Chief Economists Forum Research Institute, stated at the meeting that under the current economic situation, China's monetary policy tool of lowering the reserve requirement ratio (RRR) is preferable to cutting interest rates.

He elaborated on three aspects:

China's Monetary Policy Utilization Mainly Focuses on Adjusting the Statutory Deposit Reserve Ratio

Since 2016, China has adjusted the statutory deposit reserve ratio 23 times, all of which were downward adjustments (RRR cuts). For example, the reserve requirement ratio for large deposit-taking financial institutions (Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, China Construction Bank, China Communications Bank, and Postal Savings Bank) has decreased from 17.5% in 2016 to 9.0%, a cumulative decrease of 8.5 percentage points. This refers not only to the statutory deposit reserve ratio but also includes the excess reserve ratio, which is generally very low. In contrast, since 2016, China's policy interest rates have only been adjusted 14 times, with more adjustments to the statutory deposit reserve ratio.

"China mainly relies on RRR cuts rather than significant interest rate cuts. There is some debate in the market about whether large interest rate cuts can be made. In fact, market interest rates are still declining, but the rate cuts are gradual and slow, rather than significant. Why is there no drastic cut? There are several reasons, one of which may be the pressure on commercial banks' interest margins," Sheng Songcheng stated. Around 2010, the net interest margin of commercial banks was close to 3%, with some approaching 4%. By the end of the second quarter of this year, the net interest margin of commercial banks was 1.42%, a historical low, and it is likely to continue to decline.

Why should we pay close attention to the net interest margin of commercial banks? He explained that finance mainly consists of three aspects: banking, capital markets, and insurance. China is a country dominated by indirect financing, with banking accounting for 89.7%. In comparison, capital markets account for 3%, and the insurance industry accounts for 7.3%.

In contrast, in the United States, the banking sector accounts for 42%, capital markets 19.4%, and the insurance industry 35.4%. The U.S. is a country dominated by direct financing, so interest rate cuts do not have as significant an impact on commercial banks as they do in China. This is because China needs to maintain the normal operation of commercial banks, as their funds are the main source of support for the real economy. If commercial banks themselves face risks and do not operate normally, the economy will also face risks. Therefore, this is one of the reasons why interest rates in China do not drop drastically.

Sheng Songcheng pointed out that the current weighted average deposit reserve ratio of Chinese financial institutions is about 6.2%, which still has considerable room for RRR cuts compared to the central banks of major economies internationally. Currently, every 0.5 percentage point cut by commercial banks can provide approximately 1 trillion yuan in funds to society. Since the 1990s, Western countries have basically stopped using the statutory deposit reserve ratio tool and mainly use interest rate tools. During the pandemic in March 2020, the U.S. cut the statutory deposit reserve ratio to zero, and now the U.S. has no statutory deposit reserve ratio, all at 0 So unlike China, there is no statutory reserve requirement ratio available for use.

Lowering the Reserve Requirement Ratio is Beneficial for the Coordination of Fiscal and Monetary Policies

Lowering the reserve requirement ratio will increase the funds that commercial banks can freely use, which can better support an active fiscal policy. Data shows that currently about 68% of China's national debt is held by commercial banks, and about 75% of local government debt is held by commercial banks. If the reserve requirement ratio is lowered, commercial banks will have more funds to purchase national and local bonds, which is one way to coordinate fiscal and monetary policies.

Unlike fiscal policy, which can directly intervene in economic activities, monetary policy generally plays an indirect role and requires the cooperation of commercial banks and even the entire financial system. Its implementation effect is significantly influenced by market feedback. Currently, the excess reserve ratio of financial institutions in China is relatively low, making the lowering of the reserve requirement ratio effective in adjusting market liquidity.

China Still Has Room for Interest Rate Cuts

The interest rate elasticity of consumption and investment in China is relatively low, and the effect of interest rate cuts on stimulating consumption and investment is limited, so there is no basis for sustained large-scale interest rate cuts. A decrease in interest rates reduces the income from residents' deposits, lowers the wealth effect, and is actually detrimental to consumption.

In July of this year, residents' deposits decreased by 1.11 trillion yuan, a year-on-year decrease of 780 billion yuan. Meanwhile, deposits in non-banking financial institutions increased by 2.14 trillion yuan in a single month. "Where did this money come from? It is still the transfer of personal and corporate deposits, especially personal deposits. It can be said that the decrease in residents' deposits is largely related to the decline in interest rates," said Sheng Songcheng.

He believes that when enterprises make investment decisions, they consider investment risks and profits more, and small changes in interest rates have little impact on them. Therefore, China focuses on lowering the reserve requirement ratio rather than interest rate cuts. However, market interest rates are still continuously declining; the annual interest rate for demand deposits was previously 0.3%, and now it is 0.05%, which is already close to zero. The interest rates for one-year and three-year fixed deposits are basically in the 1% range, whereas they used to be around 3.5%.

Sheng Songcheng pointed out that there is still room for interest rate cuts. First, the current prices in China are relatively low, resulting in a higher real interest rate. Second, the exchange rate of the yuan has recently appreciated slightly against the dollar. The external environment for China's interest rate cuts has improved because the U.S. is cutting interest rates, and many people predict that the U.S. will cut rates again in September.

In addition, the structural monetary policy tool for interest rate cuts is unique to China. On May 8 of this year, China lowered the 7-day reverse repurchase operation rate (7-day OMO) by 10 basis points, while the rates for structural monetary policy tools were generally lowered by 25 basis points. The reduction in structural tools is more significant. In recent years, China's structural monetary policy tools have been continuously innovated and have played an increasingly important role, mainly in two aspects: first, supporting weak links in the economy (such as small and micro enterprises, preventing and resolving real estate risks, etc.); second, supporting key areas, such as emphasizing technological innovation, industrial upgrading, advanced manufacturing, and green development over the past decade, promoting high-quality economic development.

As of the end of 2024, structural monetary policy tools account for about 14.2% of the total assets of Chinese banks. China's structural monetary policy tools have played a significant role Author of this article: Sheng Songcheng, columnist for Wall Street Insight, Source: Sheng Songcheng, Original title: "Sheng Songcheng: China's Reserve Requirement Ratio Cut is Better than Interest Rate Cut, but There is Still Room for Rate Cuts"

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