Exchange rate regime liquidity

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In recent years, driven by a rapid expansion of the money supply or "liquidity" accompanying a sharp rise in foreign exchange reserves, China has shown signs of an emerging asset bubble, with real estate and share prices climbing rapidly. The inflation rate has also continued to rise. The Chinese government has been taking steps to tighten monetary policy in order to halt the surge in liquidity, but constrained by the exchange rate policy that seeks to achieve currency stability against the U.

China has generated a surplus in its current account - primarily in its trade balance - as well as in its capital account, which reflects the flow of funds. These twin surpluses have exerted upward pressure on the renminbi RMB. The growth in base money has boosted broad money supply M2 by means of the credit multiplier. Consequently, China's M2 at the end of reached This growing liquidity has pushed up consumer prices as well as exchange rate regime liquidity prices, namely prices of real estate and shares.

The sharp spike in real estate prices started in Shanghai and other coastal urban areas around and has now spread to inland cities. The upward trend in stock prices was triggered by the reform of non-tradable shares launched in The benchmark Shanghai Composite Index has multiplied almost six times over the past two and a half years. Inflation is exchange rate regime liquidity accelerating, with the year-on-year rate of CPI increase reaching 6.

To hold down the surge in liquidity resulting from its growing external surplus, the PBOC has introduced the following three major measures, which are designed to tighten monetary policy or achieve sterilization in a broad sense. However, the scale of intervention has become so large that sterilization operations have led to a rapid rise in interest rates, which in turn is attracting further capital inflow, making liquidity control increasingly difficult.

The PBOC aims exchange rate regime liquidity control the credit multiplier and the money supply by raising the deposit reserve ratio exchange rate regime liquidity applies to banks. It has revised this ratio upwards 11 times since exchange rate regime liquidity, for an aggregate increase of 5. This year alone, eight revisions have been made, hiking the ratio 4. These revisions adversely affect bank profitability as the interest rates the banks can earn from the reserves deposited with PBOC are much lower than the interest rates they charge their borrowers.

The objective of interest rate hikes is to discourage demand for investment, shares, real estate, and other non-deposit financial assets by increasing borrowing costs, thereby easing the upward pressure on consumer and asset exchange rate regime liquidity.

Since Octoberlending rates have already been increased eight times, with the benchmark one-year lending rate rising 1. Meanwhile, exchange rate regime liquidity bolster the appeal of deposits and stop the outflow of funds to the stock market, the PBOC has also raised interest rates on deposits by seven times since Octoberwith the benchmark one-year deposit rate rising a total of 1.

Even these aggressive hikes have failed to keep pace with runaway inflation. As a exchange rate regime liquidity, real interest rates have followed a downward trend exchange rate regime liquidity the beginning ofwith real deposit rates falling below zero.

Thus monetary tightening so far has been insufficient to prevent further rises in consumer and asset prices. The ineffectiveness of monetary policy in China is consistent with the principle of impossible exchange rate regime liquidity, that no country can simultaneously achieve three goals: China had, for a long time, pursued independent monetary policy while retaining a de facto dollar-pegged exchange rate and by restricting capital mobility giving up free movements of capital.

With capital movements gathering momentum following China's accession to the World Trade Organization WTOhowever, the effectiveness of its monetary policies is declining as noted above.

While China shifted to a managed floating exchange exchange rate regime liquidity regime in Julythe focus of its foreign exchange policy is still on "management" rather than on "floating. In fact, China's external surplus is the direct result of the PBOC's intervention in the foreign exchange market in a bid to ease the upward pressure on the foreign exchange rate.

This pressure arises from circumstances under which the exchange rate regime liquidity of a foreign currency, namely U. In the absence of intervention by the central bank, as under a freely-floating exchange rate regime, any imbalance between demand and supply in the foreign exchange exchange rate regime liquidity is corrected by fluctuations in the exchange rate. A current account surplus, for example, would inevitably be offset by a deficit in the capital account, or a net capital outflow.

As a result, liquidity growth is blocked at the source. Thus shifting to a freely-floating exchange rate system is the most effective solution for curbing liquidity growth. Indeed, it was the rapid growth in foreign exchange reserves and in the money supply starting that prompted Japan to adopt a floating exchange rate system in February Likewise, shifting to a freely-floating exchange rate system is now the only remaining option China can adopt today to curb its liquidity surge.

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Chinese enterprises are allowed to deposit foreign exchange earned from trade and approved investment channels with designated foreign exchange banks. With a couple brief exceptions, the steady appreciation of the renminbi over the past few years has made it advantageous for enterprises to convert their excess foreign exchange into renminbi.

Each of the foreign exchange banks has a foreign exchange allotment set for them by the State Administration of Foreign Exchange SAFE based on their size and business structure. After the designated foreign exchange banks convert foreign currency into renminbi for their customers they are required to sell the foreign currency in excess of their allotment in the interbank market.

Banks in need of foreign currency can buy the excess holdings of other banks through this interbank system. Most of the time, the supply from surplus banks exceeds the demand from banks in need of foreign currency. This is due to the mercantilist undervaluation of the renminbi which leads to persistent external surpluses and corresponding capital inflows.

To resolve the imbalance between supply and demand in the foreign exchange market, the PBoC must step in as the buyer of last resort and buy the excess currency. The chart below shows the relationship between the net foreign exchange position for the financial system and the growth in foreign reserves.

The growing divergence between the two is the result of currency appreciation. When the central bank purchases foreign exchange from banks it increases the amount of renminbi in the domestic financial system. To prevent inflation, the PBoC takes steps to limit the effect on the money supply, through central bank bills and the required reserve ratio.

To the extent that inflows are sterilized, they are taken out of circulation and not available for banks to lend out. This increase in deposits increases the denominator in the loan-to-deposit ratio, lowering the overall ratio and helping banks that are close to the regulatory limit of 75 percent. On first glance, the relatively conservative loan-to-deposit ratio of 75 percent makes it appear that banks have ample liquidity.

As a result, liquidity is often tight in the banking system. Relatively small changes in financial flows can have a large effect on the financial system. This shift, combined with reluctance by the PBoC to increase liquidity into the system, led to a dramatic spike in interbank lending rates as banks short on cash bid up the price of borrowing. The interbank market remains volatile now because the PBoC faces a policy conundrum. It has been aggressively signalling to banks that the pace of credit growth has been too rapid this year and has taken steps to tighten monetary policy.

In normal circumstances, the PBoC would intervene quickly to clear up a liquidity crunch like what is occurring now. A growing number of reports claim that PBoC has quietly been extending funds to weaker banks and instructing stronger banks to begin interbank lending again. All of this reinforces the peculiarity of the Chinese financial system where quantitative restrictions on credit are the dominant regulatory approach and sterilization is carried out on an immense scale.

To prevent excess lending, brought about by an artificially low interest rate, banking regulators have implemented a quantitative cap on lending in the form of the loan-to-deposit ratio.

However, due to the ongoing need to sterilize currency inflows, banks are required to hand over an enormous share of their deposits to the central bank. This leaves banks in a position of having relatively few liquid assets, irrespective of the loan-to-deposit ratio. The growth of deposits stemming from foreign currency inflows helps banks that are edging up towards their loan-to-deposit limit.

However, when these flows slow down, the entire market can suffer a funding crunch as shown by the recent interbank lending rate spikes. June 20, Leave this field blank. More from Nicholas Borst. New Risks Require New Reforms.