China's Reserve Ratio Cut Is About Economic Efficiency

The recent decision by the People’s Bank of China to cut the effective reserve requirement ratio for banks by half a percent to 1.50 percent under certain circumstances fits with the government’s attempt to reduce leverage in the financial system. And in many ways, it will lead to more efficiency and economic growth.

There’s been speculation that the move contradicts the central bank’s deleveraging efforts and that this is yet another example of China pumping liquidity into the system to support growth. If the goal was purely to add liquidity, the PBOC has several other tools that it could have used, from daily open market operations to the Medium-Term Lending Facility to the Temporary Liquidity Facility. What’s important to understand about the cut in the reserve requirement ratio is that it would depend on a bank’s proportion of loans to small- and medium-sized enterprises -- a move that would encourage lenders to allocate more capital to these companies and less to state-owned concerns.