The effect of increased bank deposits ration with Chinese Central Bank - Essay Example

College: The effect of increased bank deposits ration with Chinese Central Bank Many concerns have materialized due to the announcement made by China that banks ought to hold extra deposits with the Central Bank. This implied that banks are denied the opportunity to amass funds instead of lending them out. Besides, the implementation of such a monetary policy would see a dramatic decline in the quantity of Chinese banking system reserves. In essence, reserves include all funds that banks hold either in form of deposit balances at Central Bank reserves, loan given to banks by the central bank, loan repayments received by a bank from other banks, central bank’s direct asset purchases or cash in the banking systems ATMs or vaults which might be used in meeting the banking legal reserve requirements. More banking deposits with the Central Bank will extend the Central Bank credits which would in return create money multiplier effects in addition to posing significant balance sheet impacts. If Chinese banks make more deposits with the central, the level of their total assets increase by the amount of deposits made to the central bank. Consequently, the central bank’s liabilities increase by the same amount of banks deposits. In most cases, the move will ensure that excess reserves within the banking system are reduced. In fact, banks will have to reduce their lending to households and firms by an equivalent amount deposited with the central bank. This policy measure could be realized if the central bank opts to sell bonds to banks from its portfolio to reduce excess reserves. For instance, the central bank might sell government bonds from available portfolios and the bonds could in turn be purchased by Chinese commercial banks. When banks make bonds payments by depositing an equivalent amount in reserves to the central bank, banks liabilities will increase by the amount of deposits made to the central whereas assets will increase by the amount of interest bearing bonds. However, the central bank’s assets will increase by the amount of deposits made while the assets will reduce by an equivalent amount of bonds issued. There are also numerous economic impacts ensuing from the decision made by People’s Central Bank. The effects are apparently depicted on the economic equilibrium (GDP) and expenses incurred. Indeed, the People’s Central Bank decision announcement that banks needs to hold extra deposits with China’s central bank causes considerable economic impact. Given that the gross domestic product (GDP) of China has various components including consumption, exports, imports, investments and government expenditure, quite a number of these elements are affected by such a policy announcement. For instance, when banks hold excess reserves, it signifies increments in broad money supply. Thus, if banks increase their deposits with central bank, money multiplier reduces which in turn minimizes the inflationary pressure. A decrease in the level of inflation increases the level of disposable income which in turn increases the level of consumption but minimizes savings. When savings decrease, the level of investments will also decrease thereby creating more unemployment. Ultimately, the level of income will decrease amongst China households and this will in the long run create less demands. Besides, provided the level of banks reserves is insufficient, interbank lending will be cutback thereby contracting economic activities. This will force the central bank to lower the interest rate. However, low interest rate will discourage banks deposits and savings but offer an opportunity to borrow funds for both consumption and investment purposes from banks. As a result, China’s GDP will be augmented by the stimulated economic activities. For example, an increase in investment will lead to the creation of goods and services to meet the increased demands. Since both consumption and investment are components of the GDP, such increment will increase the level of China’s GDP. Moreover, the stance assumed by China appreciates its currency against other currencies and the U.S. dollar. This makes China’s exports considerably cheaper while the imports relatively expensive. As a result, net exports will increase thus increasing China’s GDP. The overall effect before using low interest rate will be destabilization of the equilibrium. In fact, both the equilibrium level and expenses will move downwards due to the contraction in economic activities. The decision of made by the Chinese Central Bank generates economic multipliers effects. When central bank restores credit flows, banks such as the commercial banks tend to hoard funds instead of lending them out to firms, other banks and households. Most analysts argue that this eventually lead to excess reserves. To support the assertion, it is perceived that funds deposited in these banks accounts sit idle as reserves while increasing monetary base. Therefore, the decision made by the Chinese Central Bank (CCB) to have banks increase their deposits with the CCB decreased the level of reserves in the banking system. In fact, such a monetary policy measure discourages the banks from seizing excess reserves which when sold out would result into inflationary pressures. Basically, provided the banks increase their deposits with the central bank, the money multiplier decrease. For instance, within the banking accounts, any increase in total held up reserves is habitually multiplied into an enormous boost in broad money supply. Despite the claims that excess reserves need not to be inflationary since the central bank have monetary adjustment tools such as short term interest rates, it emanates that increased deposits by central banks to other commercial banks may augment monetary base. In case the government increases the banks deposit ration with the central bank as China did, the quantity of required reserves held by such banks will decrease. In return, the deposits being made in these banks will also decrease thereby decreasing monetary base and consequently money multiplier. Thus, the measure will ensure that the total reserves within the banking system are reduced. However, if the banks are unable to quickly raise deposits or obtain equivalent loans elsewhere, banks will experience market freeze. This will eventually force them to reduce the offered loans. Such lending cutbacks coupled with declines in the total deposits as firms and households that had initially borrowed funds from banks scramble to repay loans would contract the level of economic activities. As various business entities namely households and firms struggle to repay loans, the marginal propensity to save decreases whereas marginal propensity to consume increases. Marginal propensity to consume (MPC) is the portion of total disposable income that goes to consumption. The term is commonly applied by economists to show the percentage of pay rise that individuals spend rather than save. On the other hand, marginal propensity to save is the portion of disposable income which is saved. An increase in MPC eventually leads to an increase in the spending multiplier while the a decrease in MPS as a result of increased deposit with the central bank gives rise to a decline in the investment multiplier. Average propensity to save (APS) refers to total savings divided by total income. An increase in banks deposit ratio with the central bank reduces the level of household and firms income. Since these entities will not be able to increase their savings, APS will similarly shrink. In contrast, the level of consumption increases but the total income either shrinks or remains constant. This causes an increase in average propensity to save. In conclusion, China’s deposit announcements seem to have purposely been intended to discourage and consequently reduce the quantity of excess reserves that banks hold. The government could have opted for tax imposition on excess reserves that banks hold. However, given that the excess reserves will be drawn from the financial system due increased deposit ratio, the interbank lending would be disrupted. The financial market freeze will make banks to have reflection concerns about counterparties creditworthiness and uncertainties regarding future funding needs. The inability of banks to quickly raise deposits or obtain similar loans elsewhere might force them to reduce the quantity of loans they offer to business entities which will also be accompanied by declines in the overall deposits made by firms and households. This will amount to contractions in the level of economic activities. To rescue the situation, the central bank of China may react through utilizing the standard monetary policy tool. The only option would be to change the interest rates via setting the desired target for the short-range interest rate. If the People’s Central Bank lowers the targeted rate, the economic activities will be stimulated since other interest rates will as well decrease. Lending opportunities which previously appeared to be unattractive will eventually become more profitable. Alternatively, if banks will be willing to lend, they will do so at considerably higher interest rate in order to cater for augmented credit risks. High interest rates tend to reduce investment levels and increase savings. Thus, the MPC and the propensity to invest will decrease thereby causing a general decline in aggregate demand. Moreover, even if China deposit rates remain below the inflation rate due to Central Bank tightening, individuals would be encouraged to invest or spend in the speculative assets. The end result will be fueled inflation as opposed to parking funds in the savings accounts to spearhead investments and lower consumption. Works Cited Morrison, Wayne and Labonte, Marc. China’s Currency: An Analysis of the Economic Issues. Congressional Research Service, (2011):1-38. Read More