Reserve-ratio addiction reflects underdeveloped market

As the Chinese economy slows down this year, the government has rolled out a number of measures to bolster the growth. In April, the central bank announced to cut the required reserve ratio (RRR) for rural lenders in a bid to boost liquidity for agricultural and rural sectors. The move, as many analysts expect, will herald an all-round RRR reduction for lenders sometime later this year.

Whether the government will do so is not clear, but it is clear China prefers adjusting RRR rather than interest rates when it manages liquidity.

The reserve ratio and interest rates are two common tools for central banks to steer the monetary situation.

Other major economies seldom change their RRRs and they keep the ratio very low. For example, the eurozone set the ratio at 2 percent in 1999 and lowered it to 1 percent in 2012. The ratio has remained unchanged till now.

But China has a habit of frequently resorting to RRR to manage its money market.

The habit shows that China's financial market is underdeveloped so it is less sensitive to interest rate changes.

The depth and breadth of China's financial market are smaller than those in developed countries. The variety of China's financial products remains limited and their coverage economic spectrum is also narrow.

In addition, China's interest rate regime is not fully liberalized. The market does not decide the rate by itself, so financial products are not priced on interest rates or market-oriented yields.

All these factors determine that market response to interest rate changes is not as highly sensitive as in other major economies. Because of the difference, the effect of interest rate adjustments could take time and can be discounted.

By comparison, RRR adjustments can immediately change liquidity in the banking system and quickly help achieve the money management goals of the central bank.

China likes to ticker with RRR also because it has a high saving rate, which stands at more than 50 percent, the world's highest.

A large amount of money are parked in banks as deposits, so adjusting RRR can quickly change the money that banks can have for lending and hence change monetary supply

In addition, Chinese like to invest by their own instead of entrusting their money investment agencies. In stocks, properties, bonds, funds and precious metals, it is retail investors that dominate the market. Individual investors account for 70 percent of the stock market.

Retail investors are less sensitive to interest rate changes, especially when the change is small, but institutional investors would actively adjust their investment portfolio in response to the slightest change in interest rates.

Since retail investors manage a huge bulk of the money, their slow response will greatly reduce the effect of interest rate changes. That also prompts the central bank to lean toward RRR changes, a direct and swift way of adjusting money supply, instead of interest rate moves.

The author is a Shanghai-based analyst.