Bank reserve requirements, capital controls and Chinese monetary policy

Compared with standard monetary policy literature, the Chinese monetary policy regime has two unique features. First, China uses bank reserve requirements as well as the policy interest rate as instruments of monetary policy. Second, the conduct of monetary policy is constrained by Chinese exchange rate and capital account policies. Given these external constraints is the use of bank reserve requirements as a monetary policy instrument optimal?

To answer this question, I propose to build a coherent two-country DSGE model of Chinese monetary policy that explicitly incorporates these two features. China is modeled as a semi-open economy following Jeanne (2013), in which the public has access to international financial markets but the private sector does not. In addition, the model has a dual-track banking system, in which less productive state-owned enterprises have access to formal banks which enjoy government guarantees but are subject to reserve requirements; whereas private enterprises borrow from the informal banking system. The policymaker chooses the policy rate and the reserve requirement ratio to maximise social welfare.

Using this framework, I study the policy tradeoffs associated with the use of reserve requirements both in the steady state and during the business cycle. Reserve requirements are expected to help stabilise macro quantities as well as improve allocative efficiency between state-owned enterprises and private enterprises. The optimal rule for reserve requirements and welfare gains will be computed. Furthermore, I explore to what extent the effectiveness of reserve requirements as a monetary policy tool might be affected by further exchange rate and capital account liberalisation.