Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Reserve Requirements as a Policy Tool
Transcript
- Lucas: Luna, let me start with a number that didn't get a ton of headlines last month, but it should have. On May 15th, the People's Bank of China cut its reserve requirement ratio by 25 basis points — that's the third cut in twelve months — and it got me thinking about how reserve requirements have become this forgotten tool in the central banking toolkit. Luna: Forgotten by whom? Lucas: Forgotten by the Fed, the ECB, the Bank of Japan — basically every major advanced-economy central bank. They've all moved to either zero or near-zero reserve requirements. But in emerging markets, reserve requirements are still very much alive. China uses them. India uses them. Brazil uses them. So I want to ask: why the divergence? Luna: And what exactly is a reserve requirement again? I know the basic idea, but let's ground it. Lucas: Sure. It's the percentage of customer deposits that a bank must hold in reserve — either in its vault or at the central bank — rather than lending out. So if the requirement is 10 percent, for every $100 deposited, the bank can lend out $90 and must keep $10. Simple enough. Luna: And the theory is that if you raise that percentage, banks have less money to lend, which contracts the money supply. Lower it, and they have more to lend, expanding the money supply. Lucas: Exactly. It's a blunt instrument, but it's powerful. And historically, it was the main tool. Central banks didn't always have interest rates as their primary lever. For much of the 20th century, reserve requirements were how they controlled credit growth. Luna: So why did the Fed basically retire it? Lucas: A couple of reasons. First, banks figured out how to game it. They'd create new types of deposits that weren't subject to the requirement, or they'd shift funds around. Second, and more importantly, open market operations and the federal funds rate proved to be more precise and more flexible. You can fine-tune interest rates by a few basis points. Changing reserve requirements is a sledgehammer — it can cause big swings in the money supply. Luna: And then there's the argument that reserve requirements act like a tax on banks. They have to hold a certain amount of non-interest-bearing reserves, which means they're earning zero on that money. That cost gets passed on to customers. Lucas: Right. And that's a big reason why the ECB and the Bank of Japan moved to zero requirements — they wanted to reduce the regulatory drag on banks. The Bank of England doesn't even have one. In the US, the Fed set the requirement to zero in 2020 during the pandemic and just never brought it back. It's technically still on the books, but the rate is zero percent. Luna: But in China, the PBOC cuts the reserve requirement ratio, and it's a big deal. Why do they still use it? Lucas: Because in China, the banking system is dominated by state-owned banks, and the central bank has a more direct relationship with them. The reserve requirement is a way to manage liquidity without having to rely on a fully developed interbank market. Plus, it's a visible signal — when the PBOC cuts the RRR, everyone knows they want more lending. Luna: And it's still a primary tool in India too. The Reserve Bank of India changes its cash reserve ratio pretty regularly. Lucas: Yes, India's cash reserve ratio is currently 4.5 percent. Brazil uses reserve requirements extensively — they even differentiate by type of deposit. It gives the central bank a lot of control, especially in economies where interest rate transmission isn't as strong because banks don't always pass on rate cuts to borrowers. Luna: So there's a split: advanced economies see reserve requirements as a relic, emerging markets see them as a workhorse. But is that the whole story? I mean, even among advanced economies, there are nuances. Lucas: Sure. The ECB still has a very low requirement — one percent — and they pay interest on it at the deposit facility rate. So it's not a tax anymore. And Japan technically has a reserve requirement, but it's so low it's almost meaningless. So the trend is clear: interest rates are the main tool now, and reserve requirements are a backup. Luna: But here's a question: if reserve requirements are such a blunt instrument, why did the PBOC use them three times in the past year instead of just cutting rates more aggressively? Lucas: Because there's a political economy angle. Cutting reserve requirements is seen as more 'pro-growth' and less controversial than cutting interest rates, which can signal desperation or hurt savers. Plus, in China, the property sector is still fragile, and the PBOC wants to ensure banks have enough liquidity to lend without forcing them to take on too much risk. It's a calibration thing. Luna: And there's also the fact that reserve requirements affect the money multiplier directly, whereas interest rates work through the demand for credit. If banks aren't willing to lend even with low rates — like in a liquidity trap — cutting reserve requirements forces them to hold less idle cash and, in theory, encourages lending. Lucas: Right. But in practice, during the 2008 crisis, the Fed and the ECB pumped massive amounts of reserves into the banking system through quantitative easing, and banks just held onto them as excess reserves. That broke the traditional money multiplier relationship. So even reserve requirements didn't force lending — banks just held more excess reserves. Luna: So the tool lost its potency in that environment. Lucas: Exactly. And that's another reason advanced central banks moved away from it. If banks can hold trillions in excess reserves and still not lend, adjusting the requirement doesn't do much. Interest on reserves became a better tool because it sets a floor on how low short-term rates can go. Luna: So where does that leave us? Are reserve requirements an anachronism or a viable tool for the future? Lucas: I think they're still viable in specific contexts. For example, some economists have proposed using reserve requirements as a macroprudential tool — like raising them when credit is growing too fast to cool things down, kind of like a speed bump. But the trend is definitely toward interest rates and quantitative tools. Luna: And it's worth noting that the US actually flirted with bringing them back. In 2020, there was a proposal to impose a reserve requirement on stablecoins — like a 100 percent reserve for digital dollar issuers. That's a different use case, but it shows the concept isn't dead. Lucas: That's a great point. So maybe the future of reserve requirements isn't in traditional banking but in regulating new forms of money. Anyway, I think we've covered a lot of ground here. One thing that strikes me is how much of central banking is about choosing the right tool for the right economy at the right time. There's no one-size-fits-all. Luna: Absolutely. And on that note, I want to mention something that actually keeps this show going. It's not a big thing, but if you enjoy walking through the economy with us and you've gotten something out of these episodes, you can support us by buying a coffee at buy me a coffee dot com slash fexingo. It's a couple of dollars a month — genuinely makes a difference for keeping this ad-free. Lucas: Yeah, and we mean it. No pressure at all, but if you've found yourself using something you heard here in a conversation with a friend or colleague, that's the kind of thing that keeps us motivated. And the support really helps. Luna: Right. So back to reserve requirements — I think the key takeaway is that even though advanced economies have moved on, the tool is still alive in the rest of the world, and it's worth understanding because it tells you a lot about how different central banks operate. Lucas: And next time you hear 'the PBOC cut the reserve requirement ratio,' you'll know exactly what that means and why they did it instead of cutting rates. It's a window into their thinking. Luna: Alright, I think that's a good place to leave it. Thanks for listening, and we'll be back with another episode soon.