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Bangko Sentral ng Pilipinas International Research Conference
Contemporary Challenges to Monetary Policy
Dual-track Interest Rates and the Conduct of Monetary Policy in China
Dong He and Honglin Wang
Hong Kong Monetary Authority
February 2012
Comment by Sang Chul Ryoo
Bank of Korea
Dual track interest rates and conduct of monetary policy in china
This paper sets up a theoretical model to illustrate the conduct of monetary policy within the
framework of dual track interest rates, in which bank deposit and lending rates are regulated
while money and bond rates are market determined. The model focuses on how changing
policy rates are transmitted from the regulated retail rates to the unregulated market rates,
under the assumption of funds freely flowing between a banking sector and money/bond
markets. Based on the bank’s profit maximization function where banks are price takers and
invest in money and bond markets, the model derives the optimal prices of lending rate,
deposit rate, reserve requirement rate, market interest rates, and the optimal quantities of
loan supply, deposit demand, excess reserve supply. It then analyzes the impacts of monetary
policy on market interest rates by changing the deposit rate ceiling, the lending rate floor,
reserve requirement rate and the central bank bill. The model shows that market interest
rates are most sensitive to changes in the benchmark deposit rates, significantly responsive
to changes in the reserve requirements, but not particularly reactive to open market
operations and changes in the lending rate floor.
(Comment 1) The fact that changing the deposit rate ceiling has a big impact on market
interest rates while changing the lending rate floor does not is not surprising because
the former with the upper bound is typically binding but the latter with the lower
bound not binding, under the repressive regulation. If the lending rate floor is not
binding, which means that it is below the equilibrium rate, raising the lending rate floor
has no impact on market interest rates if it still remains below the equilibrium rate.
(Comment 2) The reserve requirement rate may have less impact on market interest
rates than the deposit rate floor because raising the reserve requirement rate can on the
one hand induce higher market interest rates by generating less funds available for
banks and more demand on wholesale funding One the other hand, it can lead to lower
market interest rates because banks perceiving higher borrowing costs raise the
equilibrium lending rate, which decreases firms’ demand for loans and in turn banks’
demand for wholesale funding.
(Question 1) How do banks attract enough deposits if the deposit rate ceiling stays well
below the equilibrium rate? Bank loan may be in excess demand not because loan
demand is strong but because its supply with deposits is limited. This would distort
price discovery and intermediation by banks.
(Question 2) The result 2.2 in page 12 says the impact on market interest rates of
changing the lending rate floor is indeterminate, pointing out that a higher lending rate
floor means on the one hand a lower loan demand but on the other hand shift to bond
issuance that leads to higher market interest rates. A lower loan demand does not cause
lower market interest rates. Then I don’t see conflict between the two points.
(Comment 3) The policy implication in the same page is that in practice the PBC almost
always changes the benchmark deposit and lending rates simultaneously. Such monetary
policy should not be striking because otherwise it will change the spread between the
two benchmark rates and affect bank profitability. Note that if as a result of raising the
deposit rate ceiling the spread narrows and bank profitability falls, banks’ capital ratio
declines and so the growth of credit supply slows. Then, the transmission channel of
monetary policy becomes more complex, apart from monetary policy distorting banks’
business activities.
(Comment 4) The calibration results show that the price elasticity of market rates with
respect to deposit rates is approximately twice that with respect to the RRR. But it
crucially depends on the price elasticity of deposit supply, which is assumed to be 0.2
for the benchmark scenario. Table 9 shows that if the elasticity is 0.1, the RRR becomes
more potent as monetary policy instrument than the deposit rate ceiling. Therefore, we
should first estimate the elasticity before carrying out the calibration. This paper
assumes it to be 0.2 following Feyzioglue et al (2009). It could be better if you explain
how they estimate the elasticity.
Also, looking at the chart 2, we notice that the deposit rate ceiling and the RRR move
very closely, except for the period immediately after the global crisis. We may then
argue that different impacts on market interest rates are mainly created by policy
response to the crisis. That is, the PBC aggressively lowered the deposit rate ceiling and
the repo rates declined sharply while it mildly lowered the RRR.
If we look at the empirical results, market rates increase with the RRR in more cases in
the GARCH models than the OLS. So I think that the GARCH better explains the relative
impacts of different monetary policies.
(Comment 5) When we look at the case of Korea, we find that the price elasticity of
deposit increases with the development of capital market, in particular investment funds.
(Question 3) The spread between the lending and deposit rate slowly declines since
2005 but stop declining with the global crisis. Could you explain the main driver?
(Comment 6) Chart 2 in page 19 shows that the RRR moves in line with price-based
instruments (ceiling or floor of interest rates). This may be so because raising the RRR
gives an upward pressure to the lending rate as I commented before.
(Comment 7) Considering how restrictive regulations on bank deposit and lending rate,
it is obvious that the deposit rate ceiling should be more restrictive simply because it is
the cap and so usually binding while the floor is the minimum requirement and usually
not binding.