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The Use of Reserve Requirements as a Monetary Policy Tool: Emerging Asia and the United States Compared Emerging Asia From Bloomberg.com January 14, 2011 China’s bank reserve-ratio increase capped a week of Asia escalating its fight against inflation, with South Korea and Thailand boosting interest rates and India importing onions, a curry staple, from historical enemy Pakistan. China’s central bank yesterday told lenders to hold more deposits as reserves for the fourth time in two months, lifting required ratios by half a percentage point. The People’s Bank of China was acting in part to stem a surge in new loans at the start of the year after officials’ 2010 target was breached, analysts at JPMorgan Chase & Co. and HSBC Holdings Plc said. Countries across Asia are attempting to grapple with accelerating inflation pressures as food and commodity costs climb and liquidity rises with an influx of foreign capital. India is forecast to join Thailand and South Korea in lifting benchmark interest rates this month, and policy makers may also need to allow further currency gains to bolster their efforts. “Central bankers across Asia are increasingly worried that price pressures are developing into a potentially big problem,” said Kevin Grice, a London-based economist at Capital Economics Ltd. “Almost all the countries in the region will be raising interest rates to tackle inflation,” which, along with currency gains, may slow economic growth, he said. China’s Shanghai Composite Index of stocks dropped 1.3 percent yesterday on concern that monetary tightening would hurt corporate earnings. The loss brought the measure’s decline over the past 12 months to 13 percent. Premier Wen Jiabao’s government has lagged behind other Asian countries in raising benchmark lending rates, with two quarter-point increases since October. Officials have instead relied on reserve ratios to try and mop up liquidity resulting in part from trade surpluses and inflows of foreign capital. “Beijing needs to act more decisively on policy tightening stop inflation from accelerating too fast,” Qu Hongbin, co-head of Asian economic research at HSBC in Hong Kong, wrote in a note to clients. He predicted at least 1.5 percentage points more in reserve-ratio increases within six months, and sees two quarter- point rises in the one-year lending rate, now at 5.81 percent. The reserve requirement stood at 18.5 percent for the biggest banks before yesterday’s announcement, excluding any additional restrictions imposed on individual banks and not publicly announced. Qu predicted that the consumer-price inflation rate will rise as high as 6 percent in coming months, compared with the 5.1 percent year-on-year pace for November. By comparison, India’s benchmark wholesale-price index rose 8.43 percent in December from a year earlier, according to a commerce ministry statement in New Delhi yesterday. In South Korea, the central bank two days ago raised borrowing costs for the third time since July, while Thailand on Jan. 12 increased its benchmark for the fourth time in seven months. South Korea also said it aims to freeze the cost of utilities, including electricity and gas, cut food tariffs and ask steelmakers to refrain from boosting prices to help stabilize commodity costs. While emerging markets are leading global growth, according to a World Bank report this week, some slower-growing advanced nations aren’t immune from inflation concern. Britain’s inflation rate was 3.3 percent in November, above the government’s upper limit. The Bank of England is forecast to raise its benchmark rate 25 basis points to 0.75 percent in the third quarter of this year, according to the median forecast of economists in a Bloomberg survey. European inflation reached 2.2 percent, the fastest in more than two years in December, led by energy costs, the European Union’s statistics office said yesterday. European Central Bank President Jean-Claude Trichet said the day before inflation may remain above the bank’s 2% ceiling over the coming months, signaling he is prepared to raise interest rates if needed. U.S. Central Bank Reserve Requirements From the Federal Reserve’s web site. Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Within limits specified by law, the Board of Governors has sole authority over changes in reserve requirements. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks. The dollar amount of a depository institution's reserve requirement is determined by applying the reserve ratios specified in the Federal Reserve Board's Regulation D to an institution's reservable liabilities (see table of reserve requirements). Reservable liabilities consist of net transaction accounts, nonpersonal (i.e., corporate accounts) time deposits, and eurocurrency liabilities. Since December 27, 1990, nonpersonal time deposits and eurocurrency liabilities have had a reserve ratio of zero. The reserve ratio on net transactions accounts depends on the amount of net transactions accounts at the depository institution. The Garn-St Germain Act of 1982 exempted the first $2 million of reservable liabilities from reserve requirements. This "exemption amount" is adjusted each year according to a formula specified by the act. The amount of net transaction accounts subject to a reserve requirement ratio of 3 percent was set under the Monetary Control Act of 1980 at $25 million. Net transaction accounts in excess of the $25 million are currently reservable at 10 percent. Beginning October 2008, the Federal Reserve Banks will pay interest on required reserve balances and excess balances. Reserve Requirements Requirement Liability Type % of liabilities Effective date 0 12-30-10 More than $10.7 million to $58.8 million3 3 12-30-10 More than $58.8 million 10 12-30-10 Nonpersonal time deposits 0 12-27-90 Eurocurrency liabilities 0 12-27-90 Net transaction accounts 1 $0 to $10.7 million2 Note. Required reserves must be held in the form of vault cash and, if vault cash is insufficient, also in the form of a deposit maintained with a Federal Reserve Bank. An institution that is a member of the Federal Reserve System must hold that deposit directly with a Reserve Bank; an institution that is not a member of the System can maintain that deposit directly with a Reserve Bank or with another institution in a pass-through relationship. Reserve requirements are imposed on commercial banks, savings banks, savings and loan associations, credit unions, U.S. branches and agencies of foreign banks, Edge corporations, and agreement corporations. 1. Total transaction accounts consists of demand deposits, automatic transfer service (ATS) accounts, NOW accounts, share draft accounts, telephone or preauthorized transfer accounts, ineligible bankers acceptances, and obligations issued by affiliates maturing in seven days or less. Net transaction accounts are total transaction accounts less amounts due from other depository institutions and less cash items in the process of collection. For a more detailed description of these deposit types, see Form FR 2900 at http://www.federalreserve.gov/reportforms/default.cfm 2. The amount of net transaction accounts subject to a reserve requirement ratio of zero percent (the "exemption amount") is adjusted each year by statute. The exemption amount is adjusted upward by 80 percent of the previous year's (June 30 to June 30) rate of increase in total reservable liabilities at all depository institutions. No adjustment is made in the event of a decrease in such liabilities. 3. The amount of net transaction accounts subject to a reserve requirement ratio of 3 percent is the "low-reserve tranche." By statute, the upper limit of the low-reserve tranche is adjusted each year by 80 percent of the previous year's (June 30 to June 30) rate of increase or decrease in net transaction accounts held by all depository institutions Bottom Line Unlike China, the United States no longer uses changes in reserve requirement ratios as an active (an ongoing) monetary policy tool. Instead the United States currently depends on open market operations as a means of influencing the federal funds rate.