Central banks have the option of sterilising, or neutralising, the monetary consequences of the various currency transactions they carry out in order to minimise their impact on the market. The recent Mainland experience throws interesting light on the range of strategies available for achieving sterilisation.
I hope readers will not mind my indulging first in some elementary central banking this week. When a central bank makes use of the domestic currency, for example, to buy assets from a commercial bank or its customer, the transaction is normally effected through the central bank "creating" the money through crediting the clearing account of the commercial bank the amount concerned. There is therefore a corresponding increase in both the assets and liabilities of the central bank. The increase in the clearing balance of the banking system maintained with the central bank will have monetary consequences, typically lower interbank interest rates and greater availability of interbank liquidity. The sensitivity with which these monetary variables react to the central bank's action to buy assets depends on the characteristics of the monetary system concerned, including its structure and the monetary policy objective being pursued. In a monetary system in which the central bank pays a fixed rate of interest on the clearing balance of the banks, the sensitivity will be relatively low compared with a monetary system in which no interest is paid by the central bank on the clearing balance. Alternatively, sensitivity is higher in a monetary system in which the banks operate commercially in a highly competitive environment, requiring the efficient use of surplus interbank liquidity, than in a monetary system in which the bank management is not really accountable to the shareholders for its profitability.
The action of a central bank to buy assets could, of course, be a deliberate attempt designed to produce the monetary consequences (easing) considered desirable. But when the purchase of assets is initiated for a different reason, there may then be a need to neutralise, or sterilise, the monetary consequences. The money created through the purchase of assets can be withdrawn in many ways, but the nature of such central bank action falls into two categories. The first involves the disposal of central bank assets in the domestic currency and second involves the replacement of the excess clearing balance of the banking system by other central bank liabilities. On the asset side, if the central bank holds government debt on its books, it can be sold outright or used in repurchase arrangements; or if it has loans outstanding to commercial banks, they can be recalled. On the liability side, the central bank can issue its own debt or simply borrow from the banks. The choice of what action to take is not a simple one for central banks. There is a need to consider what financial instruments to use, having regard to their yields, and the impact of the action on the asset and liability structure, and profitability, of the banking system.
We all know that the Mainland has been accumulating a large amount of foreign reserves. As RMB, in the form of the clearing balance of the banking system, a component of reserve money, is created in the process, sterilisation of the monetary consequences, when the money market has not yet attained a high degree of sophistication, is quite a challenge. This is a fascinating subject for those watching monetary and banking developments in the Mainland. Just last year, the Mainland accumulated over US$74 billion of foreign reserves. This involved, or would have involved, a creation of over RMB610 billion of reserve money. It is not clear from published figures how much of that amount of "high-powered" money created has been sterilised. The monetary policy stance seems to have been biased towards easing, given deflationary pressures, and so capital inflow would present a good opportunity for increasing reserve money. Available figures (up to November) suggest that about 80% of reserve money created through accumulation of foreign reserves was sterilised. The instruments used and accounting for the bulk of sterilisation were (a) the unusual issue of central bank bills and (b) the reduction in lending to banks. Other changes in the balance sheet of the People's Bank of China, including that arising from (c) the familiar sale and re-purchase of government bonds, also contributed, but to a minor degree.
Obviously, as more quality and up to date information becomes available, one will be able to go deeper into the subject and analyse the implications for the robustness of the monetary system and the banking system of different sterilisation strategies. At this stage, I see the recent reduction of lending to the banks and therefore the dependence of the latter on the central bank as a positive sign. The issue of central bank bills will also provide a helpful financial instrument for monetary management, particularly when tighter monetary conditions become desirable. It will be interesting to see if the single issue on 25 September last year of RMB190 billion of bills will become a continuous feature. The sale and repurchase of government bonds is, however, predicated upon the undesirable arrangement of the central bank financing budget deficits and therefore should really be phased out, perhaps through outright sales instead. Whatever strategy favoured, it seems inevitable that, when monetary conditions require sterilisation, the holding of government and central bank debt by commercial banks and their customers will increase along with the accumulation of foreign reserves.
Joseph Yam
20 February 2003
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