Sterilized Intervention, Bank Credit, and Chinese Monetary Policy
63 Pages Posted: 6 Dec 2016 Last revised: 16 Jun 2019
Date Written: May 15, 2019
Since the early 2000s, China's central bank has been intervening actively in foreign exchange markets to prevent sharp appreciation of Chinese Yuan. At the same time, it issues central bank bills, a type of short-term central bank debt, to absorb the increase of bank reserves caused by its interventions. This should have largely neutralized the expansionary effects of the intervention if banks are reserve constrained. However, bank deposits and loans increased significantly during the sterilized intervention period even if the level of bank reserves remained almost unaffected. We reproduce these facts in a dynamic stochastic general equilibrium model in which banks hold central bank bills and excess bank reserves as part of their liquidity management. Sterilized intervention increases the supply of central bank bills, which facilitates banks' liquidity management and leads to bank credit expansion. This liquidity management channel is shown to have quantitatively important implications for economic fluctuations. Counterfactual experiments show that economic fluctuations can be significantly reduced if the central bank sterilizes its interventions using an "illiquid bond" that cannot be used for liquidity management. We show that by adjusting reserve requirement policy according to a simple and implementable rule, the central bank can replicate the equilibrium paths of the counterfactual economy where the "illiquid bond" is used for sterilization.
Keywords: Sterilized Intervention, Open Market Operations, Reserve Requirement Regulation, Monetary Policy, Bank Credit, China
JEL Classification: E58, E51, F3
Suggested Citation: Suggested Citation