The Role of Reserve Requirements: The Case of Contemporary China Compared to Postwar Germany

The role of reserve requirements has evolved significantly over time and differs across countries, though there are two broad trends. For central banks that operate in highly developed financial markets the role of reserve requirements as the primary instrument of monetary policy has been decreasing over the past few decades. The role of mandatory reserves is reduced to smoothing fluctuations of short-term interest rates, which helps to communicate the operational target of the central banks more clearly. For central banks operating in emerging market economies, however, tweaking reserve requirements has gained importance. Reserve requirements supplement a policy mix that aims at stabilizing the exchange rate and combating high and volatile capital inflows, especially as the low interest rate environment of advanced economies has accelerated a global search for higher yield. We offer a comparison of the experience at the People’s Bank of China (PBC) during the recent past and that of the Bundesbank from the post-war period until the start of the European monetary union. It presents a case study suitable for explaining the different functions of reserve requirements and how characteristic features and external conditions influence the feasibility of each function. Reserve requirements have been most actively used in China and Germany during shifts in exchange rate regimes that coincided with periods of high and volatile capital inflows. Economic theory, however, can additionally drive visions of what reserve requirements should perform. We conclude that some misconceptions of the role of money, credit and liquidity influence the bias between theory and practice.