Reserve Requirements and Optimal Chinese Stabilization Policy 1 Chun Chang 1 Zheng Liu 2 Mark M. Spiegel 2 Jingyi Zhang 1 1 Shanghai Jiao Tong University, 2 FRB San Francisco 2nd Ann. Bank of Canada U of Toronto Conference on the Chinese Economy Toronto, October 2-21, 216 1 The views expressed herein are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of San Francisco or the Federal Reserve System. 1 / 44
The PBOC frequently adjusts reserve requirements (RR) China required reserve ratio Percent 25 2 15 1 5 24 25 26 27 28 29 21 211 212 213 214 215 Source:Bloomberg Since 25, adjusted RR 4 times Between 26 and 211, RR rose from 8.5% to 21.5%
Introduction RR play a role in managing external imbalances in China Mop up foreign exchange reserves under closed capital account (Ma, et al. (213)) Cheaper alternative to sterilization since global financial crisis (e.g., Chang, Liu, and Speigel (215)) May therefore be understood as an expedient way for alleviating inflation pressures while reducing sterilization cost 3 / 44
Introduction RR increases encourage shadow banking activity Shadow bank lending increased over 3% per year between 29 and 213 Unregulated, kept off of banks balance sheet (e.g., wealth management products) Reduces costs of financial services but increases financial risks [Gorton and Metrick (21), Elliott, et al (215)] Shadow banking expansions attributable to tightened banking regulations (Elliott, et al (215); Hachem and Song (216); Chen, Ren, and Zha (216)) binding loan/deposit caps Interest rate controls Increases in RR (only affect formal banking) 4 / 44
Introduction Impact of RR on financing costs affects resource allocations RR act as a tax on commercial banks Disproportionately affects State-owned enterprises (SOEs) SOEs enjoy implicit government guarantees on loans Superior access to bank loans despite lower average productivity Shadow banking not subject to RRs Main source of financing for privately-owned enterprises (POEs) (Lu, et al. (215)) RRs reallocates resources from SOEs to POEs Reduces SOE activity relative to POE POEs have higher average productivity (Hsieh-Klenow, 29) Thus, raising RR increases aggregate TFP 5 / 44
Introduction Illustrative macro evidence of RR s reallocation effects Simple BVAR with RR, 3-mo deposit rate, log real GDP, SOE investment share Data 1995:Q1 to 213:Q4 4-qtr lags with Sims-Zha priors Ordering implies RR responds to all shocks in impact period Results show positive shock to RR reduces SOE investment share Increase in GDP surprising, but possible due to increased TFP Results robust to RR being ordered last 6 / 44
BVAR: RR reallocates investment away from SOEs #1-3 6.8831.68 Error Bands Required reserve ratio #1-3 1.9445 Interest rate -3.76-1.2972 #1-3 4.2445 Real GDP #1-3 5.7697 SOE investment share -4.625-1.7645 4 8 12 16
Introduction Corroborating micro evidence of RR s reallocation effects Do RR increases reduce SOE stock returns relative to POE? Consider regression model: H h= H R e j,t+h = a +a 1 RR t 1 +a 2 SOE jt RR t 1 +a 3 SOE jt +bz jt +ε jt where R e j,t+h = R j,t+h ˆβ j R m,t+h denotes risk-adjusted excess return, RR t 1 denotes changes in RR, and Z jt is a vector of controls (size, book-to-market, industry fixed effects, year fixed effects) Focus on relative effects on SOEs (a 2 <?) Daily data for non-financial firms listed on Shanghai/Shenzhen stock exchanges, 25-215 Identification: event study of RR announcement effects 8 / 44
Introduction RR announcements effects on stock returns Event window 1-day (H=) 3-day (H=1) 5-day (H=2) RR t 1.26.479.157 (7.2) (9.21) (15.74) SOE jt RR t 1 -.12 -.225 -.442 (-3.21) (-3.32) (-5.5) SOE jt -.7 -.26 -.41 (-2.6) (-5.29) (-6.47) Size jt -.34 -.99 -.155 (-27) (-43) (-53) BM jt.9.24.47 (2.22) (3.29) (4.96) Sample size 4119971 479847 4353 R 2.71.182.288 9 / 44
Introduction What we do Build a DSGE model with financial frictions and Chinese characteristics to study: 1. implications of RR policy for allocation efficiency, aggregate productivity, and social welfare 2. role of RR policy in stabilizing business cycle fluctuations 3. optimal RR under simple policy rules and interactions with interest-rate policy 1 / 44
Introduction Two sector DSGE model State-owned enterprises (SOEs) and privately-owned enterprises (POEs) Identical ex ante production technology, POEs have higher average productivity Both sectors require financing for working capital Follow BGG (1999) framework Costly state verification induces financial friction SOEs enjoy superior access to commercial bank borrowing Stems from implicit guarantees Private firms finance working capital with shadow banks 11 / 44
Introduction Creditors specialize in lending activity Conventional commercial banks Specialize in lending to SOEs Subject to government reserve requirements Government guarantee on SOE debt Underfunded SOEs are liquidated, but government pays lender to make up loan losses SOE bankruptcy still incurs monitoring costs, as in BGG Informal shadow banks Specialize in lending to POEs Exempt from RR regulation and receive no government guarantees If POE underfunded, undergoes costly liquidation Complete separation in financial activity assumed for simplicity, but captures reality 12 / 44
Introduction Allocative and welfare implications of RR policy Raising RR improves aggregate productivity Adversely impacts SOE sector dependent on bank finance Diverts resources to POE sector Raises aggregate productivity (since POE productivity higher) Welfare outcomes unclear Higher incidence of SOE bankruptcies higher bailout costs Ambiguity surprising given productivity advantage of POEs 13 / 44
Introduction Compare stabilizing performances of interest rate and reserve requirement policy rules Can t solve Ramsey, so concentrate on simple policy rules Coefficients chosen to maximize household welfare Tradeoff between reallocating resources from SOEs to POEs and social default costs Results Interest rate rule more effective for stabilizing inflation and output RR rule more effective for reallocating resources Welfare substantially higher when optimize over both rules 14 / 44
The model Households (1) Representative household utility function [ ] U = E β t ln(c t ) Ψ H1+η t, 1 + η t= Imperfect mobility of labor across sectors H t = (µh 1+σ L s,t + (1 µ)h 1+σ L p,t ) 1 1+σ L. where H s and H p denote labor supplied to SOEs and POEs, respectively 15 / 44
The model Households (2) Budget constraints C t + I t + D st + D pt P t +R t 1 D s,t 1 + D p,t 1 P t = w st H st + w pt H pt + r k t K t 1 + T t where I t is capital investment, D st and D pt deposits in banks and nonbanks, and T t lump-sum transfers Capital accumulation with adjustment costs (CEE 25) K t = (1 δ)k t 1 + [1 Ω k 2 ( ) 2 It g I ]I t, I t 1 16 / 44
The model Retail sector Final good Y f CES composite of differentiated retail products Each retailer is price-taker in input markets and monopolistic competitor in product markets Demand curve facing each retailer ( ) Pt (z) ɛ Y t (z) = Yt f Retailer takes demand schedule as given and sets price P t (z) Quadratic price adjustment costs as in Rotemberg (1982) Ω p 2 P t ( ) Pt (z) 2 πp t 1 (z) 1 C t 17 / 44
The model Intermediate goods Two sectors: j = p for POE and j = s for SOE Production function for sector-j firm: [ ] α Y jt = A t Ā j ω jt K 1 α jt (Hjt) e 1 θ Hjt θ where K j = capital, H j = household labor, Hj e = managerial labor ω jt F jt ( ) idiosyncratic productivity shock, realized after production and freely observable only to firm A t = aggregate productivity shock; Ā j = scale of TFP in sector-j (a constant) 18 / 44
The model Financial frictions Firms finance working capital with net worth N j,t 1 and external debt B jt (BGG) Working capital constraint satisfies N j,t 1 + B jt P t = w jt H jt + w e jth e jt + r k t K jt where wjt e is the real wage rate of managerial labor Constant returns implies that revenue linear in net worth Y jt x t = Ã jt ω jt N j,t 1 + B jt P t where ω jt denotes idiosyncratic productivity and Ãjt is rate of return on firm investment (in consumption units) 19 / 44
The model Defaults Firms default when they are unable to pay their debts Occurs if realized productivity ω jt sufficiently low: ω jt < ω jt Z jt B jt à jt (N j,t 1 + B jt ) where Z j,t is contractual rate of interest If firm defaults, liquidated by lender with fraction m jt lost output Government covers SOE (not POE) loan losses using lump sum taxes 2 / 44
The model Financial intermediaries Commercial banks: Take deposits from household at rate Rt, subject to RR Government guarantees imply risk-free loan rate R st for SOEs (R st 1)(1 τ t ) = (R t 1). RR drives wedge between loan and deposit rate Shadow banks: Not subject to RR, Rpt = R t No government guarantees on POE debt default premium over funding cost (i.e., credit spread) on private loans 21 / 44
The model Financial contracts Optimal financial contract is a pair ( ω jt, B jt ) that solves max à jt (N j,t 1 + B jt )f (ω jt ) subject to the lender s participation constraint à jt (N j,t 1 + B jt )g(ω jt ) R jt B jt where B jt denotes loan amount and ω jt is cutoff productivity for firm solvency Defaults socially costly: ωjt ωjt f (ω jt )+g(ω jt ) = 1 m jt ωdf (ω)+l j [ω jt (1 m jt )ω]df (ω) where l s = 1 and l p = are fractions of government guarantees 22 / 44
The model Monetary policy Two instruments for monetary policy: deposit rate and RR Consider two types of simple (Taylor-like) policy rules Interest rate rule ( ) Rt ( πt ) ( ) GDPt ln = ψ rp ln + ψ ry ln R π GDP t 1 g Reserve requirement rule ( τt ) ( πt ) ( ) GDPt ln = ψ τp ln + ψ τx ln τ π GDP t 1 g 23 / 44
Quantitative results Steady state impact of RR increase.4 SOE output/poe output 1.91 Output-based TFP 1.98.35 1.96 1.94 1.92.3 1.9 1.898 1.896.25.2.4.6.8 1 1.894.2.4.6.8 1.22.2.18.16.14.12.1.8.6 SOE bankruptcy ratio.4.2.4.6.8 1 Required reserve ratio (=) 4 2-2 -4-6 -8-1 #1-4 Welfare gains -12.2.4.6.8 1 Reallocation from SOE to POE improves TFP Higher funding costs increase SOE bankruptcies Tradeoff interior optimum τ =.73 under our calibration 24 / 44
Quantitative results Compare macro stability and welfare under 4 policy rules Benchmark policy: Taylor rule with ψ rp = 1.5 and ψ ry =.5 and constant τ Optimal interest-rate rule: ψ rp and ψ ry set optimally to max welfare, and τ kept constant Optimal reserve-requirement rule: ψ τp and ψ τy set optimally, Taylor rule coefficients kept at benchmark values Jointly optimal rule: Coefficients for both interest rates and reserve requirements set optimally Consider 2 shocks: TFP and government spending 25 / 44
Quantitative results Aggregate Responses to TFP Shock: Benchmark Impulse responses to TFP shock 1 GDP.1 Inflation.95 -.1.9 -.2.85 -.3.8 -.4 -.5.75 -.6.1 Deposit rate 1 Required reserve ratio.5 -.1 -.2 -.3 -.5 -.4-1 26 / 44
Quantitative results Sectoral responses to TFP shock: Benchmark Impulse responses to TFP shock 1.2 SOE output 1.2 POE output 1 1.8.8.6 SOE leverage.2.6 POE leverage 2 1 -.2 SOE bankruptcy ratio 5-5 -1 SOE credit spread.2 POE bankruptcy ratio 4 2 POE credit spread.4.2 -.2 27 / 44
Quantitative results Aggregate Responses to TFP Shock: Benchmark vs optimal τ Impulse responses to TFP shock 1 GDP.1 Inflation.95 Benchmark Optimal = rule -.1.9 -.2.85 -.3.8 -.4 -.5.75 -.6.1 Deposit rate 1 Required reserve ratio 8 -.1 -.2 6 4 2 -.3 -.4-2 28 / 44
Quantitative results Sectoral responses to TFP shock: Benchmark vs optimal τ Impulse responses to TFP shock 1.5 SOE output 1.5 POE output 1.5 1 SOE leverage.2 -.2 SOE bankruptcy ratio 4 2-2 SOE credit spread.2 -.2.5 POE leverage 2 1-1 POE bankruptcy ratio 4 2-2 POE credit spread.4.2 -.2 29 / 44
Quantitative results Aggregate Responses to TFP Shock: Benchmark vs optimal R Impulse responses to TFP shock 1 GDP.1 Inflation.95 Benchmark Optimal R rule -.1.9 -.2.85 -.3.8 -.4 -.5.75 -.6.1 Deposit rate 1 Required reserve ratio.5 -.1 -.2 -.3 -.5 -.4-1 3 / 44
Quantitative results Sectoral responses to TFP shock: Benchmark vs optimal R Impulse responses to TFP shock 1.5 SOE output 1.2 POE output 1 1.8.5 SOE leverage.2.6 POE leverage 2 1 -.2 SOE bankruptcy ratio 5-5 -1 SOE credit spread.2 POE bankruptcy ratio 4 2 POE credit spread.4.2 -.2 31 / 44
Quantitative results Macro stability and welfare under alternative rules Variables Benchmark Optimal τ rule Optimal R rule Jointly optimal rule Policy rule coefficients ψ rp 1.5 1.5 1.93 1.51 ψ ry.5.5.32 -.14 ψ τp. 374. 232 ψ τy. 417. -913 Macro Volatility GDP 5.36% 5.384% 5.329% 5.335% π.624%.64%.385%.46% C 5.88% 5.85% 5.56% 5.57% H.83%.776%.848%.95% R.543%.53%.488%.734% Welfare gains relative to benchmark C equivalent.19%.23%.493% 32 / 44
Quantitative results Jointly optimal rule allows for complementary use of policy tools Adjust R-rule to stabilize inflation and GDP Adjust τ-rule to achieve desired reallocation of resources across sectors τ-rule also used to stabilize financial accelerator effects on POEs Leads to higher welfare gains than each individually optimal rule the two policy instruments are complementary 33 / 44
Conclusion Conclusion Examine RR policy in DSGE model with BGG financial accelerator and Chinese characteristics Changes in RR incur tradeoff between allocation efficiency and bankruptcy costs Reserve requirements and interest rates are complementary policy instruments Interest rate effective for macro stabilization RR more useful for improving allocation efficiency and welfare Caveats: Results are second-best May change with opening to global capital markets 34 / 44
Additional materials: Impulse responses to government spending shock Aggregate responses to govt spending shock: Benchmark Impulse responses to government spending shock.1 GDP.12 Inflation.5.1.8.6 -.5.4.2 -.1.2 Deposit rate 1 Required reserve ratio.15.5.1.5 -.5-1 35 / 44
Additional materials: Impulse responses to government spending shock Sectoral responses to government spending shock: Benchmark Impulse responses to government spending shock.1 SOE output.1 POE output -.1 SOE leverage.2 -.2 SOE bankruptcy ratio 1.5 SOE credit spread.2 -.2 -.1 POE leverage.1 -.1 -.2 POE bankruptcy ratio 2-2 -4 POE credit spread.2 -.2 -.4 36 / 44
Additional materials: Impulse responses to government spending shock Aggregate responses to Govt spending Shock: Benchmark vs optimal τ Impulse responses to government spending shock.1 GDP.12 Inflation.5 Benchmark Optimal = rule.1.8.6 -.5.4.2 -.1.25 Deposit rate 2 Required reserve ratio.2 15.15 1.1.5 5 37 / 44
Additional materials: Impulse responses to government spending shock Sectoral responses to government spending shock: Benchmark vs optimal τ Impulse responses to government spending shock.1 SOE output.2 POE output.1 -.1 -.2 SOE leverage.2 -.1 POE leverage.2 -.2 SOE bankruptcy ratio 2 1-1 SOE credit spread.2 -.2 POE bankruptcy ratio 2-2 -4 POE credit spread.5 -.2 -.5 38 / 44
Additional materials: Impulse responses to government spending shock Aggregate responses to govt spending shock: Benchmark vs optimal R Impulse responses to government spending shock.1 GDP.12 Inflation.5 Benchmark Optimal R rule.1.8.6 -.5.4.2 -.1.2 Deposit rate 1 Required reserve ratio.15.5.1.5 -.5-1 39 / 44
Additional materials: Impulse responses to government spending shock Sectoral responses to government spending shock: Benchmark vs optimal R Impulse responses to government spending shock.1 SOE output.2 POE output.1 -.1 SOE leverage.2 -.2 SOE bankruptcy ratio 1.5 SOE credit spread.2 -.1 POE leverage.2 -.2 -.4 POE bankruptcy ratio 2-2 -4 POE credit spread.5 -.2 -.5 4 / 44
Additional materials: Impulse responses to government spending shock Aggregate responses to govt spending shock: Benchmark vs. alt policy rules Impulse responses to government spending shock.1 GDP.12 Inflation.5 Benchmark Optimal R rule Optimal = rule Jointly optimal rules.1.8.6 -.5.4.2 -.1.25 Deposit rate 2 Required reserve ratio.2 15.15.1 1 5.5-5 -1 41 / 44
Additional materials: Impulse responses to government spending shock Sectoral responses to govt spending shock: Benchmark vs. alt policy rules Impulse responses to government spending shock.4 SOE output.2 POE output.2.1 -.2 SOE leverage.2 -.1 POE leverage.5 -.2 SOE bankruptcy ratio 2 1-1 SOE credit spread.2 -.5 POE bankruptcy ratio 5-5 POE credit spread.5 -.2 -.5 42 / 44
Additional materials: Impulse responses to government spending shock Aggregate Responses to TFP Shock: Benchmark vs. alternative policy rules Impulse responses to TFP shock 1.15 GDP.1 Inflation 1.1 1.5 1.95.9.85.8 Benchmark Optimal R rule Optimal = rule Jointly optimal rules -.1 -.2 -.3 -.4 -.5.75 -.6.1 Deposit rate 1 Required reserve ratio -.1 -.2 8 6 -.3 4 -.4 -.5 -.6 2 -.7-2 43 / 44
Additional materials: Impulse responses to government spending shock Sectoral responses to TFP shock: Benchmark vs. alternative policy rules Impulse responses to TFP shock 6 SOE output 1.5 POE output 4 1 2.5 SOE leverage.2 -.2 SOE bankruptcy ratio 1-1 -2 SOE credit spread.2 -.2 POE leverage 2 1-1 POE bankruptcy ratio 4 2-2 POE credit spread.4.2 -.2 44 / 44