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| Structure of Base Currency Injection, Bank Risk and Liquidity Stratification |
| HE Yujie, LIU Xinrui
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School of Finance, Zhejiang Gongshang University;
School of Economics, Hangzhou Normal University |
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Abstract The 20th National Congress of the communist party of China clearly states, “Deepening structural reform in the financial sector and modernizing the central bank system.” Base currency injection forms the foundation and core of credit expansion and liquidity creation within the financial system. The People's Bank of China (PBoC) also emphasizes the need to “improve the mechanism for base currency injection.” As China's economy enters a new normal phase, the mechanism for base currency injection is gradually shifting from the foreign exchange reserve mechanism to innovative monetary policy tools. However, current research on monetary policy focuses primarily on the quantity and price of base currency issuance, with little consideration given to the structural characteristics such as channels and recipients of base currency injection. Changes in the mechanism and recipients of base currency injection can profoundly impact the liquidity landscape of the banking sector. This paper explores how the structure of base currency injection contributes to bank liquidity stratification. Furthermore, this paper discusses how liquidity stratification affects the risks faced by small and medium-sized banks.
Compared to foreign exchange channel, innovative policy tools channel involves direct lending to commercial banks, resulting in a discriminatory effect on the recipients of base currency injection. State banks have a greater advantage in obtaining base currency. This creates a situation where state banks accumulate liquidity while non-state banks face liquidity shortages, thus leading to “liquidity stratification”. By constructing bank-panel data from 2013-2022, this paper finds that the increase in the proportion of claims on other depository corporations triggers a rise in issuance volumes of interbank negotiable certificate of deposit (NCD) by non-state banks (small and medium-sized banks). However, this increase does not affect the issuance volumes by state banks. This indicates that the structural change in the base currency injection leads to bank liquidity stratification. The impact of the base currency injection structure on NCD issuance volumes is more pronounced in larger issuing banks, for higher ratings, or during period of the COVID-19 pandemic. Mechanism suggests that as the risk aversion level of state-owned banks increases, the impact of base currency injection structure on the NCD issuance by non-state banks becomes more pronounced. Further analysis suggests that the base currency injection structure exacerbates risk exposure of non-state banks through liquidity stratification. And when the risk aversion of state banks is relatively high, the positive impact of the base currency injection structure on bank risk is more pronounced. The transition in the base currency injection mechanism also results in the risk transfer from state banks to non-state banks.
The main contributions of this paper are as follows. Firstly, it analyzes the structural characteristics of the evolution of China's basic monetary issuance mechanism. It integrates the unique “state-owned vs. non-state-owned” bank heterogeneity framework of China and explores the impact of the base currency injection structure on the bank liquidity stratification, through the NCD issuance samples. Secondly, this paper compares innovative monetary policy with the foreign exchange reserve from the perspective of mechanism transformation and the central bank's operational preferences for implementing tools. It comprehensively elucidates how innovative monetary policy shapes the structural changes in base currency injection and further influences bank liquidity stratification, thereby enhancing our understanding of innovative monetary policy tools. Thirdly, this paper further analyzes the risk-driving factors behind liquidity stratification and its impact on the risk of small and medium-sized banks. It finds a more important risk transfer feature in the liquidity stratification pyramid framework in which state-owned large banks transfer liquidity to small and medium-sized banks.
This paper offers the policy implications. Firstly, there is a need to further enhance the PBoC’s mechanisms for base currency issuance and liquidity management framework. The central bank should intensify the implementation of structural monetary policy tools, and lower barriers for members participating in innovative monetary policy tools such as MLF (Medium-term Lending Facility). Secondly, this paper proposes incentivizing state-owned banks to increase their risk-taking and systematically strengthening the performance evaluation of risk-taking and liquidity management. Simultaneously, larger banks should reinforce credit cooperation with small and medium-sized banks. Thirdly, this paper proposes strengthening the management and risk prevention of NCD issuance among small and medium-sized banks to avoid excessive competitive issuance and competitive rate increases.
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Received: 20 September 2023
Published: 03 July 2024
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