China's central bank has taken a step toward further improving the way it controls monetary supply.

The People's Bank of China (PBC) usually manages banking-system liquidity with traditional methods deriving from its administrative power, such as adjusting credit quota and reserve requirement ratio (RRR) of commercial banks. However, in line with the times, the PBC is heading toward a change that gradually steers itself away from the administrative power in its macro-control efforts.

On January 18, the PBC said it would immediately begin using short-term liquidity operations (SLO) to inject or withdraw cash from the banking system when needed. SLO would supplement its current twice-a-week open market operations when the liquidity in the banking system suffers from temporary fluctuation.

In 2013, the central bank will continue using the dynamically differentiated RRR system, which requires different banks to set aside different levels of deposits with the central bank according to each bank's capital adequacy ratio and risk-control requirement, according to an insider at the PBC quoted by domestic media.

These moves mark a transition before the realization of totally market-based adjustment and are in accordance with the market-based reforms of the central bank.

The Central Economic Work Conference held in December 2012 pledged that China's total social financing aggregate, a broad measure of liquidity in the economy, will be expanded. It is predicted that the newly added bank loans will total 9 trillion yuan ($1.45 trillion) and total social financing aggregate will amount to 19 trillion yuan ($3.06 trillion) this year.

Both the SLO and the dynamically differentiated RRR system are a big step forward compared with the traditional policy weapons such as RRR and credit control. The PBC's emphasis on market-based instruments indicates that in the future, the central bank is more likely to choose more flexible instruments over the previous administration-driven ones.

SLO and RRR are quantitative instruments and SLO is a replacement of the latter. They differ in that the SLO is more flexible, more frequently used and more accurate in control. On the other hand, the effect of RRR is closely related to the amount of deposits in a country. Taking the current 94 trillion yuan ($15.12 trillion) bank deposit for instance, every 0.5 percent RRR adjustment will add or subtract 470 billion yuan ($75.58 billion) liquidity to the market, causing turbulence to inter-bank capital.

The dynamically differentiated RRR system is a replacement of the credit quota control. Compared with heavy-handed credit control orders, the dynamically differentiated RRR system will give commercial banks a more stable market expectation to help them avoid chaos caused by unexpected credit control orders.

Traditionally, Chinese commercial banks are apt to grant more loans at the beginning of a year and experience a credit crunch at the end of the year due to the credit cap. From now on, the dynamically differentiated RRR system will ease the seasonal fluctuation of bank loans.

The central bank's latest efforts in getting rid of administrative instruments are in line with China's market-oriented reform. However, it should be noted that the Chinese economy is less sensitive to interest rate moves given that reforms in the real economy haven't been carried out. On par with the central bank's market-based practices in macro-control, reforms in other fields should be carried out in time to follow the trend. n

This is an edited excerpt of a report by Anbound, a Beijing-based research company, published on the website of Caijing Magazine