Sheng Songcheng: Why is it said that lowering the reserve requirement ratio is more important than lowering interest rates now?

On January 10-11, 2026, the China Chief Economists Forum Annual Conference was held in Shanghai, with this year's theme being "The Game in the Middle: Building a Strong Nation by Carrying Forward the Past and Opening Up the Future." Sheng Songcheng, Director of the China Chief Economists Forum Research Institute, Professor at China Europe International Business School, and Senior Academic Advisor at the China Europe Lujiazui International Financial Research Institute, delivered a keynote speech titled "Timely Reduction of Reserve Requirement Ratio and Interest Rates, in Coordination with Active Fiscal Policy."

Key Highlights:

• Monetary policy will maintain a "small step" approach. In a complex economic environment, the central bank tends to adopt a prudent and gradual adjustment method, focusing on the effectiveness of policy transmission and market feedback.

• Reducing the reserve requirement ratio is prioritized over lowering interest rates. Lowering the reserve requirement ratio can directly enhance banks' capacity for fund allocation, better complement fiscal policy efforts, and help maintain bank interest margins and financial system stability.

• There is still room for interest rate cuts, but they should be implemented steadily. The low price environment provides conditions for interest rate cuts, but factors such as limited interest rate elasticity should be considered to avoid significant cuts, focusing instead on coordination with structural tools.

• Coordination between fiscal and monetary policy is key. Monetary policy needs to actively support fiscal expansion, facilitating government bond issuance through measures such as lowering the reserve requirement ratio, to form a macroeconomic adjustment synergy.

The following is the full text of the speech:

I am pleased to participate in this China Chief Economists Forum Annual Conference and honored to share and communicate with everyone. The topic I am discussing today is "Timely Reduction of Reserve Requirement Ratio and Interest Rates, in Coordination with Active Fiscal Policy," focusing on three main aspects: 1. The likelihood of a "small step" approach in monetary policy is high; 2. Reducing the reserve requirement ratio is preferable to lowering interest rates; 3. There is still some room for interest rate cuts.

1. The likelihood of a "small step" approach in monetary policy is high. The core reason for the high possibility of adopting a "small step" model in China's monetary policy is that monetary policy typically targets short- to medium-term economic adjustments. In the face of complex uncertainties, a prudent attitude of "crossing the river by feeling the stones" is necessary. Moreover, there is often a certain time lag from the implementation of monetary policy to its transmission to the real economy and its impact.

Compared to fiscal policy, which can directly intervene in economic activities, monetary policy often operates indirectly and relies on the cooperation of functional departments, commercial banks, and the entire financial system. Its effectiveness is largely influenced by market feedback.

For example, during the 2008 global financial crisis, the Federal Reserve significantly released liquidity, hoping that commercial banks would expand credit issuance. However, commercial banks were reluctant to cooperate due to risk concerns, leading to an excess reserve ratio of 20% for U.S. commercial banks in 2014. This fully illustrates that without the cooperation of the financial system, the central bank's monetary policy objectives are difficult to achieve.

In addition, the monetary policy transmission mechanism is also quite complex, with longer transmission paths. In recent years, China has gradually formed a transmission chain of "policy interest rate (OMO, especially 7-day OMO) — Loan Prime Rate (LPR) — Loan interest rate," but the central bank finds it challenging to precisely control each link: Even if the OMO rate is adjusted, the LPR may not change synchronously, and even if it does, there may be differences in the magnitude of the changes, while the actual loan interest rate is ultimately determined by the market, monetary conditions, and the supply and demand relationship for credit. Currently, China's monetary policy toolbox is becoming increasingly rich, and the central bank is continuously strengthening the role of interest rate regulation. Through various liquidity support tools and secondary market transactions of government bonds, it injects liquidity and adjusts funding costs, effectively smoothing short-term market fluctuations.

It is important to clarify that the central bank can only buy and sell government bonds in the secondary market and is strictly prohibited from operating in the primary market to avoid triggering the monetization of fiscal deficits—this is a common rule among major global economies, which China has always strictly adhered to. Monetization of fiscal deficits could lead to unlimited monetary expansion, resulting in severe inflation risks. In recent years, the liquidity injection by China's central bank has included both short-term and medium-term tools, as well as long-term tools.

Two key points are emphasized here: first, the reserve requirement ratio as a long-term liquidity injection tool of the central bank; a reduction in the reserve requirement ratio can directly release usable funds for commercial banks; second, China introduced two important policy tools, open market transactions of government bonds and reverse repos, in August and October 2024, respectively. This marks a continuous enrichment of the policy toolbox, and the central bank's means of ensuring reasonable and ample market liquidity are becoming increasingly diversified.

Second, a reduction in the reserve requirement ratio is preferable to a reduction in interest rates. This is a viewpoint I have long maintained, not denying the necessity of interest rate cuts, but highlighting that under the current national conditions in China, the adaptability and positive effects of a reduction in the reserve requirement ratio are more prominent.

A reduction in the reserve requirement ratio can increase the funds that commercial banks can autonomously allocate, better aligning with proactive fiscal policies—in China's macro-control system, fiscal policy plays a leading role, while monetary policy serves a coordinating function; both are indispensable.

Most government bonds and local government debts are held by commercial banks. Data shows that about 65% of government bonds and 78% of local government debts are held by commercial banks. A reduction in the reserve requirement ratio allows commercial banks to obtain sufficient funds to allocate to government bonds, achieving efficient linkage between fiscal and monetary policies.

From the data, the net issuance of government bonds has basically remained in sync with the liquidity injection by the central bank, with only 2024 being a special case: that year, bond yields fell sharply, especially long-term yields, raising market concerns about financial risks, leading the central bank to correspondingly reduce liquidity injection.

Looking back to February 2016, I published an article titled "Significantly Increasing China's Fiscal Deficit Ratio," proposing to appropriately raise the fiscal deficit ratio over a longer period to create conditions for proactive fiscal policies. This viewpoint has now been validated, with China's fiscal deficit ratio expected to be 4% in both 2024 and 2025, and it may remain at this level in 2026.

If special local government bonds and special government bonds are included in the broad deficit ratio statistics, the actual scale has reached 8% or even higher, which aligns with the current realistic demand for stable economic growth in China.

The Central Economic Work Conference clearly stated the need to maintain necessary fiscal deficits, total debt scale, and total expenditure. It is expected that fiscal policy will continue to maintain an expansionary tone in 2026. The emphasis on coordinating reductions in the reserve requirement ratio and interest rates also stems from the need for the financial sector to seek a balance between supporting the real economy and maintaining its own stable operation.

Financial stability is the core of economic stability. Currently, there are risk hazards in the real estate sector, and if the financial system encounters further issues, it will severely impact the national economy. Japan once fell into a long-term stagnation due to the combination of real estate and financial risks From the comparison of the financial industry structure between China and the United States, the asset proportion of our banking industry is about 90%, while that of the United States is only 45%; the asset proportion of capital market-related institutions (such as funds, investment companies, etc.) in our country is 3%, while in the United States it is 19.4%; the asset proportion of our insurance industry is 7.3%, while that of the United States reaches 35.4%. This structure indicates that our financial system is primarily based on indirect financing, and the stability of the banking industry is crucial, thus it is necessary to remain highly vigilant against banking risks.

Because of this, since 2016, our country's statutory deposit reserve ratio has been adjusted a total of 23 times, all of which were reductions. The deposit reserve ratio for large deposit-taking financial institutions has decreased from 17.5% to 9%, a cumulative decline of 8.5 percentage points, continuously releasing liquidity and benefiting financial institutions; while the policy interest rate (mainly the 7-day OMO) has only been adjusted 14 times, with both the frequency and magnitude of adjustments being lower than that of the reserve requirement ratio.

This practice fully reflects the idea of "mainly relying on reserve requirement cuts, with moderate interest rate reductions," primarily due to the continuous increase in the pressure on commercial banks' interest margins: In 2008, the net interest margin of our commercial banks exceeded 3.5% at its peak, with some banks reaching 3.8%, while by the end of the third quarter of 2025, public data showed that the net interest margin was only 1.42%, at a historical low. A significant reduction in interest rates would further squeeze the banks' profit margins and affect the stability of the financial system.

From an international comparison perspective, the average deposit reserve ratio of our financial institutions is about 6.2% (including statutory deposit reserves, excess reserves, etc.), while the United States has abolished the statutory deposit reserve ratio, and the Eurozone is generally below 2%, with Germany, France, and Italy being around 1%. This indicates that there is still considerable room for reserve requirement cuts in our country.

Third, there is still some room for interest rate cuts. Our country does not have the foundation for sustained large-scale interest rate reductions, which differs from the views of some market participants. The core reason is that the interest rate elasticity of consumption and investment in our country is relatively low:

From the consumption side, even if deposit rates decline, residents are more inclined to transfer deposits to wealth management, the stock market, and other areas, rather than significantly increasing consumption expenditure;

From the investment side, through discussions with numerous entrepreneurs, I found that the core consideration for corporate investment decisions is the return and risk, rather than slight changes in loan interest rates. The adjustment of loan interest rates has limited impact on their willingness to invest.

Therefore, significant interest rate cuts are unlikely to achieve the expected effects of expanding consumption and promoting investment, and may instead trigger financial risks, so a gradual interest rate cut model should be adopted.

At the same time, there is still some room for interest rate cuts, mainly based on two factors:

First, the low price level leads to relatively high real interest rates. In 2024, the CPI year-on-year growth is 0.2%, far below the expected target of 3%, and the cumulative CPI growth for the entire year of 2025 is zero. The PPI has experienced negative growth for 39 consecutive months, providing support for interest rate cuts from the price level perspective;

Second, the RMB exchange rate remains on an appreciating trend, and in 2025, the Federal Reserve has cumulatively cut interest rates by 75 basis points, while our policy interest rate has only been adjusted by 10 basis points, and some structural monetary policy tool rates have decreased by 25 basis points. In the global interest rate cut cycle, our gradual interest rate cuts have external environmental conditions.

In addition, our central bank guides the optimization of credit structure through innovative structural monetary policy tools. By the end of 2024, the balance of structural monetary policy tools accounted for 14.2% of the total assets of the People's Bank of China, having reached a maximum of 17% at one point. These tools are mainly used to support technological innovation and economically weak sectors In recent years, China has placed great emphasis on technological innovation, industrial upgrading, and the development of new productive forces. Structural monetary policy tools are precisely aligned with this demand. In response to weak economic sectors such as real estate, China has introduced support measures such as a whitelist system, with the relevant funding scale reaching 7 trillion to 8 trillion yuan.

China's structural monetary policy tools possess both "quantity" and "price" dual adjustment functions, enabling them to play a targeted incentive role. This is a characteristic and advantage of China's monetary policy, contrasting sharply with the single regulatory model of Western countries, which is either to lower or not to lower rates. It reflects the central bank's precise adaptation to significant economic and social activities.

Due to time constraints, this concludes my core viewpoints. In summary, both reserve requirement ratio cuts and interest rate reductions need to be advanced steadily. It is expected that China will remain in a gradual reserve requirement ratio and interest rate reduction cycle over the next two years, with the core goal of guiding the economy towards stable and positive development.

Currently, China's economy is approaching the bottom of the cycle and is expected to gradually recover. In this process, fiscal policy needs to play a leading role, while monetary policy should ensure coordinated support. Through the collaborative efforts of counter-cyclical and cross-cyclical macroeconomic regulation, the national economy can steadily recover and continue to improve.

Source: Dolphin Research