On September 5, 2022, the People's Bank of China (PBOC) announced a significant policy change that would take effect on September 15, 2022. The central bank decided to cut the foreign exchange deposit reserve requirement ratio for financial institutions by 2 percentage points, reducing it from the existing 8% to 6%. This adjustment is expected to release approximately $19 billion in foreign exchange liquidity, with the primary goal of easing the downward pressure on the renminbi's exchange rateThe relationship between the reserve requirement and currency fluctuations can be quite intricate, particularly when we examine it through the lens of U.Sdollar deposit reserves.

To fully understand the implications of this reserve requirement cut, it's crucial to look at how Chinese banks interact with U.Sdollar accountsAny Chinese bank that wishes to open a U.S

dollar account must establish a relationship with a clearing bank in the U.S., meaning they need an account at an American financial institutionFor instance, a Guangdong-based exporter may open a U.Sdollar account at the Industrial and Commercial Bank of China (ICBC) for trade settlements, while ICBC holds its U.Sdollar deposits at J.PMorgan Chase in the United StatesWhen a U.Simporter pays this exporter, the funds are transferred from the importer’s U.Sbank to the account ICBC has at J.PMorgan, ensuring that the transaction remains within the U.Sbanking system.

This lead us to an interesting revelation: all U.Sdollar deposits held by individuals, corporations, or banks within China's borders are essentially only digital "shadows" of actual dollar funds held in U.SbanksUnless someone possesses physical U.Sdollar notes, the dollars they "hold" are merely numbers on a screen, inaccessible beyond a digital display.

But what about China's foreign exchange reserves? The reality is somewhat similar

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While theoretically, the PBOC could request the Federal Reserve to airlift cash equivalent to trade surpluses (for example, $500 billion), the logistics and costs associated with such an operation are impracticalInstead, China’s central bank maintains accounts at the Federal Reserve, as well as large American banks like J.PMorgan and Citibank, to facilitate trade settlements and manage foreign exchange reserves effectively.

When the PBOC conducts foreign exchange transactions, one might perceive the cash flow to occur entirely within China’s bordersHowever, while renminbi transactions can and do take place in China, any U.Sdollar transactions inherently must occur within the United StatesFor instance, if ICBC sells $10 billion to the PBOC, the central bank pays ICBC 69 billion renminbi, successfully completing the renminbi transactionHowever, the completion of the U.S

dollar transaction follows a different path: if both the PBOC and ICBC hold accounts at J.PMorgan, the bank has to transfer the $10 billion from ICBC’s dollar account to the PBOC account before this transaction is considered finalized.

Grasping the underlying mechanics of dollar accounts within the Chinese banking system is essential to understanding what happens when the foreign exchange reserve ratio decreasesThe reduction process can be broken down into five steps.

First, on September 5, the central bank's announcement reduces the reserve requirement from 8% to 6%, effective September 15. The PBOC must recalculate how much in foreign exchange reserves needs to be heldBy the end of July 2022, the total foreign currency deposit balance held by domestic financial institutions was approximately $953.7 billionUnder the old reserve ratio of 8%, this means that $76.3 billion must be held in reserve

After the cut to 6%, only $57.2 billion will be required, resulting in a reduction of $19.1 billion in foreign exchange reserves.

It is important to note that this $19.1 billion isn't strictly made up of U.Sdollars; it also includes other currencies like euros, yen, and poundsFor simplification, we will discuss it solely in terms of U.Sdollars.

Second, where do these foreign exchange deposits actually reside? As established previously, all U.Sdollar deposits from Chinese banks exist in accounts at American clearing banksOn September 15, these clearing banks will execute transfer instructions from the PBOC, moving the excess foreign exchange reserve funds of $19.1 billion from the PBOC's account to the accounts of Chinese commercial banks.

The third step comes into play if a specific Chinese commercial bank has a different American clearing bank than the one the PBOC uses

In that case, the PBOC will transfer funds through the New York Federal Reserve to the respective clearing bank's reserve account, and the clearing bank will reflect the increased dollar amount in the Chinese bank's account.

The fourth step involves understanding the adjustment in account balances: the account balance of a Chinese bank at an American clearing bank will see an increase of $19.1 billionHowever, the Chinese bank's total asset-liability balance remains unaffected since that money simply transitions from being "frozen" at the central bank to available for use.

Finally, the increase of $19.1 billion in active dollar reserves allows Chinese banks to leverage this amountUnder the new 6% reserve rate, it produces around $380 billion in new dollar credit, thus improving the dollar credit supply-demand dynamic and potentially mitigating the depreciation of the renminbi.

However, this process raises several theoretical questions.

First, can the Chinese banking system create U.S

dollars? The answer is a resounding yesIf a Chinese exporter borrows U.Sdollars from a Chinese bank to finance trade, that bank can use the loan documentation to back-create dollar deposits in the U.SThe actual payment happens as the Chinese bank settles the amount with the American importer using the funds from their U.Sclearing bank account.

In this sense, the fractional reserve banking system acts like an amplifier: when the input is renminbi, the output is amplified renminbi credit; when the input is U.Sdollars, the output is amplified dollar creditThis principle underpins the creation of Eurodollars (or offshore dollars).

Second, the deposits in U.Sclearing bank accounts serve as "reserves" for the overseas dollar creation efforts by Chinese banksThe American clearing banks operate similarly to a central bank for the dollars that are created within China, while the PBOC sets the reserve rate to either expand or contract the ability of Chinese banks to generate U.S

dollar credit.

Third, a disparity exists inherently within the currency realmMoney and credit are not on equal footing; credit is utilized for transactions, while money serves as the means of settlementWithin the U.Sdollar system, the reserves held by the Federal Reserve represent money, whereas bank deposits created by American clearing banks merely reflect creditConversely, for offshore dollars, bank deposits represent money while the overseas dollars created by Chinese banks manifest as creditThis disparity creates a limitation: while a Chinese bank can generate unlimited dollar credit, it cannot create actual dollar money without sufficient dollar deposits at U.Sclearing banksTherefore, cross-border U.Sdollar payments cannot occur if the bank lacks adequate dollar reserves.

Looking at the aftermath of the announcement regarding the reserve ratio cut, we see that the anticipated outcome did not stop the depreciation trend of the renminbi