Reserve requirements are a powerful monetary tool, but they come with certain costs to the banking sector, Monetary Authority Chief Executive Joseph Yam says.

In his latest Viewpoint column published today, Mr Yam said while changes in reserve requirements can affect short-term interest rates by changing banks' demand for reserves, these actions can have disruptive effects on banks since they need time to adjust their portfolios to accommodate the changed requirements, especially if the financial markets are not fully developed and the distribution of excess reserves among banks is uneven.

He said another reservation in the use of reserve requirements for monetary or supervisory purposes is the cost being imposed on banks.

"A reserve requirement higher, for whatever purpose, than a prudent liquidity ratio means that banks are forced to hold an excess amount of low-yield assets. Reserve money (or deposit reserves) held with central banks is usually paid quite low interest rates. In any case, even for the purposes of ensuring adequate liquidity to repay deposits, there may be higher-yield and equally liquid assets than the reserve money that banks are required to hold."

He said capital inflow and the reluctance of the private sector to hold the very limited choice of foreign currency assets on the Mainland (partly as a result of exchange rate expectation and foreign exchange control) will continue to influence monetary developments on the Mainland.