Managing liquidity and the money supply

As a follow-up to my previous post, here's what happened to Malaysia's international reserves over the last year (RM millions):

I don't have a good explanation as to why international reserves continued to rise in the early part of 2008. Net foreign portfolio investment had already turned negative by Q2 (which partly explains the fall in the KLCI), and gains from trade don't remotely offset the loss. My first instinct, that revaluation of reserves were responsible, turned out not to be true - the Ringgit fell 2% on a trade weighted basis in the first half of 2008, and 8% against gold. A close reading of the BOP statistics are in order here.

The second half is easier to explain, and actually makes for a pretty compelling story. Between June and December 2008, forex and gold reserves fell RM95 billion from a peak of RM409.5 billion. The cumulative impact on BNM's balance sheet was even greater (total assets in RM millions):

We're seeing here a balance sheet shrinking by over 30%! The fall in forex reserves accounted for two-thirds of the drop, with the other third coming from a drop in deposits in financial institutions. Ordinarily these would ceterus paribus imply a massive contraction in the money supply. While growth in monetary aggregates did slow and was probably sub-optimal in August and October, at no point did growth turn negative or fall below the rate of inflation (as measured by the CPI).

How'd BNM manage this? The liabilities side of the balance sheet offers the answer. First interbank deposits with BNM fell RM100 billion between April and November 2008. I'm not sure how much control BNM has over this component, apart from the SRR. In any case, the SRR rate was not cut until December and the total only amounted to about RM19 billion, which means either the banks or BNM responded to the fall in liquidity by withdrawing these interbank deposits into the system. More under BNM's control is the issue of BNM bills and bonds, the holdings of which fell RM60 billion between May and December last year. The reduction implies two things - either BNM chose not to rollover maturing bonds, or they bought back bonds on the open market and cancelled them. Either way, it's a net injection of liquidity into the system.

While these movements have helped sustain monetary looseness in 2008, I'm rather more concerned over the future path of monetary policy. At this point the OPR is set at 2.0%, with a cut in the SRR to 1.0% effective March 1 - neither is going to have much of an impact in an environment of falling demand. The slowdown in growth of monetary aggregates in 2008 may have an impact on loan supply, but I think the picture here too is of slowing demand - in other words, a drop off in velocity may leave monetary policy too tight relative to what we need.

What are BNM's options in such a case? There's still another RM50 billion in BNM bills that can be taken off the market, as well as approximately RM140 odd billion in interbank deposits. Utilising these options should not be inflationary, as neither imply an expansion in BNM's balance sheet. Alternatively, BNM could start buying MGS, of which there's over RM40 billion in the banking system, although this move would be inflationary. That's nearly RM200 billion in ready ammunition.

This whole discussion might be moot, though. Despite relatively strong loan growth (over 9% throughout 2008), the banks are still sitting on piles of cash. The banking system's LD ratio is below 80%, so there's plenty of lending capacity without BNM goosing liquidity further.