Wednesday, March 4, 2009

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.


  1. Two points:

    1. The rise in Bank Negara's foreign reserves in the first half of 2008 could have been driven by (a) the repartriation of export earnings from good commodity prices in 2007 and first half of 2008; (b)the effects of gold prices; and (c) speculative demand for ringgit re the relatively high interest rates and favourable BOP.

    2. Because there was already an excessive liquidity in the system, the outflow in the second half should have no monetary impact nor on lending. I think there is still a lot of room for liquidity to drain from the system.

    2. Speculation of the ringgit as the ringgit interest rates were still relatively high and the trade balance positive.

    My conclusion is that if the central bank is not careful, pushing interest rates down will send more liqidity to better yielding assets abroad. The question is what is the optimal holding of foreign reserves by the central bank.

  2. Good comments, thanks! BTW, that's three points ;)

    1a. More than likely - I'll need to look at the detailed BOP data to confirm.
    1b. Gold prices weren't a factor, I checked. Gold dropped in RM terms through most of 2008.
    1c. Possible, but I'm not convinced interest rates were necessarily that big a factor, especially in real terms.

    2. True.

    3. I think this point calls for another post - it's worth examining. The reason for my ambivalence regarding this point is that the empirical evidence for interest parity conditions driving exchange rate movements is shaky at best.

    Re: your conclusions. I'm not sure this will happen, but it bears close monitoring. So far from the data, banks are focusing on domestic assets. Given the relative trajectory of interest rate cuts globally, I'm uncertain they (or anybody else) will be able to find higher yields elsewhere. It's an open secret though that reserve accumulation in East Asia has been excessive.

  3. Hi there

    etheorist suggested that I drop by. I can see that between you and etheorist, the rest of us can look forward to a scintillating dialogue on economics in general and the Malaysian economy in particular. The Malaysian econ blogosphere has just been enriched manifold.

  4. anybody got investor profile info for TBills? can help with No 3...... maybe