Changing The Reserve Ratio ≠ Changing Monetary Policy

Or, Part Three of Why I Feel Snarky This Week

A few weeks back, Bank Negara cut the Malaysian statutory reserve ratio by 0.50%, and the People’s Bank of China did the same thing last week. Most of the commentary was along the lines of “easing monetary policy” and “adding to stimulus” and “boosting lending and investment”.

That’s a load of bull.

I’ve had to explain this multiple times over the past few weeks, so rather than having to do it all again, I thought I might as well write it out.

BNM Watch: No Change

Unlike the last time, the Monetary Policy Committee’s statement yesterday was an anticlimax (excerpt):

Monetary Policy Statement

At the Monetary Policy Committee (MPC) meeting today, Bank Negara Malaysia decided to maintain the Overnight Policy Rate (OPR) at 3.00 percent.

Global growth has moderated in the recent months as growth in the advanced economies slowed by more than expected following the greater policy uncertainties, worsening of confidence and heightened financial market volatilities, amidst continued weaknesses in labour market conditions. Going forward, the advanced economies are expected to register a slower pace of growth than earlier anticipated...

...In the domestic economy, recent indicators point to slower growth in external demand following the weaker global economic environment. Domestic growth prospects, however, continue to remain positive, underpinned by the expansion in private consumption and private investment. Employment conditions remain favourable amid sustained business and consumer confidence. The public sector will also continue to support economic growth. Moving forward, the more challenging external environment has, however, increased the downside risks to the domestic economy...

...Going forward, inflation is expected to remain relatively stable for the rest of the year. While cost-push inflation continues to remain, the pace of increase is expected to be more gradual. The upside risks to inflation will also be contingent on whether the strength of domestic demand will be sustained, in the event of further deterioration in the external conditions...

There was also no mention or separate statement on the SRR, which remains at 4%. Given the data coming out lately, the chance of an interest hike at the next meeting on November 11 (also the last for the year) is also vanishing – though that outlook may change if, as they say,  conditions change in the next couple of months.

July 2011 Consumer Price Index Report

Again late, though this time there’s more meat to get into. The July numbers don’t make comfortable viewing (log annual and monthly changes):

BNM Maintains OPR: The World Is Ending!

Ok, not really. But I’m honestly puzzled by this action, especially taking into account the language used in the statement issued by the Monetary Policy Committee (excerpt; emphasis added):

Monetary Policy Statement

At the Monetary Policy Committee (MPC) meeting today, Bank Negara Malaysia decided to maintain the Overnight Policy Rate (OPR) at 3.00 percent…

…Going forward, global growth will remain highly uneven across regions, with increased downside risks. For the region, growth is expected to be sustained by robust domestic demand, increased investment activity and intra-regional trade….

…Going forward, growth is expected to improve, underpinned by continued strength in private consumption and private investment. This growth prospect however, could be affected by the heightened external risks…

…Supply factors continue to be the key determinant affecting consumer prices with global commodity and energy prices projected to remain elevated. There are also some signs that domestic demand factors could exert upward pressure on prices in the second half of the year.

The MPC’s assessment is that the risks to inflation are on the upside. While the outlook for growth remains positive, there are heightened uncertainties arising from global developments that have created higher downside risks to growth. The MPC will assess carefully the evolving economic conditions and to the extent that the growth momentum is sustained, further normalisation of monetary conditions will be considered to safeguard price stability.

MPC Statement: OPR Stays At 2.75%, SRR Up 1%

In a move that took nobody by surprise, the Monetary Policy Committee opted to keep the Official Policy Rate at 2.75% (excerpt; emphasis added):

Monetary Policy Statement

At the Monetary Policy Committee (MPC) meeting today, Bank Negara Malaysia decided to maintain the Overnight Policy Rate (OPR) at 2.75 percent...

...Global inflation is increasing primarily due to the rising energy and commodity prices. For several countries, this has been exacerbated by domestic demand conditions which have prompted policy responses. Meanwhile, most emerging economies, particularly in Asia, continue to be affected by significant shifts in global liquidity, which have increased the risks to macroeconomic and financial stability.

In the domestic economy, latest available indicators suggest continued expansion in private consumption and sustained business spending activity amid more modest growth in external demand. Going forward, economic growth is expected to be moderate in the earlier part of the year and to improve during the course of the year, driven by strong expansion in domestic demand...

...Domestic headline inflation has increased to 2.4% in January 2011. Driven primarily by the significant increases in global commodity and energy prices, domestic prices are expected to continue to rise. There are, however, some incipient signs that domestic demand factors could result in possible upward pressure on prices in the latter part of the year in line with the sustained expansion in economic activity.

Moving forward, while the stance of monetary policy is expected to remain supportive of growth, the degree of monetary accommodation may be reviewed given the sustained growth in the economy and risks to inflation. This is to ensure the sustainability of the growth prospects of the Malaysian economy.

Everything You Wanted To Know About Central Bank Reserve Requirements…And Then Some

A new IMF working paper discusses reserve requirements and the role they play in liquidity management and monetary policy (abstract):

Central Bank Balances and Reserve Requirements
Simon Gray

Most central banks oblige depository institutions to hold minimum reserves against their liabilities, predominantly in the form of balances at the central bank. The role of these reserve requirements has evolved significantly over time. The overlay of changing purposes and practices has the result that it is not always fully clear what the current purpose of reserve requirements is, and this necessarily complicates thinking about how a reserve regime should be structured. This paper describes three main purposes for reserve requirements – prudential, monetary control and liquidity management – and suggests best practice for the structure of a reserves regime. Finally, the paper illustrates current practices using a 2010 IMF survey of 121 central banks.

SRR To Cool Hot Money Flows…Not

This one’s making a mountain of a molehill (excerpt; emphasis added):

Worries over SRR hike impact on loans

Statutory reserve requirement may be raised to curb hot money

KUALA LUMPUR: There are fears in the banking and finance sector that a hike in the statutory reserve requirement (SRR) to cool hot money inflow may impact loan activity and result in an economic slowdown.

Bank Negara's SRR, which is currently set at 1%, is the amount of money that all the country's commercial, investment and Islamic Banks must set aside and lodge with it.

BNM Signalling No Hikes Ahead

Yesterday’s MPC statement was as bland as they come, until the very last line:

Monetary Policy Statement

At the Monetary Policy Committee (MPC) meeting today, Bank Negara Malaysia decided to maintain the Overnight Policy Rate (OPR) at 2.75 percent...

…At this stage, the MPC considers the current monetary policy stance as appropriate and consistent with the current assessment of the economic growth and inflation prospects. The stance of monetary policy continues to remain accommodative and supportive of economic growth. However, the large and volatile shifts in global liquidity are leading to a build up of liquidity in the domestic financial system. While the liquidity in the financial system has been manageable, going forward, additional policy tools such as the statutory reserve requirement and macroprudential lending measures may be considered to avoid the risks of macroeconomic and financial imbalances.

What that says to me is that BNM won’t consider using a sledge hammer to whack a fly – unless there’s evidence of a systemic change in aggregate price picture. I think the SRR will be used as a signalling measure, telling the markets that BNM is considering tightening further. It’s pretty much a paper tiger at the moment, given the current SRR level (1%) and the banking system’s actual reserve ratio (15%).

Excess Reserves Don’t Necessarily Lead To Excess Credit Creation

I just can’t leave this topic alone. But it’s interesting to contrast the Malaysian experience with what’s going on in the US and Europe right now.

In my post on hyperinflation, I made the assertion that credit creation is no longer an asset side phenomenon driven by the logic of fractional reserve accounting, but limited on the liabilities side of the balance sheet by capital ratios. This in turn means that excess reserve creation carried out by western central banks isn’t necessarily inflationary.

Here’s some supporting evidence, in the Malaysian context. First the track record of loan growth since 1998 (log annual changes):

Changing The Statutory Reserve Ratio: Why It Doesn’t Really Matter

I thought I’d go over this because there seems to be a lot of confusion, particularly from people who should know better. Malaysia is not China (which has raised theirs to crazy-high levels), nor is it Taiwan (currently contemplating a rise in lieu of an interest rate hike).

First, a refresher.

We have to recognise that the modern banking is based on a fractional reserve system, in other words banks are able to lend out money and cash because they know that at any given time, their depositors will only need or demand a small fraction of the deposits the banks are holding on their behalf.

So a reserve ratio of 1% (as it is now in Malaysia) means that banks could in theory lend out 100 times their holdings of cash (read this post for a fuller discussion). Reserve requirements are therefore a prudential measure to ensure that banks have enough cash on hand to meet customer demand – loans are of course illiquid and cannot be used for this purpose, so you have to have some cash or cash equivalents (like NIDs/NCDs).

In a modern financial system, bank reserves are kept at the central bank, where they earn nothing. From a monetary policy perspective, a central bank could therefore theoretically control the amount of credit granted by the financial system through varying the reserve ratio – an increase in the reserve ratio reduces the amount a bank could potentially lend, and vice versa. For instance, going from 1% to 2% effectively reduces the ability of banks to lend from 100x to just 50x their cash holdings. Note that all this happens on the asset side of a bank’s balance sheet.

That’s the economics narrative anyway, the one taught in textbooks.

The problem is, if you have anything like a fair-sized debt securities market (which Malaysia does – the biggest in the region) and an active interbank market, changing the reserve requirement doesn’t really affect lending much. What a change in the reserve requirement will do however is change the composition of banks’ other assets and crimp their interest margins, but not necessarily the growth in their loan book. To see this, let’s have a look at the asset side of Malaysian commercial banks’ aggregate balance sheet (unaudited December 2009 data):

	RM billions
Cash	7.7
Stat Reserve	3.6
Deposits placed and Reverse Repos	23.4
Amounts due from within Malaysia	200.5
Amounts due from outside Malaysia	40.2
Negotiable Instruments of Deposits (NIDs)	37.1
Malaysian securities	180.3
Loans and Advances	777.7
Fixed Assets	13.8
Other Assets	77.7
Total Assets	1,361.9

Note that loans and advances account for just 57% of total assets – you can immediately see the problem relative to the stylised narrative I’ve described above. Since over a third of banks’ aggregate balance sheet consists of liquid or semi-liquid assets, banks won’t have a problem meeting any putative rise in the reserve requirement without compromising their ability to lend.

A hike in the SRR from 1% to 2% will take approximately RM5.7 billion from the banks by my calculations, based on the December numbers. To meet that requirement, banks can draw down their interbank deposits (captured under amounts due in Malaysia) of which there’s about RM30 billion – the rest of it is mainly taken up by BNM repos.

Given some advance warning they can also liquidate some NIDs, or sell down some of their holdings of Malaysian securities, the bulk of which is illiquid private debt securities, but which also include some RM54 billion in MGS for which there is a ready market. But any or all these actions will likely cause interbank rates to start rising relative to the OPR as liquidity gets tighter, which BNM is likely to counteract by pumping in liquidity – which makes the whole exercise moot.

Raising the SRR might raise the cost of funds (from which the Base Lending Rate is calculated), and thus the cost of borrowing – but not by very much, perhaps 1-2 bp per 1% increase from memory. The SRR will only become even marginally effective as it starts getting higher – much higher than even the 4% level that prevailed before the Great Recession started.

The historical high was reached in June 1996, when the SRR was raised to 13.5%, but even then it didn’t put much of a dent on runaway lending as loan growth averaged over 20% in log terms between 1995-97. The same reasons applied back then too, with loans around just 60% of total assets.

I’ve noticed that China hasn’t been very successful in reining in lending using higher reserve requirements. Don’t look for it to be a big factor in Malaysia either.

Lies, Damn Lies, and Then There Are Statistics

UBS Securities Asia Ltd has issued a report that has generated a bit of a buzz in the online media titled "Malaysia - Another Bizarre Story" (try here, alternate here). The headlines in the online media however are less timid:

“Money leaving Malaysia in massive amounts and bizarre fashion”

“Malaysia's Disastrous Capital Flight”

Ye Gods.

I’ve covered the issue of capital flight before in this post (read the comments for an interesting discussion). There’s no doubt that capital has been leaving the country in the aftermath of 1997-98, which in my opinion and from anecdotal evidence is largely due to domestic investment abroad. However, this UBS report is highly misleading as it purports to show that large amounts of capital left the country in 2009, which isn’t the case at all - at least, not any worse than it usually has.

Here’s my view (point by point, in blue) of where this report went wrong.

“Question: which Asian country had the biggest FX reserve losses in 2009? The answer is Malaysia, and by a very wide margin; we estimate that official reserves fell by well more than one-quarter on a valuation-adjusted basis.”

This is the main evidence that the report uses to justify its conclusion. But note that the basis of this estimate is from peak 2008 levels against current levels, which is more than a little disingenuous (look at notes for the first chart in the report). The assessment of “more than a quarter” loss suffers from what’s called the “base” effect – if you use a period with a high denominator, you can get negative growth even if the actual levels are increasing (international reserves, RM millions):

I put in a longer sample period so it’s easier to see what’s going on. Using a more conventional year on year calculation, this is what you get (log annual changes):

See what I mean? For most of 2009 growth in reserves was negative, despite the fact that the actual level of reserves was largely flat to increasing. Malaysia suffered technical deflation for much of 2009 for much the same reason, but I don’t hear anyone crowing over consumer prices falling.


Here's what monthly growth looked like (log monthly changes):

Through the whole of 2009, we've had exactly three months where reserve growth was negative, while the rest of the year saw reserves rising. This type of problem is the reason why I've consistently advocated looking at levels rather than growth metrics during times of violent change. You simply miss a lot of what's going on by using a period-to-period percentage change approach.


I’m also a little suspicious of the claim that the estimates were valuation adjusted – BNM already books revaluation losses and gains every quarter. If you revalue again based on published statistics, that would constitute double counting and would exacerbate movements in reserves.

“Other structural surplus neighbors like China, Hong Kong, Singapore, Taiwan and Thailand have all seen sizeable increases in FX reserves over the past 12 months … and yet Malaysian reserves nearly collapsed.”

Sloppy analysis – reserves at end 2008 stood at RM317.5 billion, versus RM331.3 billion at end 2009, including a revaluation loss of over RM10 billion for 2009 as a whole. That means a net increase of RM13.8 billion over a 12 month period – sure doesn’t look like a collapse to me.

More important, the first three countries listed all have an explicit exchange rate target. China has effectively halted Yuan appreciation against the USD in the last year and a half, Hong Kong has a currency board arrangement with the USD which effectively means forex reserves back the money supply, and Singapore explicitly uses the exchange rate as the instrument for implementing monetary policy unlike the more conventional interest rate target as used in Malaysia. I don’t know off-hand how Taiwan manages monetary policy (Taiwan is not an IMF member, and aren’t categorized within the IMF’s exchange regime framework), but Thailand uses a managed float with an inflation target, also implying intervention in foreign exchange markets.

Why this is important is that the countries listed all accumulate or lose reserves due to implicit or explicit exchange rate targets. Malaysia does not fall under that category under either a de facto or de jure basis, and I’ve gone on record to state that I don’t think BNM has an exchange rate target for the Ringgit at all. Hence, if there is no intervention, there should be effectively little to no change in reserves – which is what happened in 2009.

So what’s the story for 2008, because there was a massive loss in reserves back then? Looking at the reserve levels, you see a mild run-up from 2005 to 2006, and then acceleration from end-2006 to about mid-2008. Not coincidentally, reserve accumulation happened simultaneously with the commodity bubble of those years:

That's the main difference between Malaysia and the other countries we were compared to in the report - we are a commodity exporting country, none of the others are. Given that exports of commodities didn’t change much in volume but export receipts did, we had an abnormal influx of income that was more nominal than real. In the aftermath of the collapse in prices post July 2008, we had a drop in income that was also more nominal than real. Hence, from BNM’s perspective, the appreciation of the exchange rate (as well as the money supply impact of the inflow of trade receipts) warranted intervention to mitigate the Ringgit’s (and the money supply's) rise during the boom, and limit the Ringgit’s (sharp) fall (and the potential contraction in the money supply) in its aftermath. In addition, BNM had to meet the sudden demand for USD from the banking system as depositors and investors pulled out:

If you look at newspaper reports at the time (4Q 2008), BNM as good as admitted buying MYR against USD to support the currency:

Now if these factors are taken away – receipts from a commodity bubble boosting forex supply within the banking system and forcing an overshooting appreciation of the exchange rate, we would not have had reserve accumulation in 2007-2008 in the first place, and reserve accumulation would simply be on the same trend as it was from 2005-2006. And we wouldn't be arguing about a loss of reserves we probably shouldn't have had in the first place.

3.       “And this despite a massive, unprecedented decline in high-powered “base” money, as shown in Chart 4. Indeed, over the past 12 months Malaysia recorded one of the biggest base money contractions in the entire EM world, matched only by the Baltic states (Chart 5). This is in part because the Malaysian central bank responded with a sharp drop in reserve requirements to keep banks liquid … but still, we can’t help but note that the domestic financial system seems uniquely unaffected by apparent capital outflows.”

This one’s a bit funny – the writer was obviously not referring to M1 (currency + demand deposits) (RM millions; and log annual changes):

He’s referring to base money which is a bit different – currency + bank reserve deposits. This is a rather funny metric to use, because under a modern regulatory system, bank reserve deposits are barely relevant. As long as the statutory reserve ratio is below the risk-weighted capital ratio (8% under the original Basle requirements, somewhat more nebulous under Basle II), then the money multiplier is effectively limited by the capital ratio and not the reserve ratio.


Hence BNM’s cut in the reserve ratio was a token and not an effective policy change, unlike the situation in China for instance where the reserve ratio is one of the primary instruments for managing the supply of credit (because it's double the capital ratio). BNM hasn’t seriously used the reserve ratio as a policy instrument since before the 1997 crisis.

What’s even funnier is the description of the cut as “sharp” – it was a 50% cut, which sounds big until you realize that it was from 1% to 0.5%. And the banks have more or less ignored the reserve requirement anyway – the banking system has been flush with cash for years, and they haven’t bothered to lend out the excess (banking system deposits with BNM in RM millions; loan-deposit ratio):

Hence there should be no surprise that interest rates have trended lower in 2009 – there hasn’t actually been a large outflow of capital (and hence a contraction in the money supply), there hasn’t been a massive loss of reserves, and...there isn’t really a story here except maybe UBS wanting to sell something.


(H/T Hafiz Noor Shams - free plug for you, mate!)