March 2011 Monetary Conditions Update

I’m increasingly leaning towards the view that we might see a rate hike tomorrow, when BNM’s Monetary Policy Committee is scheduled to meet. The reasons aren’t hard to figure out – inflation is rising, and credit creation is probably above BNM’s comfort zone (and mine). I’d also consider that 1Q 2011 growth will probably come in stronger than people expect.

But I’m getting ahead of myself. Money supply growth on its own isn’t too excessive (log annual and monthly changes; seasonally adjusted):

August 2010 Monetary Conditions Update

With most of August falling within the month of Ramadhan, an uptick in the money supply is to be expected – much like for Chinese New Year, BNM makes available newly printed money (the physical kind) for “duit raya” and “ang pow”.

On that basis, an acceleration in M1 growth is normal (log annual and monthly changes; seasonally adjusted):

June 2010 Monetary Conditions Update

Despite three consecutive 25bp hikes in the Official Policy Rate, growth in M2 is keeping pretty steady (log annual and monthly changes, seasonally adjusted):

Dec 2009 Monetary Policy Update: Mystery Solved

If you remember my last post on monetary conditions in Malaysia, I was scratching my head over the apparent dichotomy between a whopping increase in the supply of securities into the capital and money markets, while prices defied gravity. Turns out I spoke too soon:

Yields on MGS rose across the board, but especially for 2-yr to 3-yr maturities (which was where the bulk of the issuance in November occurred). And of course, January we've seen the KLCI falling back along with markets across most of the region. I'll call that little mystery now over.

Other interest rates however have been moving the other way - yields on BNM bills and T-bills have dropped slightly, and the average lending rate has fallen to just above 4.8% (an all time low, AFAIK). All of this of course came before the latest Monetary Policy Committee (MPC) meeting this week, which had language indicating that BNM might raise the OPR faster than the markets expect. Stay tuned for more on this subject.

There was little of note in terms of changes in the money supply situation, but there were some interesting things going on with BNM's balance sheet. There has been an injection of liquidity into the system the last couple months, though not anywhere near the scale of intervention in 2008:

This may just be a "normal" liquidity injection, as demand for cash rises at the year-end (people getting bonuses and what-not), as 2007-2008 was an aberration in terms of money demand. One last item:

BNM functions as the government's "banker", hence tracking government deposits with BNM is a useful barometer of actual government spending. With just RM0.5b in MGS redemptions in December, looks like a full RM6b was drawn down from the government's account. Note that there has been a tendency for government deposits to fall in the last couple of months of the year (seasonally adjusted, the level is actually higher than normal), but these aren't normal times. With no annual bonuses for the civil service declared, there isn't the typical one-time drain on financial resources, so I'm inclined to take this as proof of actual government consumption/investment - your tax dollars at work, stimulating the economy.

September 2009 Monetary Policy Update

Banks have begun to raise their lending rates on home loans and other financing – is this justified? From a consumer perspective this is a blow against disposable income, albeit a rather small one (for the moment). But from the banks’ perspective, the rate hike has been probably overdue. The Base Lending Rate (BLR) is supposedly the rate at which banks would lend to their best customers, and essentially provides enough of a margin over their cost of funds (COF) to cover loan defaults, overhead, and reserve requirements. But stiff competition in the banking sector has rendered BLR irrelevant as the benchmark lending rate:




Average lending rates have been consistently below BLR since 2004, and below 3% above overnight money since early 2007:



With prospects of economic recovery now clearer and loan demand sustained, there’s a feeling that interest margins have been overly compressed and banks are mispricing default risks. I have some sympathy for this view – when it comes to loan supply, it’s probably a little better to err on the higher side for pricing. If there is one lesson that we’ve learned from this past crisis, it’s that it’s all too easy to misjudge risk in the financial sector, more so since we have an environment of very low loan defaults and high domestic liquidity. But for those reasons, I don’t expect too much in terms of rate hikes in the next couple of months though – really about 20-30bp, 50bp on the outside.

Speaking of liquidity, there’s been slight movement on the monetary front (log annual changes):



I expect monetary growth to fall back in October-November, but to pick up later in December.

There’s not a whole lot of movement on the interest rate front either. BNM has kept the OPR at 2.00%, and the government only borrowed in September to redeem RM4 billion in MGS that had come due. MGS yields as a result stayed pat:



RM2 bilion in Khazanah bond redemptions also partially offset a year high RM4.5 billion in PDS issuance, so bond supply only marginally expanded.

The only big movement on the monetary front has been the Ringgit, but that's largely a US dollar story and not a Ringgit story, so I'll leave that for another blog post.

August 2009 Monetary Policy Update

Over the Raya holidays, I’ve taken a short break from blogging – family and getting back to work commitments has meant limited time or energy for looking at the economic situation. Plus it’s the start of football season (no, not this type of football, I mean this one - I’m actually watching the Monday Night Football stream right now) so there’s been plenty of distractions the past couple of weeks. But there’s some interesting developments going on and there’s the run up to the tabling of the Budget at the end of this month, which means I’ll hopefully be posting pretty frequently from now on.

But talking about Raya holidays provides a nice segue into what the numbers will say about the economy in August and September. I’ve been harping about seasonal adjustments a great deal in this blog, and holidays are a great example of how differing work/holiday conditions impact economic output. In other words, don’t be surprised if the numbers appear to have turned down the last couple of months – I don’t think I was the only one to take a break off from work or slowed down during fasting month. Looking at the August numbers appears to bear this out.

First, BNM always increases the currency in circulation just prior to Hari Raya and Chinese New Year – no prizes for guessing why. You’d therefore expect to see a jump in money supply figures around those times but especially in M1, as is the case this August (log annual and log monthly changes):




Based on what I’ve described, I wouldn’t ordinarily put too much weight on this increase in monetary aggregates as signaling further monetary easing by BNM or as an autonomous jump in financial activity. There is one interesting anomaly however, with foreign currency deposits in the banking system jumping by RM8.6 billion in August, which is about 2/3rds of the increase in M2:



There’s no obvious reason that I can find for the increase, as neither the stock market nor the Ringgit budged very much in August. International reserves are also up, so BNM has obviously taken some steps to drain forex deposits from the system (log monthly changes in international reserves):



…but that leaves the increase in the banking system unexplained. I’m not sure at this stage whether I want to speculate as to why.

Moving on, loan growth has decelerated (log monthly changes):



…but as I said, this is probably more a function of getting into fasting month and what it entails for output. To underscore what I mean, here’s the loan growth data for working capital and credit cards (log monthly changes):





Since there is an expected drop in output, loan demand from businesses will fall and there will be a corresponding increase in consumption. No surprises here. The corollary is that the opposite should occur after Hari Raya (or Chinese New Year), in other words a drop (or deceleration) in monetary aggregates, increase in business demand for loans, while consumption loans drop.

Now you may ask why I don’t just seasonally adjust the figures in this case, as I’ve done previously? If you haven’t the time or inclination to apply seasonal adjustments (as I explained here) but still want to eyeball the data yourself, it pays to keep potential seasonal factors in mind. Another issue is that seasonal adjustments as applied to Malaysian data are a bit problematical because neither Hari Raya nor Chinese New Year is based on the solar calendar. That means the “seasonal effect” doesn’t occur in the same period every year, which makes statistical treatment a little difficult. Knowing how the numbers react during particular periods therefore helps analysis.

Having said that, seasonally adjusting the numbers doesn’t change the viewpoint very much:

M1 (log monthly changes):


Loan Growth (log monthly changes):


On the interest rate front, lending rates have continued to drift lower – which as far as I’m concerned is good news. What I find interesting is that the lending margin has drifted below the 3% level previously identified as being required for banks to survive an increase in NPLs while maintaining profitability (see this post for details):



This is probably a function of NPLs not actually rising very much during this downturn, which means that banks could be more comfortable competing on price without jeopardizing their capital base at a time when loan demand is softening:



The only other interest rate story of interest (pardon the pun), is in MGS:



Note the flattening of the yield curve at the long end – yields for 10-20-year MGS have dropped between 20bp-30bp in the July-August timeframe, and another 5bp or so in September. Looking back, I think that uncertainty over the public borrowing requirement a few months back really drove prices down. What we’re seeing now is a calmer market, especially since there’s now little support (or requirement) for a third stimulus package and noises from the government about fiscal consolidation in operational expenditure.

Banks: Leverage and the Interest Rate Spread

I've been railing against the slow adjustment in the interest rate margin between what Malaysian banks are charging and their cost of funds (proxied by the overnight interbank rate). Turns out they're not alone in doing this.

An article on VoxEU* examines the profit record of banks during the Great Depression, and makes some telling comparisons with current developments. To make a long story short, commercial banks are probably going to remain relatively healthy (at least, those that don't actually go bust), especially compared to their investment banking brethren. What really caught my eye though is the remarks about the interest rate margin - Euro area and US commercial banks are charging approximately between 2.5%-3.0% above their cost of funds, which is suffcient to handle an average loan portfolio default of about 5% over the next four years. That actually corresponds nicely with what Malaysian banks are charging:



If that's the case, the spread's likely to remain pretty much as it is until we get a handle on actual default rates later this year. Since we're looking at the bottom probably occuring in 2Q2009, that means defaults should peak some time in 1Q2010 assuming a sustainable recovery emerges in the second half of the year.

So we're at or close to the bottom as far as lending rates are concerned, though I still think banks could have cut faster in response to the cuts in the OPR.

In another VoxEU article**, the Research Dept of the Bank of Italy looks at leverage ratios in the global banking industry over the last ten years or so. As you may know, leverage before the crisis, which is the multiple of assets over the underlying capital base (or alternatively your gearing level)***, was sky high in some of the more badly affected banks - the US investment banks were allowed from 2004 to leverage their balance sheet up to 30x, which to my mind was insane.

If you like big numbers, that's 3000% of their capital base. I was surprised to learn that the Euro area banks actually had much higher leverage ratios (one bank exceeded 60x), which may explain why the European banking system was as badly affected as that of the US and UK. In any case, it's clear that leverage was a contributory factor in the fragility of the international financial system.

What are the leverage ratios in Malaysia? Not that bad by comparison:




Of course, this doesn't include off-balance sheet assets, but since domestic banking institutions haven't been that active internationally, I don't think the risk element is any higher than what is implied by the "official" numbers. Having said that, this is one metric I'm going to pay attention to in future.

Technical Notes
*"Lessons from banking profits in the Great Depression", Daniel Gros

**"Financial sector pro-cyclicality: Lessons from the crisis, Part I", Columba, F; Cornacchia, W; and Salleo, C

***There's a difference between leverage as defined here and the risk weighted capital ratio (RWCR), which is a reciprocal of the leverage ratio but with a difference in calculation. The RWCR (min: 8% under Basle I, equivalent to approximately 12x leverage) is based on risk weighted assets, where certain asset classes attract lower risk weights, which effectively reduces the value of assets used in the calculation.

Why Are Lending Rates Falling Less Than Cuts In Interest Rates?

The Star today has a report on why lending rates have lagged cuts in interbank rates over the past few months. Which is fine - there are indeed good technical reasons for such lags and I've experience enough in the banking industry to readily believe why this is happening.

What isn't explained is why lending rate cuts are also less than the fall in interbank rates. I've covered this topic before, but it bears repeating. Borrowing costs are not fully reflecting the drop in bank funding costs - in effect, banks have increased their margin on lending to the point where the real interest rate (as opposed to the nominal rate) is actually higher now than at the beginning of the downturn:




That makes little sense to me, both from a policy perspective as well as a business perspective. We see here a conflict of incentives that could bite the banks if economic conditions continue to deteriorate. On the one hand, there is the desire to buffer income against the possiblity of loan defaults, which to be fair are likely to rise this year.

On the other hand, higher real interest rates reduces the propensity to borrow and invest, thus reducing the pace and trajectory of potential economic recovery, as well as to increase the systemic probability of the very loan defaults that banks fear. By acting to buffer potential losses, banks may actually be encouraging it to happen instead.