The Endogenity Of Money

I’ve been meaning to write a post about my…conversion…to endogenous money theory for many moons now, but its always been on the back burner. The reason why I think endogenous money is important is because conceptually, it provides a much more accurate view of how the financial and monetary system in the modern era actually works.

And the reason why I’m posting about it now is because somebody did a remarkably good summary of endogenous money theory (excerpt):

Endogenous Money 101

Money is at the centre of all modern capitalist economies. Understanding its nature and origins is therefore of great importance. At the heart of Post Keynesian monetary theory is the idea of endogenous money.

This is opposed to the mainstream exogenous money supply theory: the idea that the central bank has direct control over the money supply and its growth. The latter theory is wrong, and I review that major points of endogenous money below.

Modern Money Creation

A fascinating article on VoxEU yesterday about what I’d consider to be shadow banking, and its a fairly clear exposition (excerpt):

The (other) deleveraging: What economists need to know about the modern money creation process
Manmohan Singh & Peter Stella

The world of credit creation has shifted over recent years. This column argues this shift is more profound than is commonly understood. It describes the private credit creation process, explains how the ‘money multiplier’ depends upon inter-bank trust, and discusses the implications for monetary policy.

More On Monetary Policy Transmission Through Interest Rates

After a short hiatus for the beginning of fasting month, I’m back…or at least until we come up to Aidil Fitri

As a follow up to my post a couple of weeks back on the monetary transmission mechanism, there’s a new working paper out from the IMF that essentially confirms my findings (abstract):

Determinants of Interest Rate Pass-Through: Do Macroeconomic Conditions and Financial Market Structure Matter?
Nikoloz Gigineishvili

Summary: Numerous empirical studies have found that the strength of the interest rate pass-through varies markedly across countries and markets. The causes of such heterogeneity have attracted considerably less attention so far. Unlike other studies that mainly focus on small groups of mostly developed and emerging markets in the same region, this paper expands the cross-sectional coverage to 70 countries from all regions, including low income, emerging and developed countries. It uses a wide range of macroeconomic and financial market structure variables to uncover structural determinants of pass-through. The paper finds that per capita GDP and inflation have positive effects on pass-through, while market volatility has a negative effect. Among financial market variables exchange rate flexibility, credit quality, overhead costs, and banking competition were found to strengthen pass-through, whereas excess banking liquidity to impede it.

My calculated elasticities for Malaysia’s policy interest rate pass through falls right on the average for Asia as a whole. So Malaysia's not that far out of line.

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.

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):

Lies, Damn Lies Part II

I thought I might take a little time to clarify a few things from my previous post.

First, why does the exchange rate regime matter in terms of movements in reserves? In theory, a fixed exchange rate regime requires that a central bank buys and sells foreign currency to maintain the exchange rate parity between the domestic currency and the target currency, which is typically either the USD (a'la Bretton Woods arrangements from 1944-1972) or a "basket" of currencies. Both China (implict) and Hong Kong (very explicit) use fixed rate regimes. Singapore is slightly different - MAS uses an exchange rate target to manage domestic monetary conditions, although the mechanism is similar.

With a fixed rate target, reserves will accumulate or be lost with changes in trade and capital flows - if there is an excess of inflows (trade surplus, or portfolio inflows), then demand for local currency exceeds foreign currency and the exchange rate should appreciate.

To maintain parity, the central bank creates domestic money (yes, out of thin air - it's only an accounting entry), and uses this to buy foreign currency. This has the effect of meeting the increased demand for local currency, as well as simultaneously creating greater demand for foreign currency, and hopefully balancing out the market exchange rate. In this scenario, the foreign currency bought by the central bank goes into its foreign exchange reserves account (on the asset side of the central bank's balance sheet), while liabilities (domestic cash) increases by the same portion.

A secondary effect of these transactions is thus a de facto increase in the domestic money supply and downward pressure on interest rates, since money was created to buy the foreign currency. If this is a concern to the central bank, then it "sterilises" the intervention by draining liquidity from the money market through the issue of securities. The total net effect of a full intervention and sterilisation exercise is thus an increase in reserves (assets) and an increase in issued securities (on the liabilities side), with the money supply staying pat.

The reverse happens when there is an outflow and full intervention - reduction in reserves (asset side) and a reduction in money supply (liabilities) in the case of non-sterilisation, or reduction in securities (liabilities) in the case of sterilisation.

There's actually only one effective difference between money and securities - they're both liabilities of the central bank, but from the banking system's perspective only money can be used to further credit (i.e. loans to you and me). Hence, in a fixed rate regime, domestic monetary policy operations are far more complicated.

Under a free float regime, of course, there's no apparent necessity for intervention at all and thus no incentive to accumulate reserves, except for one big reason I'll cover later.

So given the narrative above, here's what happened in Malaysia in 2008:

1. Big changes in inflows and outflows

First the run-up in commodity prices increased Malaysia's exports earnings beyond the average, up to about the middle of 2008 (trade balance, balance of payments basis, RM millions):

Then, as the financial crisis took hold in the latter half of 2008, there was a huge flight to safety by foreign investors:

2. And here's what the commodity and financial markets were doing:

Notice the symmetry between all the markets. Also note that investors (the smart money) had already begun to pull out before the markets peaked.

3. The impact on financial institutions:

Here's one good reason why a central bank would accumulate reserves even under a floating regime - if foreign liabilities exceeds assets, then there is the potential for an external default in either the private sector or within the banking system itself - not from insolvency, but through lack of liquidity. You have the money, but not the right kind of money. To avoid that, you save up on the right kinds of external money to make sure you can meet all your external obligations i.e. accumulate reserves.

Another way of having this insurance is by doing swap agreements with other central banks, thus creating a collective pool of external reserves i.e. what we're doing now under the Chiang Mai Initiative. This reduces the cost of hoarding on your own.

4. And this what BNM did to manage the whole shebang (all items from BNM's balance sheet, RM millions):

Note how this fits into the narrative above. With upward pressure on the Ringgit in 2007-2008, BNM intervened by supplying Ringgit to the market in exchange for foreign currency, while simultaneously issuing BNM bills to limit growth in the domestic money supply. After commodity prices started dropping, and portfolio investors started pulling out, the opposite happened - intervention to support the Ringgit, and buying and cancelling of bills to ensure the domestic money market remain liquid.

While BNM does not have an exchange rate target (at least I don't think they do), from comments by the Governor they have made a commitment to reduce volatility - in other words, they won't stop a depreciation or appreciation but they will limit excessive movements.

Since the inflow of trade receipts in 2007 and early 2008 weren't viewed as sustainable, they obviously felt that upward pressure on the Ringgit had to be capped to avoid a sharp depreciation afterward. And when inflows did turn into outflows, BNM also acted to limit the downward movement. These operations are consistent with a managed float regime, where volatility reduction is a goal.

Hence the sharp changes in reserves, as well as the changes in BNM bills left outstanding in the market - intervention was also sterilised to maintain BNM's real target, which is the short-term domestic interest rate:

5. One last point on the statutory reserve requirement:

The money multiplier (see this post on what this means) based on banks' reserve deposit assets:

...and reserve deposits as a percentage of loans:

As I said in the last post, banks aren't basing credit expansion on the reserve ratio, but rather on the capital ratio:

A statutory reserve requirement of 1% implies a potential money multiplier of 100x, while 0.5% implies 200x. The actual average is actually only around 4x, in contrast to the leverage ratio which was almost right to the limit of what's allowable.

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!)