Friday, July 8, 2011

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.

Given that:

  1. Growth is slowing, yet is expected to recover;
  2. Demand-led inflation is in the offing;
  3. The use of the phrase “further normalisation” suggests that the MPC considers the current monetary stance to continue to be biased towards growth;

…it’s hard to see why they shouldn’t continue to “normalise” interest rates. External developments are definitely important given Malaysia’s high trade exposure, but with money supply and loan growth accelerating (suggesting strong domestic demand), to me the balance of risks suggests erring on the side of caution rather than staying pat. Maybe the May data is confusing the MPC as much as it did me (here and here).

One further consideration is that a stop-and-go monetary policy action fosters uncertainty in financial markets and in investment decisions. Worse, it suggests indecision and an inconstancy of purpose, neither very good things for central bank credibility. I’m curious how decisions in the MPC are made, and who argued for which course – we’ll never know as the minutes aren’t published, unlike the Fed’s or the BOE’s.

On a related note, as expected, BNM raised the statutory reserve ratio 100bp to 4.0%. I’ve been thinking about the SRR on and off for the past week, and I think it’s a tool that doesn’t quite do what it’s supposed to do, but has some interesting consequences.

Recall that the modern banking system is ostensibly based on fractional reserve banking – banks in theory only need to set aside a portion of their liquid assets relative to their non-liquid assets (primarily loans). The remainder can be loaned out. This mechanism is true, but only for a monetary system where cash is backed by gold or foreign reserves. But within that context, an SRR has the effect intended – it reduces the amount of high-powered money that can be converted into loans.

But under the modern fiat-money system, banks don’t need deposits to make loans. The very act of lending creates the required deposits. While the SRR might raise the cost of lending (through reducing the level of liquid assets required to meet transactional demands), it doesn’t actually reduce the ability of a bank to lend or create money. Hence the relative failure of the People’s Bank of China to rein in domestic lending through successive rises in China’s reserve rate.

Moreover, the idea that the SRR is an effective tool to manage overall liquidity doesn’t quite hold water, in the presence of a central bank interest rate target – reducing interbank  liquidity raises the interbank rate, which requires the central bank to replace the liquidity it just leeched from the market to maintain the interbank rate at the target rate. That in effect makes the SRR a potential (cheap) alternative to open market operations.

So what other use could it have? One consequence of the growth of capital markets is that there’s been a shift in the pattern of corporate finance to more bond issuance than bank borrowing. But banks are major players in this area too, with the result that the asset composition of banks’ balance sheets have continuously tilted more towards corporate and government securities, rather than loans to customers. But that means the SRR could have an effect on liquidity through reducing the amount of cash available for investing in debt securities, even if the loan market (and money creation) would still be unaffected. As a consequence, that means that the SRR could potentially be a tool to help indirectly influence asset prices and long term interest rates – making it a fairly broad monetary policy tool, not just a liquidity tool.

So the SRR isn’t quite as useless as I originally thought it to be. But the ramifications are pretty interesting.


  1. Artikel yang menarik..
    Salam dari sahabat di Jogja...^_^

    Universitas Islam Indonesia

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  6. I've been thinking about the SRR as well but I think the SRR does decrease the money supply, assuming actual reserve at various banks in Malaysia was below the new SRR (if it was higher, then the SRR wouldn't matter).

    After all, in fractional reserve banking, the amount of money lent out converges to a point. This is true even with fiat currency. So, that reserve does affect money supply. It decreases it.

    Further, even with purely interest rate-targeting policy, how BNM’s response depends on the targeted rate. If the targeted rate is higher than current one (consensus expected as 25 basis point hike no?), then the SRR might reduce hike pressure.

    (Add the question of independence, given that the govt will need to borrow lots of money...)

    A microscope analogy: big dial (for zoom/large quantum) is the rate, small dial is the SRR (for precision/small quantum). I’ve heard allegation that 100bp increase in SRR is the equivalent of 1.0-2.0 basis point increase in the OPR.

    My problem is that since SRR and the rate are sides of the same coin, then why not just hike the rate at a very small quantum? Like 1 basis point? 5 basis point?

    p/s - sorry for the spam. I wrote and then I thought about it again. I need to research on before saying anything about price-level target with the SRR in mind (which I deleted).

    The reason why I mentioned PLT earlier was that you wrote something about asset-price, which can be addressed through PLT. But I'm too excited about Bersih to research and think about it.

  7. Sorry for the late reply - I've been following the news too.

    Yes, the SRR wouldn't be effective in reducing overall liquidity if the actual reserve ratio (statutory plus excess) was higher than the SRR itself. That's the problem; the reserve ratio hasn't fallen below 15% since mid 2002, and has been above 10% since Jan 1999. SRR at 4.0% will do diddly-squat.

    I was actually thinking much as you are - in the presence of an interest rate target, the SRR is effectively an alternative tool to open market operations for managing the actual rate, as well as being cheaper too because BNM can reduce excess money supply interest-free.

    But then I started thinking about the ramifications on bank balance sheets. From my own banking experience, reserve ratios were never figured into credit decisions. Taken another way, deposits (bank liabilities) don't matter for credit creation (bank assets) at all. The act of creating credit also creates the matching deposit - which is the exact opposite story to that of fractional reserve banking, where banks take existing deposits and extend credit based on those, keeping only a fraction for liquidity and transactional purposes.

    In aggregate, it looks the same but operationally and from the point of view of individual banks its not.

    The difficulty for the bank is that when the loan is actually utilised, unless the counterparty is also a customer of the bank, then both cash (assets) and deposits (liabilities) will be reduced. It's at this point that a reserve ratio (and/or liquidity ratios) will have some meaning.

    But in equilibrium, an increase in the reserve ratio only operates on the asset side of a bank's balance sheet, not both, and does not reduce its size. The effect on credit operates only through the interest rate channel, and that only minimally through cost-of-fund calculations.

    What I'm getting at here (probably badly) is that an increase in the reserve ratio mainly reduces a bank's ability to invest its ready cash in alternative investments such as debt securities, MGS or equities i.e. asset prices.

    Even if the stat ratio is raised higher than the banking system's effective reserve ratio, the main impact will be through an adjustment in the composition of assets, and not on credit creation - since loans are non-market traded and highly illiquid, the brunt will be felt on a bank's holdings of liquid securities and investments.

    The loans to asset ratio has been dropping for years - it was 65% pre-1997, dropped to about 51% in 2007, and recovered to around 57% right now. I think it'll start dropping again as more companies tap the capital markets for funding. Total financing (MGS+PDS+loans) on the other hand is over 70%. That might not sound like much, but the difference is effectively nearly RM200 billion.

    From a macro viewpoint, managing the non-loan assets of the banking system is becoming increasingly important. That's where the SRR might be most effective, as it directly affects the availability of banks' investment funds.