No liquidity problem: ANZ research
The liquidity of Fiji’s banking system reflects the ebbs and flows of economic activity, both domestically and in relation to the rest of the world.
While falling, it is certainly not at crisis levels. In fact, it is far from that, as aggregate wholesale deposit rates have only edged a little higher, on average.
Should we get to levels that inhibit growth, threaten the solvency of financial institutions or impact on financial stability, then the Reserve Bank of Fiji (RBF) will inject more liquidity.
It has the tools to execute that. However, a smaller liquidity pool has pushed up banks’ cost of funds. Banks need to carry sufficient liquidity to fund loan demand and to meet internal liquidity ratios, so they are aggressively competing for a shrinking pool of liquidity. This has pushed deposit rates higher with aggregate time deposit rates edging up (Figure 2).
The RBF appears comfortable with a small rise in banks’ cost of funds.
So far, the higher cost of funds has been absorbed into bank margins. Lending rates have not changed much, with weighted average rates stable at 5.7 per cent since June 2017 (Figure 2).
But, if liquidity continues to remain tight, lending rates are likely to push higher, which would dampen credit growth and import demand. This might be the RBF’s aim.
At least, we don’t think it would be concerned by such a tightening in liquidity.
Currency devaluations
Currency devaluations, on the other hand, don’t seem to be linked to the falling liquidity.
The RBF has devalued Fiji’s currency four times in response to economic shocks: twice in 1987 following the military coups, once in 1998 in response to the Asian financial crisis and again in 2009 due to the global financial crisis.
Each devaluation was intended to discourage capital outflows and shield foreign reserves, make Fiji’s tourism sector competitive and restore investor confidence.
The liquidity level was not the main trigger for devaluations.
The fact that liquidity in 2009 was just below FJ$300m (similar to current levels) is coincidental.
We do not believe that Fiji’s economy suffers from a lack of investor confidence or carries a risk of capital flight to trigger a devaluation. The economy has grown for nine consecutive years, driven by consumer demand, exports in particular tourism and strong public investment. Private sector investment is picking up, with upgrades and new investments under way in the tourism sector.
We, like the IMF, believe Fiji is on course to register a 10th year of economic expansion in 2019. The IMF is projecting Fiji’s economy to grow by 3.4 per cent in 2019, before slowing, albeit marginally, to 3.3 per cent in 2020.
The RBF also retains a comfortable buffer of foreign reserves, so we do not think there will be a currency devaluation.
Foreign reserve levels drive Fiji’s banking system liquidity
Financial system liquidity describes the reserves that commercial banks hold with a central bank, which exceed the mandatory reserve requirement at the end-of-day. Commercial banks use these balances to settle claims against each other and to fund new loans and investments.
In Fiji, the system liquidity is commonly referred to as Bank Demand Deposits (BDD) reflecting the fact that banks can make deposits and withdrawals at any time from these accounts.
The level of liquidity is influenced by the level of foreign reserves, which is, in turn, determined by Fiji’s trading transactions and capital flows with the rest of the world. When there is a surplus of foreign currency receipts – meaning exports, foreign direct investment, aid money and foreign currency loans exceed foreign currency payments – then both the level of foreign reserves and liquidity rise.
Surplus foreign currency is usually sold to the central bank, which pushes up the level of foreign reserves.
The central bank then credits the commercial banks’ exchange settlement accounts, resulting in a rise in system liquidity.
So the change in the level of banking system liquidity is highly correlated with the changes in the nation’s foreign reserves.
Fiji’s Banking Act 1995 stipulates the proportion of commercial bank deposits (and other similar liabilities) that banks should hold with the RBF.
This Statutory Reserve Deposit (SRD) ratio along with currency in circulation are the other factors that can influence the liquidity of the system.
Because the SRD ratio is seldom changed (used sparingly as a policy tool) and the change in the currency in circulation is fairly constant, variations in the level of foreign reserves are the overriding drivers of shifts in Fiji’s liquidity.
Why does liquidity matter?
The smooth operation of the payments relies on sufficient liquidity. And that underpins financial system stability and credit growth, which is key to economic growth. Liquidity is also the main determinant of interest rates, so it can influence domestic spending. If demand is weak, central banks allow liquidity levels to rise, which is described as ‘loose’ or ‘accommodative’ monetary conditions. When liquidity levels are accommodative, there is less competition for funds so interest rates are generally low. Consequently, loose monetary conditions can spur credit growth, although this also depends on commercial banks’ risk appetite and demand for loans. Generally speaking, though, as the price of credit (interest rate) falls, the volume of credit increases. Conversely, when system liquidity declines, interest rates generally rise due to competition for a larger share of a smaller pool of funds. These higher cost of funds can be passed on to borrowers, which can then slow the pace of credit growth.
Accordingly, the central bank manages the financial system liquidity so that it delivers the lending rates and/or a rate of credit expansion in the economy that best achieves its desired level of domestic demand.
And that usually means meeting its objectives of low and stable inflation and retaining a sufficient buffer of foreign reserves. Managing system liquidity is, therefore, the main tool central banks use in managing domestic demand, on average, through the business cycle.
It also helps the central bank retain a sufficient buffer of foreign reserves to underwrite the value of the currency.
What is Fiji’s optimal level of liquidity?
Well, that is a call for the Board of the RBF, and is decided at their monthly meetings.
When the RBF has a bias towards tightening monetary conditions (reducing liquidity), it will raise the policy rate and vice versa.
In a functioning money market, changes in policy rate are enough to stimulate or reduce demand.
This is certainly the case for advanced economies, which have well developed money and capital markets. Changes in the official central bank rate flow through to lending rates almost instantaneously. However Fiji, being a small open economy, is vulnerable to sudden shifts in their external accounts, through either large increases in commodity prices (in particular oil which pushes up imports) or severe weather events that disrupt exports.
Consequently, foreign reserves and bank liquidity can vary considerably from year to year, creating obstacles for the transmission channel.
Hence, changes in the policy indicator rate are not sufficient to influence domestic demand. Management of the system’s liquidity sometimes becomes more important in achieving the desired domestic demand outcomes. Hence, the RBF Board’s decisions on the appropriate policy rate factor in liquidity levels.
While the RBF has not explicitly tightened its monetary policy – either by raising the policy rate or increasing the SRD ratio – it has allowed the level of liquidity to fall and commercial banks’ costs of funds to rise.
The RBF is comfortable letting liquidity settle at a lower level and has publicly stated that it is not concerned by the current levels. It views the present level as not detrimental to credit expansion and economic growth.
Some implications of the current lower level of liquidity.
As discussed, falling liquidity has pushed commercial banks cost of funds higher.
So far, this has not been passed on to borrowers, with banks absorbing the increase into their margins.
The lending rate through 2018 and into 2019 stayed flat at 5.7 per cent (Figure 2) and is 1.4 ppts below the average lending rate since 2000 of 7.1 per cent.
If liquidity remains tight, we anticipate these rates to gradually push higher over the short-term. The elephant in the room is government deficit financing.
We will know the government’s deficit financing needs when the budget is announced in June. The government will have two options, either to borrow domestically or tap the international bond markets.
The former will be a further drain on domestic liquidity. However, this may be negated by the RBF calling in some of the Fiji National Provident Fund’s (FNPF) offshore investments, which is allowed at the RBF’s discretion.
As these reserves are not part of the RBF’s foreign exchange holdings, calling them in won’t impact the official reserves. However, the FNPF will receive the Fiji dollar equivalent of their recalled reserves and that will boost liquidity.
Current liquidity does not pose a risk to commercial bank solvency
Liquidity in Fiji since the 2000s has averaged FJ$310m a year.
Current liquidity, at FJ$290m, is just below the average for the last 19 years.
As a proportion of nominal GDP, the current ratio of around three per cent, while below the 4.5 per cent average since 2000, is well above a recent low of 0.9 per cent registered in 2008 and is significantly higher than the 0.7 per cent recorded in the 1990s. Further, and perhaps more importantly, present liquidity levels have not resulted in a sharp lift in wholesale deposit rates with average time deposit rates rising 70bps over the last two years from 2.95 per cent in December 2016 to 3.58 per cent in December 2018.
That the cost of funds has been absorbed into bank margins is a sign that banks are not under stress.