LIQUIDITY CRUNCH
THE banking system plays an important role in the economy. It lubricates the engine of the economy which are the productive sectors, foreign trade and government operations. Liquidity is an important indicator of the conditions of the banking system.
I am motivated to share my experience on liquidity after listening to the Parliament debate and public discussions. I wish to contribute to these debates and explain what liquidity means, what drives it, and very importantly, the impact of the reduction in liquidity on the economy and government operations.
This first of two articles explain the basics that we need to grasp to fully understand the reasons for the changes in liquidity. This will prepare the ground for the second article which will analyse the possible impact of the decline in liquidity.
What is liquidity?
When we talk about liquidity, we are referring to the liquidity of the commercial banks. There are several definitions of this liquidity.
The broad definition is the total assets of the commercial banks because banks can convert these assets into cash. But some assets like loans may take some time to recall and the conversion process cost money.
For the purpose of our discussion, I have chosen to adopt the narrow definition of liquidity which means the free cash that the commercial banks hold at any point in time.
These would consist of currency notes and coins, plus any asset that is easily converted into cash. For security reasons, commercial banks do not hold too much cash. Instead, they deposit most of their cash with the Reserve Bank of Fiji (RBF).
The commercial banks are also mandated by law to maintain special deposits with the RBF equivalent to a minimum percentage of their total deposits.
These special deposits are called “statutory reserve deposits” (SRD) and are held for prudential reasons and used as an instrument of monetary policy. The definition of free liquidity excludes these SRDs.
Commercial banks aim to hold a level of liquidity based on the volatility in their deposit base. The RBF also has a view on the appropriate liquidity in the banking system which is consistent with its monetary policy stance.
The departure point is that the commercial banks are concerned about their individual liquidity while the RBF is concerned about the system liquidity.
When they wish to increase their individual liquidity, the commercial banks can:
Sell their assets like government bonds and treasury bills;
Slow down lending by raising interest rate or rationing loans;
Borrow from the RBF for a short period of time. To encourage this to happen, the RBF may lower its lending rate; and
Borrow from other banks.
To raise the liquidity of the entire banking system, the RBF can:
Reduce the SRD releasing these deposits to commercial banks. The RBF has been using this option lately; and
Reduce their policy rate hoping to influence short-term money market rates and ultimately the deposit and lending rates. This policy rate has remained the same since 2011.
To reduce liquidity, the RBF and the commercial banks can do the following:
Commercial banks can buy more government bonds and treasury bills;
Commercial banks can accelerate lending by lowering interest rate;
The RBF can sell RBF Notes to absorb liquidity; The RBF can increase the SRD forcing commercial banks to deposit more monies with it; and
The RBF can increase their policy rate.
What the commercial banks and the RBF choose to do will create ripple effects within the banking system and beyond to the government operations and the economy.
What causes liquidity to change?
The level of liquidity of the banking system is affected by two factors. First are the policy actions by the RBF to maintain financial stability. As discussed above, the RBF has several levers that they can use for this purpose.
The other factors that affect liquidity are the changes in its determinants.
The assets of the banking system determine the amount of liquidity. The major assets of the banking system are foreign reserves and loans of commercial banks. When these changes, liquidity will change.
Loans by commercial banks change gradually. In most instances, the fluctuations in foreign reserves are the major cause of the changes in liquidity.
How do foreign reserves affect liquidity?
When we sell something abroad, foreigners pay the foreign currencies to our commercial banks who give us the Fiji dollar equivalent.
In turn, the commercial banks are required by law to sell these foreign currencies to the RBF at the end of each working day. When this happens, total liquidity rises as new money has been injected into the system.
The reverse happens when we pay for imports. Foreigners demand to be paid in the major global currencies such as the US dollars.
To pay for imports, importers convert Fiji dollars to foreign currencies through their commercial banks who in turn buy these foreign currencies from the RBF. When this happens, liquidity is reduced as money has leaked out of the system.
Trend in liquidity
In my view, there should be no disagreement that liquidity as defined by the free reserves of commercial banks has declined. How much has liquidity declined by?
Source: RBF Quarterly Review June 2019
By the end of 2018, liquidity has declined to half of its 2013 level — a massive drop of about $300 million. Furthermore, the decline is structural as shown by the arrow in the chart. Because of prudential reasons, the RBF cannot continue to reduce the SRD.
What is causing this structural decline in liquidity? The simple answer is the decline in foreign reserves. For instance, foreign reserves declined by about $300m in 2018 leading to the drop of the same amount in liquidity.
What is an adequate level of liquidity?
Some may rightly ask, what is the right level of liquidity? Presenting liquidity in dollar terms will not answer this question. Commercial banks normally hold liquidity based on the size of their liabilities which are mostly deposits.
As these liabilities grow, we would expect commercial banks to hold more liquidity.
But we see that liquidity in dollar terms is falling while deposits with commercial banks are growing. The result is the decline in, what is termed, the liquid asset ratio (liquid assets over total deposits).
Source: RBF Quarterly Review June 2019
The liquid asset ratio was negative or zero in the first five months of this year. In my recollection, this has never happened before.
To me this means two things: a) that the commercial banks are not able to hold as much liquidity as they wish to hold; or b) that the market has become more efficient. In my view, it is more of the latter.
The above analysis confirms three things: a) that liquidity has declined; b) the decline is structural; and c) the level of free liquidity in the banking system is inadequate.
How serious is this scenario? We will discuss how serious it is in the next article.
But the writings have been on the wall for a longtime. The decline in foreign reserves is systemic not cyclical.
It reflects the lack of sustainable solutions to reverse the demise of our traditional exports. We will add fuel to the fire if we chose to borrow offshore to artificially prop up our foreign reserves.
Some may argue that the RBF can use its monetary levers to raise liquidity. But increasing liquidity is much more difficult to achieve than reducing liquidity. In any case, the root of the multiple problems that we face is not monetary in nature.
These monetary and financial indicators like liquidity are simply symptoms of problems in the fiscal and real sectors.
We therefore cannot solve our problems through monetary or financial policies alone.
In any case, from my experience and knowledge, the monetary levers that the RBF has to raise liquidity are sluggish and prone to serious side effects.
Understanding the above fundamentals will allow us to analyse the impact of the low level of liquidity and possible solutions that we should urgently consider in the next article. Savenaca Narube is a former governor of the Reserve Bank of Fiji. The views expressed in the article are his and not necessarily of this newspaper.