Dealing with Excess Liquidity

1
Dealing with Excess Liquidity

• Joint Africa Institute
• September 15th, 2005
• Geoffrey Heenan. IMF.

2
What is Excess Liquidity?

• Conceptually, excess liquidity is the sum of
  financial assets that can be very quickly
  mobilized for lending or to purchase foreign
  exchange.
• Generally defined as banks holding of reserves
  over and above what they need for transactions
  purposes.
• Can include currency in circulation in heavily
  cash-reliant economies.
• May include other assets, such as short-term
  deposits at central bank or treasury bills, if
  these can be quickly converted into bank reserves
  at the discretion of commercial banks.

3
How Should Excess Liquidity Be Estimated?

• Estimating transactions demand for excess
  reserves can be difficult
• Use historical pattern of interbank rates and
  activity to estimate a demand curve.
• Canvass banks for their estimates of their
  transcation needs and then aggregate.
• Transactions demand for reserves will depend on
• Characteristics and efficiency of payments
  system.
• Level and volatility of deposits.
• Design of reserve requirements.
• Transactions demand for reserves may exhibit
  large seasonal fluctuations, and may be driven in
  long run by financial reforms and macroeconomic
  stablization.

4
Example of Relationship between Excess Reserves
and Money Market Conditions
Volume
Yields
Excess Reserves
5
What Causes a Surplus of Funds?

• Capital account inflows, such as foreign aid in
  developing countries or foreign direct investment
  in emerging markets.
• Current account inflows, such as commodity export
  revenues or workers remittances.
• Monetization of the fiscal deficit.
• Floors on deposit rates and other controls that
  artificially increase the supply of deposits.

6
What Prevents Excess Funds from Being Lent and
Invested?

• Institutional factors that increase the risk of
  bank lending
• Legal shortcomings problems with enforcing
  credit contracts and seizing collateral, lack of
  defined property rights.
• Lack of credit reporting and bureaus.
• Banking system dominated by state-owned banks
  that are not profit maximizers.
• Caps on lending rates and quantitative controls
  imposed on banks by authorities.
• Cyclical factors that limit banks willingness to
  lend, including weak growth prospects and the
  need to rebuild banks balance sheets after a
  downturn or crisis.

7
Why is Excess Liquidity a Problem?

• Excess liquidity is a symptom whose underlying
  causes are structural problems in the financial
  system or macroeconomic imbalances.
• Need to distinguish between static issues
  (arising from the continued presence of excess
  liquidity on banks balance sheets) and dynamic
  issues (arising from the potential for a sudden
  expansion in credit or increased pressure in the
  foreign exchange market)

8
Static Issues Arising from Excess Liquidity

• Excess reserves are scarce financial resources
  that are yielding neither returns nor liquidity
  services.
• They represent a deadweight loss arising from
  various inefficiencies of the financial system.
• Static issues include
• Ineffectiveness of monetary policy.
• Reduced bank profitability.
• Lack of incentive for banks to manage liquidity
  effectively

9
Ineffectiveness of Monetary Policy

• Monetary policy using market-based instruments
  becomes ineffective.
• When there is excess liquidity, banks are not
  forced to transact with central bank to meet
  liquidity requirements and therefore central bank
  loses ability to influence short-term rates (and
  hence long-term rates and credit growth)
• This is not the standard low interest rate
  liquidity trap (a la Keynes). In most cases, real
  and nominal rates remain high in spite of excess
  liquidity.

10
Monetary Policy Effectiveness and Excess Liquidity

• Removing excess liquidity may not solve problem,
  since excess liquidity is a symptom of factors
  that impede monetary transmission.
• Lack of a functioning money market
• Administrative controls
• Structural impediments to lending
• However, monetary policy based on administrative
  controls may still be effective.

11
Excess Liquidity and Bank Profitability

• Excess liquidity in the form of noninterest
  bearing deposits at the central bank or cash in
  vault reduce bank earnings, thereby reducing
  banks capital and increasing vulnerability.
• May result in higher lending-deposit rate
  spreads, reduced investment
• Again, excess liquidity may be a symptom of other
  factors impacting bank profitability
• Poor bank management.
• Structural impediments to lending.
• Lack of money and other markets.

12
Banks Liquidity Management and Money Market
Development

• Excess liquidity reduces banks incentive to
  manage liquidity using money markets, since most
  banks will have surplus funds.
• Money markets will therefore be very thin or
  nonexistent.
• Again, question of what causes what.

13
Dynamic Issues Excess Liquidity Fuelling a Rapid
Increase in Credit

• Banks could suddenly decide to use excess
  liquidity to finance an expansion in their
  lending, which in turn would lead to an increase
  in deposits and further growth in credit and
  monetary aggregates.
• This could lead to inflation and a deterioration
  in the balance of payments if the economy faces
  resource constraints.
• A rapid increase in lending is usually associated
  with a deterioration in loan quality, increasing
  the risk of a financial crisis.

14
Is Rapid Credit Growth a Threat?

• Since excess liquidity is often caused by
  structural impediments to lending, there is
  little reason to believe that banks will change
  their lending behavior unless something else has
  changed.
• Such changes could include financial sector
  reforms or an increase in confidence arising from
  macroeconomic stabilization. In these cases, it
  may be prudent to reduce excess liquidity in
  order to avoid excessive credit growth.
• When there are large liquidity inflows (due to
  privatization or resource revenues) in a country
  with well-functioning banking system, the central
  bank may wish to sterilize these inflows in order
  to avoid both a real appreciation and excessive
  credit growth.

15
Excess Liquidity and FX Market

• Excess liquidity can lead to pressure in the FX
  market
• Banks can use excess liquidity to buy foreign
  exchange on their account.
• If banks lower their deposit rates in response to
  excess liquidity, the public may withdraw local
  currency deposits to purchase foreign currency.
• This is limited by the enforcement of net open
  limits and exchange controls.
• However, could cause a problem in a crisis if
  these limits and controls can be circumvented.

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If Excess Liquidity is Due to FX Inflows, then
Why Not Sell the FX?

• NIR is low and needs to be increased.
• Dutch disease if some of the inflows are used to
  purchase nontradeables, then the real exchange
  rate will appreciate, reducing the
  competitiveness of the economy.
• If the marginal return on investment in the
  domestic economy is less than overseas returns,
  then savings should be invested aboard.
• Particularly relevent for resource exporters
• Should be separated from reserves held for
  international liquidity purposes.

17
Four Types of Response to Excess Liquidity

• Removing excess liquidity from (or preventing it
  from entering) banking system.
• Stopping excess liquidity from going to credit
  growth and FX market.
• Addressing structural impediments causing excess
  liquidity.
• Address macroeconomic imbalances
• Appropriate response depends on causes of excess
  liquidity, and whether static or dynamic issues
  are more important.

18
Removing Excess Liquidity

• Sales of domestic securities by CB.
• Quasi-fiscal cost is the same whether CB or
  government securities issued.
• Does not address bank management issues
  exchanges a noninteresting bearing asset for an
  interest bearing one lets banks off the hook.
• Increase in reserve requirements.
• Sales of FX, problems alluded to earlier.
• Build-up of government deposits
• Oil funds, privatization funds.

19
Stopping excess liquidity from going to credit
growth and FX market

• Quantitative credit controls impedes
  development of banking sector, risk management.
• Strengthened prudential controls more
  appropriate, addresses loan quality issues.
• Enforcement of net open position limits.
• Exchange controls has implications for FDI and
  optimal portfolio choices.

20
Addressing Structural Issues

• Impediments to lending
• Credit reporting, legal framework for enforcement
  of credit contracts, collateral, property rights.
• Removal of interest rate controls (both deposists
  and loans)
• Improve bank management (including state-owned
  banks)

21
Addressing macroeconomic imbalances

• Fiscal consolidation reduce need for
  monetization of deficit.
• Allow appreciation (but may conflict with real
  exchange rate and NIR objectives)

22
Summary

• Need to estimate banks transaction demand for
  excess reserves.
• Sterilizing excess liquidity is costly, and may
  not be necessary if liquidity isnt going
  anywhere.
• However, if there is a sudden inflow or
  structural reforms (capital account
  liberalization, banking reforms), should
  sterilize to limit flows.
• First best policy is to address underlying
  problems improves efficiency of financial system.