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Dealing with Excess Liquidity


Ineffectiveness of monetary policy. Reduced bank profitability. ... of Monetary Policy. Monetary policy using market-based instruments becomes ineffective. ... – PowerPoint PPT presentation

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Title: Dealing with Excess Liquidity

Dealing with Excess Liquidity
  • Joint Africa Institute
  • September 15th, 2005
  • Geoffrey Heenan. IMF.

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
  • Generally defined as banks holding of reserves
    over and above what they need for transactions
  • 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.

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
  • 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

Example of Relationship between Excess Reserves
and Money Market Conditions
Excess Reserves
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.

What Prevents Excess Funds from Being Lent and
  • 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.

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)

Static Issues Arising from Excess Liquidity
  • Excess reserves are scarce financial resources
    that are yielding neither returns nor liquidity
  • 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

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

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.

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.

Banks Liquidity Management and Money Market
  • 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
  • Again, question of what causes what.

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.

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
  • 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.

Excess Liquidity and FX Market
  • Excess liquidity can lead to pressure in the FX
  • 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.

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.

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
  • Address macroeconomic imbalances
  • Appropriate response depends on causes of excess
    liquidity, and whether static or dynamic issues
    are more important.

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.

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.

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

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

  • Need to estimate banks transaction demand for
    excess reserves.
  • Sterilizing excess liquidity is costly, and may
    not be necessary if liquidity isnt going
  • 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.
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