Liquidity: is there a shortage?

Liquidity has become a controversial public issue in recent months. Commercial banks claim that they are suffering from severe liquidity crunch. Business people, especially those associated with the stock market, echo the same view. The central bank of the country (Bangladesh Bank), on the other hand insists that there is no shortage of liquidity in the economy. Ordinary people are left wondering which group is telling the truth. Actually, both are – from their own perspectives.

Liquidity refers to the supply of the means of payments of an economy. It comprises notes and coins and bank deposits since these could be used to settle ordinary payments. In Bangladesh, the totality of liquidity is indicated by what is called 'broad money' or M2.

The amount of money in circulation is an important determinant of transactions done in the economy. As such it has substantial influence on the aggregate demand of the economy. A shortage of money restricts demand by making it more difficult to engage in transactions. Investment is particularly susceptible to liquidity.

The amount of money in circulation is determined to a large extent by the central bank. The central bank is the only issuer of coins and currency notes. It is empowered by appropriate laws and regulations to influence the quantity of monetary transactions that commercial banks can undertake. It has an array of instruments in its armoury to influence the money market. These include cash reserve ratio (CRR), statutory liquidity ratio (SLR), repo, reverse repo, discount window, moral suasion, as well as direct intervention and plain and simple jawboning. The policy regarding the deployment of these instruments is known as monetary policy.

The principal objective of monetary policy in most countries including Bangladesh is to keep inflation low. There is a close relationship between inflation and money. An accelerated monetary growth will sooner or later translate into higher inflation. Since the central bank is uniquely suited to control the money supply, it is given the responsibility to control inflation. Hence, BB's comments on liquidity may be expected to be heavily influenced by its intent to hold down Bangladesh's inflation rate.

Commercial banks mediate between savers and investors of the economy. They mobilise deposits in order to lend them out at a profit, which derives from the fact that the deposit rate is considerably lower than the leading rate. The more they can lend out, the greater would be their profit. Hence, they have a tendency to lend as much as their borrowers demand. However, if they lend too much, they could suffer from a liquidity shortage. In such a situation it is possible that they may be unable to honour the commitment to return deposit money on demand. If this happens, there could be a run on the bank, which could easily spill over to other banks jeopardising the health of the entire financial sector.

In order to prevent such an undesirable outcome, central banks usually require that the commercial banks hold certain proportion of their deposit with them. In Bangladesh, commercial banks are required to hold 6 percent of their deposit liabilities as cash reserves with Bangladesh Bank. Additionally they are required to hold 13 percent of their deposits in cash and 'unencumbered approved securities'. It is obvious that if the reserve requirements are raised, the commercial banks can lend less of their deposits and earn less, while a reduction permits them to lend more and earn more.

When there is a high demand for credit, interest rates rise and the profitability of lending rises. If it were not for the required liquidity ratio, the banks would have lent or invested as much as they could even at the risk of being caught illiquid.  Obviously, when such a situation develops they would complain of a liquidity shortage. Since the demand for liquidity at the existing rate of interest exceeds what they can supply, it is to be expected that they will create pressure on BB to increase the supply of liquidity by switching to more expansionary monetary policy such that they could lend or invest more. Business people who are keen to increase investment would also join the chorus.

The graph below shows the growth rates of money, GDP and prices since 2001-02. It should be immediately evident that the growth rates of liquidity during the last two years were the highest since 2001-02. Given that the GDP growth fell off significantly since 2005-06, it was natural to deduce that a higher monetary growth would fuel inflation. Hence, Bangladesh Bank quite justifiably asserted that there was no shortage of liquidity. Indeed, a conservative central bank would have reduced liquidity in such a situation!

Bangladesh Bank apparently ignored an important indication emanating from the data. The graph shows a fairly close co-movement between monetary growth and inflation until 2006-07. There was large spike in inflation in 2007-08 due mainly to the very large increase in oil and food prices in the world market. However, despite the rapid growth of liquidity, inflation was subdued in 2008-09 and 2009-10. This was good news on the inflation front, but in the context of a stagnant economy, it should have raised the question what the greater liquidity was financing. Although Bangladesh Bank suspected that a large part of domestic credit was diverted to the share market, it did not follow up the matter seriously. This proved costly later.

Many of the commercial banks were heavily involved in the share market. Some of them ignored liquidity requirements as well as the Bangladesh Bank regulation that restricts a commercial bank's investment in the share market to no more than 10 percent of its deposits. Since the share market was very buoyant, they wanted to invest even more. In this milieu Bangladesh Bank finally decided to strictly impose the regulatory requirements. In addition it also raised the CRR by 1 percentage point in December 2010 to 6 percent, which implied that the reserve requirement increased by nearly Tk1900 crore. Since many banks were already over-leveraged, this additional reserve requirement created enormous liquidity pressure, which saw the inter-bank call money rate jump up to 190 percent. The need for cash led to hasty selling of shares that contributed to the subsequent share market crash.

There is little doubt that poor portfolio management by the commercial banks led to their liquidity crisis. However, the crisis was in the making for more than a year. As the supervisory body of the commercial banks, Bangladesh Bank should have acted sooner to prevent the liquidity crisis from developing and spilling over to the stock market. The timing of the Bangladesh Bank action was also inopportune coming as it did at the year-end closing time of the banks.

The crisis underscores the soundness of the old wisdom that central banks should in general avoid tinkering with such blunt instruments as the reserve ratio to achieve their short term policy objectives. Any hike in the reserve ratio impacts more on the weaker banks or banks with liquidity shortages, which may quickly turn an adverse but manageable liquidity position into a crisis situation.

In recent years Bangladesh Bank has taken several innovative steps such as inclusive banking, loans to sharecroppers, bank accounts for farmers, solar power and environmental awareness etc. These are no doubt all highly laudable measures; however, they must not be viewed as either substitutes of, or as important as, the core functions of the central bank. It should be understood that there are other government agencies mandated and better suited to address these issues, but there is none to control the money market, which is exclusively the mandate of Bangladesh Bank. Every additional objective in general requires an additional policy instrument and additional resources to achieve. Bangladesh Bank should take a close look at its strategy and assess what it can realistically achieve given its limited resources.

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M. A. Taslim is a professor of the Department of Economics, University of Dhaka.