In an effort to ease the liquidity shortage in the market, the Central Bank has reduced the Statutory Reserve Requirement (SRR) on rupee deposit liabilities of commercial banks.
The Central Bank says the shortage of liquid dollar balances in international financial markets arising from the ongoing global financial crisis and the higher demand for domestic funds has caused a prolonged liquidity shortfall in the domestic financial markets. Therefore, the Bank decided to further reduce the SRR and thereby to inject more liquidity to the banking system. It is expected that this action would lead to releasing around Rs. 17 billion to the banking system. The Central Bank anticipates that this move will not only ease the liquidity pressure but also will help to bring down interest rates and costs of funds.
By definition, the SRR is the minimum amount of reserves a commercial bank is required to hold with the Central Bank. Traditionally, central banks all over the world required commercial banks to maintain a minimum reserve ratio to ensure the banks’ capacity to fulfill their deposit obligations to customers. Eventually, it became a popular monetary policy instrument. By changing the SRR, a central bank can directly influence the lending capacity of the banking system in two ways. Firstly, as noted earlier, the immediate effect of a reduction in the SRR is the release of funds that commercial banks can use for lending purposes that would otherwise be idling in the Central Bank as required reserves without earning any interest. Secondly, a reduction in the SRR also influences the money multiplier, which in fact is the amount (in rupees) of deposits or loans that the banking system can create from one rupee of excess reserves. A reduction in the SRR leads to an increase in the money multiplier and in turn, the lending capacity of banks. Following the liberalization of the financial sector, central banks in many countries have been increasingly depending on market-based monetary policy instruments, mainly on open market operations. As a result, the significance of the SRR as a monetary policy instrument has diminished over time.
An increasing trend in the money multiplier pertaining to broad money supply (M2 = currency plus demand, time and savings deposits) is evident in Sri Lanka particularly since the mid-1990s. It rose from 2.91 in 1995 to the present level of 4.46. A major factor that contributed to this rapid increase is the gradual reduction of the SRR from 15 % in 1996 to 12 % in 1997, to 11 % in 1999, and to 10 % in 2001. Since then it had remained at 10 % until it was reduced to 9.25 % in October. Apart from the reduction in the SRR, the ratio of currency to deposits held by the public also contributed to the downward trend in the money multiplier over the decades. The currency/deposit ratio which was at a peak level of 73 % in 1961 fell to 27 % in 1980 and to 14 % in 2008. This happened due to variations in households’ portfolio choice in favour of deposits and other monetary assets vis-a-vis currency. This shift could be attributed to a number of factors including the spread of the banking network, financial innovations and attractive returns of bank deposits.
Let us now approximately examine the effects of the recent reductions in the SRR on the money supply. As explained above, the size of the money multiplier depends on two factors, namely the public’s currency/deposit ratio and the banks’ reserve ratio. As at end September, the total bank deposits amounted to Rs. 1,097 billion which required a reserve requirement of Rs. 110 billion at the previous SRR of 10 %. As the present SRR is only 7.75 %, banks have to keep only Rs. 85 billion as reserves. Thus, the Central Bank releases reserves amounting to Rs. 25 billion to commercial banks. The banks can use these additional funds to increase their lending. According to my computations, the downward adjustment of the SRR would raise the money multiplier by about 0.59 from the present level of 4.46 to around 5.05 causing a multiple increase in the money supply. This is in addition to the original monetary expansion arising from release of funds to banks. The additional amount of liquidity thus coming to the market as a result of the increase in the multiplier will be around Rs. 150 billion.
As expected, the injection of liquidity may help to ease the current credit crunch. However, the argument that it would benefit to stimulate the economy will largely depend on how the increased bank lending is going be used by the borrowers. Obviously, utilization of such additional liquidity for productive purposes will enhance economic growth. But if such lending is used for consumption purposes, there will be further pressures on both the inflation and import payments, which have already reached uncomfortable proportions. In spite of the marginal decline in consumer prices in the last two months, the annual average inflation still remains over 23 %. Meanwhile, the trade deficit increased by 88 % in the first 9 months of this year to $4.6 billion from $2.4 billion in the corresponding period of last year.
The decline in global commodity prices would ease the balance of payments situation in the coming months. But the additional liquidity injected to the market will have a positive impact on import payments thereby worsening the external payment position. Meanwhile, the inflationary pressures arising from the increased money supply will also have adverse effects on the export competitiveness further widening the trade deficit. This would call for a depreciation of the rupee. Inflationary pressures emanating from these underlying forces are likely to negate the expected reduction in interest rates as well.