Fiji Does Not Have Liquidity Problem, No Trigger For Devaluation

"The sharp decline in system li­quidity over 2018 and into February 2019 has stirred debate on whether the current (lower) levels will hin­der economic growth and prosper­ity."
19 Mar 2019 18:04
Fiji Does Not Have Liquidity Problem, No Trigger For Devaluation
Reserve Bank of Fiji.

At the end of December 2018, Fiji’s banking system liquid­ity was FJ$306m (Figure 1).

This is -49.5 per cent lower than December 2017.

The sharp decline in system li­quidity over 2018 and into February 2019 has stirred debate on whether the current (lower) levels will hin­der economic growth and prosper­ity.

Some commentary has suggested that further falls could result in a devaluation of the Fijian dollar.

In this note, we explain what li­quidity means, its key drivers and why it is an important economic indicator.

We address the question of what defines optimal levels of liquidity, draw implications from the current levels and investigate whether low liquidity triggered Fiji’s four previ­ous currency devaluations.

The liquidity of Fiji’s banking system reflects the ebbs and flows of economic activity, both domesti­cally and in relation to the rest of the world.

While falling, it is certainly not at crisis levels. In fact, it is far from that, as aggregate wholesale de­posit rates have only edged a little higher, on average.

Should we get to levels that inhibit growth, threaten the solvency of financial institutions or impact on financial stability, then the Reserve Bank of Fiji (RBF) will inject more liquidity.

It has the tools to execute that. However, a smaller liquidity pool has pushed up banks’ cost of funds. Banks need to carry sufficient li­quidity to fund loan demand and to meet internal liquidity ratios, so they are aggressively competing for a shrinking pool of liquidity.

This has pushed deposit rates higher with aggregate time deposit rates edging up (Figure 2).

The RBF appears comfortable with a small rise in banks’ cost of funds.

So far, the higher cost of funds has been absorbed into bank margins.

Lending rates have not changed much, with weighted average rates stable at 5.7 per cent since June 2017 (Figure 2).

But, if liquidity continues to re­main tight, lending rates are likely to push higher, which would damp­en credit growth and import de­mand. This might be the RBF’s aim.

At least, we don’t think it would be concerned by such a tightening in liquidity.

Currency devaluations

Currency devaluations, on the other hand, don’t seem to be linked to the falling liquidity.

The RBF has devalued Fiji’s cur­rency four times in response to eco­nomic shocks: twice in 1987 follow­ing the military coups, once in 1998 in response to the Asian financial crisis and again in 2009 due to the global financial crisis.

Each devaluation was intended to discourage capital outflows and shield foreign reserves, make Fiji’s tourism sector competitive and re­store investor confidence.

The liquidity level was not the main trigger for devaluations.

The fact that liquidity in 2009 was just below FJ$300m (similar to cur­rent levels) is coincidental.

We do not believe that Fiji’s econ­omy suffers from a lack of investor confidence or carries a risk of capi­tal flight to trigger a devaluation.

The economy has grown for nine consecutive years, driven by con­sumer demand, exports in par­ticular tourism and strong public investment. Private sector invest­ment is picking up, with upgrades and new investments under way in the tourism sector.

We, like the IMF, believe Fiji is on course to register a 10th year of economic expansion in 2019.

The IMF is projecting Fiji’s econ­omy to grow by 3.4 per cent in 2019, before slowing, albeit marginally, to 3.3 per cent in 2020.

The RBF also retains a comfort­able buffer of foreign reserves, so we do not think there will be a cur­rency devaluation.

Foreign reserve levels drive Fiji’s banking system liquidity

Financial system liquidity de­scribes the reserves that commer­cial banks hold with a central bank, which exceed the mandatory re­serve requirement at the end-of-day.

Commercial banks use these bal­ances to settle claims against each other and to fund new loans and in­vestments.

In Fiji, the system liquidity is commonly referred to as Bank De­mand Deposits (BDD) reflecting the fact that banks can make deposits and withdrawals at any time from these accounts.

The level of liquidity is influenced by the level of foreign reserves, which is, in turn, determined by Fiji’s trading transactions and capi­tal flows with the rest of the world. When there is a surplus of foreign currency receipts – meaning ex­ports, foreign direct investment, aid money and foreign currency loans exceed foreign currency pay­ments – then both the level of for­eign reserves and liquidity rise.

Surplus foreign currency is usu­ally sold to the central bank, which pushes up the level of foreign re­serves.

The central bank then credits the commercial banks’ exchange settle­ment accounts, resulting in a rise in system liquidity.

So the change in the level of bank­ing system liquidity is highly cor­related with the changes in the na­tion’s foreign reserves.

Fiji’s Banking Act 1995 stipulates the proportion of commercial bank deposits (and other similar liabili­ties) that banks should hold with the RBF.

This Statutory Reserve Deposit (SRD) ratio along with currency in circulation are the other factors that can influence the liquidity of the system.

Because the SRD ratio is seldom changed (used sparingly as a policy tool) and the change in the curren­cy in circulation is fairly constant, variations in the level of foreign re­serves are the overriding drivers of shifts in Fiji’s liquidity.

Why does liquidity matter?

The smooth operation of the pay­ments relies on sufficient liquidity.

And that underpins financial sys­tem stability and credit growth, which is key to economic growth. Liquidity is also the main determi­nant of interest rates, so it can in­fluence domestic spending.

If demand is weak, central banks allow liquidity levels to rise, which is described as ‘loose’ or ‘accommo­dative’ monetary conditions.

When liquidity levels are accom­modative, there is less competition for funds so interest rates are gen­erally low.

Consequently, loose monetary conditions can spur credit growth, although this also depends on com­mercial banks’ risk appetite and demand for loans.

Generally speaking, though, as the price of credit (interest rate) falls, the volume of credit increases.

Conversely, when system liquidity declines, interest rates generally rise due to competition for a larger share of a smaller pool of funds.

These higher cost of funds can be passed on to borrowers, which can then slow the pace of credit growth.

Accordingly, the central bank manages the financial system li­quidity so that it delivers the lend­ing rates and/or a rate of credit expansion in the economy that best achieves its desired level of domes­tic demand.

And that usually means meeting its objectives of low and stable in­flation and retaining a sufficient buffer of foreign reserves.

Managing system liquidity is, therefore, the main tool central banks use in managing domestic demand, on average, through the business cycle.

It also helps the central bank re­tain a sufficient buffer of foreign reserves to underwrite the value of the currency.

What is Fiji’s optimal level of liquidity?

Well, that is a call for the Board of the RBF, and is decided at their monthly meetings.

When the RBF has a bias towards tightening monetary conditions (reducing liquidity), it will raise the policy rate and vice versa.

In a functioning money market, changes in policy rate are enough to stimulate or reduce demand.

This is certainly the case for ad­vanced economies, which have well developed money and capital mar­kets. Changes in the official central bank rate flow through to lending rates almost instantaneously.

However Fiji, being a small open economy, is vulnerable to sudden shifts in their external accounts, through either large increases in commodity prices (in particular oil which pushes up imports) or severe weather events that disrupt exports.

Consequently, foreign reserves and bank liquidity can vary con­siderably from year to year, creat­ing obstacles for the transmission channel.

Hence, changes in the policy indi­cator rate are not sufficient to influ­ence domestic demand.

Management of the system’s li­quidity sometimes becomes more important in achieving the desired domestic demand outcomes.

Hence, the RBF Board’s decisions on the appropriate policy rate fac­tor in liquidity levels.

While the RBF has not explicitly tightened its monetary policy – ei­ther by raising the policy rate or increasing the SRD ratio – it has allowed the level of liquidity to fall and commercial banks’ costs of funds to rise.

The RBF is comfortable letting li­quidity settle at a lower level and has publicly stated that it is not concerned by the current levels. It views the present level as not det­rimental to credit expansion and economic growth.

Some implications of the current lower level of liquidity.

As discussed, falling liquidity has pushed commercial banks cost of funds higher.

So far, this has not been passed on to borrowers, with banks ab­sorbing the increase into their margins.

The lending rate through 2018 and into 2019 stayed flat at 5.7 per cent (Figure 2) and is 1.4 ppts be­low the average lending rate since 2000 of 7.1 per cent.

If liquidity remains tight, we an­ticipate these rates to gradually push higher over the short-term. The elephant in the room is gov­ernment deficit financing.

We will know the government’s deficit financing needs when the budget is announced in June.

The government will have two options, either to borrow domes­tically or tap the international bond markets.

The former will be a further drain on domestic liquidity.

However, this may be negated by the RBF calling in some of the Fiji National Provident Fund’s (FNPF) offshore investments, which is allowed at the RBF’s dis­cretion.

As these reserves are not part of the RBF’s foreign exchange hold­ings, calling them in won’t impact the official reserves.

However, the FNPF will receive the Fiji dollar equivalent of their recalled reserves and that will boost liquidity.

Current liquidity does not pose a risk to commercial bank solvency Liquidity in Fiji since the 2000s has averaged FJ$310m a year.

Current liquidity, at FJ$290m, is just below the average for the last 19 years.

As a proportion of nominal GDP, the current ratio of around three per cent, while below the 4.5 per cent average since 2000, is well above a recent low of 0.9 per cent registered in 2008 and is signifi­cantly higher than the 0.7 per cent recorded in the 1990s.

Further, and perhaps more impor­tantly, present liquidity levels have not resulted in a sharp lift in whole­sale deposit rates with average time deposit rates rising 70bps over the last two years from 2.95 per cent in December 2016 to 3.58 per cent in December 2018.

That the cost of funds has been ab­sorbed into bank margins is a sign that banks are not under stress.


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