We all want a perfect world.
Just before 2017 came to a close, the Tax Reform for Acceleration and Inclusion (TRAIN) package was enacted into law. Given the state of income distribution in the Philippines, this is expected to spare 99 percent of the Filipino population
from paying income tax because those earning not more than P250,000 per annum will now be tax-exempt. Under the new law, there is a “simpler” and “fairer,” income-tax system that will benefit almost everyone.
Dreaming of utopia
Recently, there have been some segments of the community who would like to have another sort of TRAIN. There are banks who were reported to be complaining of “tightness” in liquidity in the Philippine financial system. In fact, some of them are now raising the specter that the financial system is in a very tight liquidity situation that should warrant a reduction in the reserve requirements (RR).
At the same time, they are quick in proposing an increase in the BSP’s policy rate to mitigate any inflationary impact of the proposed monetary move.
In theory, RR adds to banks’ intermediation cost and effectively acts as a tax on intermediation. The current RR ratio stands at 20 percent, which means that, for every P1 of deposit and deposit substitute generated by banks, the BSP requires that 20 centavos be set aside as buffer, representing the portion that banks cannot lend out. This is clearly a monetary measure to manage liquidity, as it is a prudential policy to ensure banks have liquid buffers in case of any contingency.
There is a clear case to balance the interpretation and subsequent analysis whether the banking system is coming under increased strain to the point that the risks involved warrants a reduction in the RR soonest.
Is this certainly the case?
Looking at the facts as fact
IRC has paved the way for active liquidity management
First, total placements in the BSP liquidity facilities amounted to almost P1.3 trillion on May 25, 2016 (last Wednesday of May), before the implementation of the interest rate corridor (IRC) system. The volume fell to P571 billion as of January 16, 2018.
Ergo, the market must be tight.
Is this the correct interpretation?
Before the IRC, there was so much placement in BSP facilities but, today, the number says there is less. True.
But where did the money go?
Banks should be the first to know that they have been funding their clients’ higher need for loans. Loans grew by more than an average of 19 percent in 2017. Banks have also reduced their placements with BSP in order to buy foreign exchange for funding their clients’ imports, external debt payments and prepayments, as well as outward investments. This is precisely what the BSP wants to see happening. Banks should be more creative and aggressive in deploying deposits to fund productive activities, as well as managing their liquidity to minimize idle funds. We want the banks to reduce their reliance on Central Bank facilities and, instead, take on a more active role in increasing the economy’s productive capacity and promoting more economic activities. We want the banks to buy more government securities and help fund infrastructure and, in the process, also help develop and deepen the capital markets.
This is what is happening, and it’s therefore puzzling why some would find the evolving condition as tight.
Credit and liquidity remains buoyant
Second, there is no sufficient basis to say that liquidity is tight when money supply remains to be ample and buoyant, and credit growth is robust. Latest data shows that M3 (an indicator of money supply and liquidity) and bank lending continue to expand at double-digit rates. M3 grew by 14 percent year-on-year to about P10.4 trillion in November 2017, from P9.1 trillion last year. Meanwhile, loans extended by banks continued to expand robustly by 19.2 percent to P6.96 trillion, from P5.84 trillion for the same period.
Overall credit growth is also considered to be keeping pace with the requirements of the economy, with broad-based bank-lending growth reflecting solid demand for loans across key economic sectors and households.
Now that the funds have been deployed as loans, payments for FX purchases and government securities, what happens next?
There is a cycle here. The funds disbursed by Philippine banks to clients will actually circulate within the banking system.
As loans, the liquidity is used by borrowers to pay their creditors and suppliers, who would, in turn, deposit their payments with their own banks. The funds used to buy dollars would also end up with the dollar-surplus banks, which sold the dollars for pesos in the first place.
Similarly, the liquidity received by the national government (NG) from selling securities would end up with the BSP as its depository or to the government’s own creditors and suppliers, who would place their payments back to the banks themselves. This circling of funds is called the money-multiplier process.
RR as the BSP’s liquidity-management tool and microprudential tool
Third, we emphasize that the RR ratio is fundamentally a monetary tool, and reductions in the ratio will tend to have corresponding monetary—and, therefore, inflationary consequences.
So, how is the inflation rate doing?
The balance of risks to the inflation outlook is on the upside for 2018-2019. The BSP estimates that inflation could settle in the upper bound of the 3-percent ± 1- percentage point target range for 2018-2019 due to the significant upside risks, including those arising from the NG’s fiscal reform program. This means that, if we reduce the RR at a time when prices are expected to rise, then, while that makes a lot of sense for financial intermediation, it is bad for monetary policy. And, if interest rates are jacked up, the banks stand to gain on both fronts: more funds to lend at higher interest rates. They get back their funds from reserves for which they don’t get paid for, lend them out or place them with the BSP’s facilities to earn interest. Hence, the BSP will have to do its homework in finding the best time to adjust the RR. A good consideration without doubt is that such a move should be consistent with the BSP’s monetary-conditions assessment and the stance of monetary policy. RR adjustment is necessary, but not at the expense of price stability.
At the same time, the liquidity released through a reduction in RR could fuel risk-taking activity and the buildup of risks to financial stability. Infusing liquidity into the financial system at a time of robust credit growth through a reduction in RR could fuel: (a) unnecessary lending and borrowing activities in sectors that warrant close monitoring, such as real estate; or (b) speculative activity against the peso.
Activation of liquidity ratios
Fourth, the BSP has just announced the activation of the liquidity coverage ratio (LCR), a macroprudential tool that addresses excess liquidity in the system. This move by the BSP to preemptively arrest excessive liquidity fundamentally implies that liquidity is not getting tighter.
On the other hand, if there is overleveraging or excessive risk-taking activities in some sectors, there are macroprudential regulations, such as the LCR, that are in place. Monetary policy is not the cure for everything. There are more focused tools that directly constrain lending where it is in excess and, therefore, keep financial stability in check.
BSP’s powerful tools: Patience and time
The BSP has particular interest in managing and providing the right amount of liquidity in the financial system, but prudent policy-making dictates that policy actions be evaluated vis-à-vis their stated objectives. The BSP’s main objective is to maintain price stability and monetary stability, not simply to reduce taxes (implicit tax brought about by the RR) that may result from its monetary policy.
Against this backdrop, the BSP has always exercised patience in collecting data and calibrating policy scenarios. The BSP endlessly conducts surveys and assesses the impact of recent developments to ascertain any second-round effects and evidence of inflation expectations becoming more elevated.
The BSP has effectively shifted to the IRC that absorbs liquidity, providing further latitude for the BSP to reduce its reliance on RRs for liquidity absorption at a proper timing, pacing and magnitude. These considerations, as being data-driven, depend on the current outlook for inflation, ample domestic liquidity, robust credit growth and
potential risks to financial stability.
Indeed, there is a time for everything, and this is also true for monetary policy.