It is hard to see the relevance of costly liquidity sterilisation in the present environment
Stabroek News
May 7, 2004
Dear Editor,
Before I present my take on the excess liquidity issue, let me congratulate you on your well-thought-out editorial in the Stabroek Business supplement of April 30, 2004. You are absolutely correct that there is no automatic link between excess liquidity and inflation. If there is such a link it is most likely to work through the exchange-rate channel.
Excess bank reserves simply cannot translate into higher purchasing power. In other words excess liquidity, once it exists, simply does not automatically hit the public's pocket. The mechanism for this to occur does not exist in Guyana where certain financial markets (eg a government bond market) are non-existent or very rudimentary. But more importantly, within the Guyana context, people earn money when they work or alternatively money responds when production is carried out. Of course, one can have higher purchasing power by counterfeiting the national currency or robbing banks or sprinkling money onto the public from a helicopter (some may remember Milton Friedman here). But in a civilized society and under normal circumstances we rule out such possibilities. Also, when prices increase the government, businesses and individuals will need more cash to maintain real transactions at levels prior to the price increase. Hence, money must again respond to its higher demand levels. The point being made here is we should not be afraid that too much bank liquidity will drive prices up; indeed the causal process is more likely to be in the opposite direction.
Although not numerous, there have been several studies on Guyanese inflation over the years. However, Syfox's 1992 study and Gampat's 2000 study readily come to mind. Syfox attributed a greater role to money, while Gampat was a lot more agnostic. But what should be obvious is that a single equation study that regresses inflation on money will find a nice coefficient according to expectations. This is because the two are highly correlated and what is found is simply prima facie causation rather than underlying causation. If one reverses the equation by regressing money on price one will also find a nice relationship. So which is it? In my opinion, I tend to believe the latter. The lesson here is inflation is simply not a monetary phenomenon. One has to look at the structure and institutional characteristics of an economy to work out its causes. This is what Gampat tried to do and came up with some interesting results.
So once we start to figure out that excess liquidity does not naturally lead to an inflationary situation, we must start questioning the wisdom of the weekly T-bill auctions. However, as you implied in your editorial, the exchange rate channel is the more likely route through which the liquidity overhang could influence price level. This might occur as banks use the surplus funds to seek out investment opportunities abroad, or simply through speculation by cambio dealers. We know one bank in particular had such inclinations in the past. However, for this to occur it means somebody is not doing his job properly. Of course, if that is indeed the case, that somebody is the Bank of Guyana (BoG). The BoG is entrusted with the mandate to defend the national currency against any such possibility. Speculators must be disciplined, while the BoG has the power to examine the portfolios of local banks to make sure that they are not over extending themselves abroad. So clearly this is an issue for regulation and supervision rather than incessant sterilization.
The BoG, of course, does rightly intervene in the domestic currency market when it sees the need to do so. Whenever it does it directly manipulates the monetary base. Hence there is no need to further manipulate reserve money (the monetary base) by sterilizing excess liquidity through the issuance of T-bills, a costly process which exacerbates domestic debt. I believe moral suasion, strict supervisions, direct intervention in the currency market, and even some coercion are enough to defend the currency. In any case given the highly open nature of the economy and recent weak growth and export performance, if the rate does decide to slide there is little that can be done.
So where is the excess liquidity coming from? Below I posit some possibilities, which are certainly not exhaustive. First, it is correct that there exists a significant amount of economic activities that are not recorded in current GDP figures. However, I do not take only the cynical view that mainly the drug trade drives the underground economy.
A significant amount of legal activities - mainly the self-employed are not captured adequately in the national accounts. These people produce and they must be paid, thus their production elicits a response in the money supply. So while there is a growth in the monetary aggregates, we are not witnessing a corresponding growth in the production figures (note the growth here is not likely to be one-to-one). This money will eventually show up as bank deposits (the largest part of M2). The illegal activities, whatever percentage, must also have a similar effect.
Second, the current system of liquidity sterilization actually contributes to liquidity in the long term. Bills issued today will mature in less than one year and have to be repaid with interest. So where will the interest payment ultimately end up? It must become income to the investors (mainly institutional investors), and if these very investors can't expand credit to the non-bank public, then they must use this income for another round of T-bill purchase. So what we have is a kind of dynamic characterized by a compounding process, building on itself after each cycle of sterilization/maturity.
Third, what must also be clear is that the excess liquidity is a clear case of market failure - in this instance the credit market. There is a very weak link between the reserve position of the banking system and credit expansion. This is because credit expansion is a function of both the willingness of banks to supply credit and also the public's demand for credit. On the demand side as businesses' confidence wanes (what Keynes called animal spirits) or individuals do not demand credit, it should be obvious that the liquidity is going to go nowhere. Given the political crisis since December 1997 the source of low confidence should be obvious. On the other hand, the supply side is characterized by both bank complacency and information failures (what economists call asymmetric information). Information asymmetries because banks just seem incapable of adequately accessing risk in order to pick bad from good borrowers. Complac-ency because they have a ready source of risk-free investment in the form of government T-bills. Abandon the sterilization, while at the same time keep an eye on banks as they search for investments abroad, and we will see them start finding investments in the domestic private sector. The banking sector in Guyana can do better - in the past they have demonstrated their abilities to innovate - but there is no incentive for them to go further under current arrangements. But if they do decide to up lending we must never forget the demand side since it might just not be there. It is particularly important that Congress Place and Freedom House remember the demand side. What I'm tying to say here is for various reasons banks prefer a portfolio low in risk and high in liquidity, while the public also have high liquidity preference holding on to bank deposits and cash. Therefore, it is hard to see the relevance of costly liquidity sterilization in such an environment.
What is needed are unconventional methods in these unconventional times. Even-tually there will have to be direct involvement of the government and opposition to address the logjam in the market for credit. Open market operation (liquidity sterilization every week), intended only for stabilization purposes, will not do the trick; it instead only adds to the domestic debt. The very structure of the economy has to be shaken up to address a clear case of market failure. From here on it is now up to the politicians. There are lots of alternatives, but they just have to look for them. If the government looks only to the IMF it will not get them there since those folks are motivated by a narrow world view and theoretical spectrum.
Finally, Guyanese policy- makers must start by addressing some fundamental questions. Once they start we will better understand the source of the excess liquidity and what must be done to address it. Here are some of the questions, which are not exhaustive. What is the nature of the money supply process in Guyana? Is money supply exogenous, endogenous, or partly endogenous? If endogenous, to what? Can the BoG really control the money supply through the monetary base as it seems to believe? Is monetary targeting, which the BoG pursues, feasible? What is the best instrument of monetary policy in the Guyana context? Can there be a best instrument? Why have most of the advanced countries (and a few middle income ones too) moved away from targeting monetary aggregates onto the direct targeting of the macro objectives (namely inflation) via the base rate of interest? Has any central bank really ever used the Friedman-type base money targeting, as the BoG seems to want to pursue? What is the base rate of interest in Guyana? Can it work under current circumstances? Why must it be pegged to the T-bill rate when most central banks have the discretion to change theirs' as they see fit? What is the transmission mechanism of monetary policy in Guyana? Is it a nice and mechanical process as neoclassical economists seem to believe? Why the fetish over the demand for money function? Possibly the most important of them all: what must be the role of government (and certainly the opposition) in all of this?
And for the more academically inclined: what is money? Once we start to address these questions we might soon realize that we are sitting on a gold mine.
Yours faithfully,
Tarron Khemraj
Richmond Hill,
New York