Over the weekend, SBP made a surprising blunt move to tighten the money supply by increasing banks’ cash reserve requirement (CRR) by 1 percent. This will suck around Rs150-170 billion from the banking system in a flash. Unlike, policy rate adjustment, efficacy of CRR is definitive and instantaneous. It is subtle and insulated from political backlash. Usually, such moves are clubbed with monetary policy decision– like the way it happened in 2008. Doing it two weeks prior to monetary policy is perhaps an attempt to arrest the drip-by-drip currency depreciation trend.
However, higher money supply is perhaps not mainly due to the private credit expansion. The prime reasons are government borrowing and higher influx of remittances. In 2008, when CRR was increased from 7 percent (average) to 9 percent at its peak, the advance to deposits ratio (ADR) for banks was over 70 percent (with some banks in 90s). At that time increasing CRR and Statuary Reserve Requirement (SLR) were making more sense to curb credit demand. Then it was reduced to 5 percent in 2012. And now in 2021, it has increased for the first time in nine years to 6 percent.
Currently, ADR is hovering below 50 percent. The government borrowing is heavily reliant on banks in days when the government has a self-imposed restriction (under a condition of IMF) on borrowing from the SBP. The weekly net injection in open market operation (OMO) is over Rs2 trillion. The toll is consistently above Rs1 trillion for some time. There is permanent liquidity injection. At the same time increasing CRR is counterintuitive. Back in 2008, SBP was mopping excess liquidity through OMOs.
The CRR reduction is to discourage private lending. SBP, on the other hand is giving one concessionary scheme over the other to enhance much needed private credit. The outstanding amount of SBP refinancing schemes (ERF, LTFF and TERF) has more than doubled in past three years (from Rs490bn in Dec18 to Rs1,058 bin in Sep 21). Now SBP is coming up with a scheme on SME lending. There are also incentives for home mortgage and green financing.
Consumer credit has been discouraged by imposing restrictions on auto finance. To curb imports, there is 100 percent cash margin requirement on certain products. On top, SBP is increasing the CRR. The timing are interesting. There is a clear sense of urgency. The CRR average requirement is based on a period of two weeks. There is minimum requirement at any given day – it was 3 percent and now increased to 4 percent. The two weeks period ended on last Friday and the new requirements are effective from last Friday.
This means banks must adjust immediately. They may sell government securities, get money through OMO injection, or bring dollar liquidity back. There will be pressure on incremental loans. Banks may look for higher time liabilities (over one year maturity deposits) as the CRR does only apply on demand deposits – CASA. The liquidity would be short and cost of funds will rise. This to push market rates up – both secondary market yields and KIBOR. There could be some deposits war within the system money.
The market yields are already up by 75-100 bps over the policy rate. These yields would move up further. SBP is using the tool to increase the rates without increasing the policy rate. The blunt tool has immediate impact. SBP may increase the policy rate by 75-100 bps (already priced in) in upcoming policy review. And rest of tightening will be done by CRR hike. The move is smart in a way to save from the political backlash which is typically on policy rate increases.
Then the question is how much this move and policy rate increase will impact the money supply when 30 percent of the money supply is in the form of hard cash. Out of Rs24 trillion money supply, Rs7 trillion is currency in circulation. The money is out in fear of documentation and may not come back even if banks entice them with higher deposits rates.
The objective of CRR increase is to reduce the money multiplier. However, the velocity of money is already falling due to abnormal growth in CIC. Velocity (computed as nominal GDP divided by broad money -M2) is down from average of 2.6 in FY10-14 to 2.1 in FY17-21. The multiplier is losing its impact. And if there is any informal market multiplier, it is insulated from CRR requirement.
Nonetheless, the real money supply is growing and is inflationary in nature. The graph is showing that the real money supply 6M moving average is persistency deviating up from its trend. That was the case during 2016-18 and so is the case now. At that time, authorities shied away from doing the needful. Now is not the case. SBP is aggressive and blunt.
SBP’s immediate wish probably is to arrest PKR depreciation. The gap between the interest rate differential and the implied interest rates differential is growing and that is putting pressure on currency. SBP might be of the view that increasing CRR may increase the implied interest rate differential (forward premium) to bring banks’ foreign currency (against FE25) parked outside Pakistan back. That money banks can use to generate PKR liquidity for meeting CRR requirement, and those dollars would be available for financing against imports or to use for paying imports. If banks bring that dollar back, the PKR may reverse its direction. Let’s see how effective this move of SBP could be.
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