Liquidity and solvency of the banking system

While our Editorial in Wednesday's issue referred to the liquidity shortage in the banking system, the statement issued by the State Bank of Pakistan focused more on the solvency of the banking system. We note with satisfaction that the State Bank of Pakistan (SBP) was able to calculate the level of liquidity in the economy and moved to adjust it according to the exigencies of the situation.
Keeping in view the extremely tight situation in the money market, leading to the interbank rate soaring to as high as 40 percent on 4th October, we had proposed, in our editorial "Liquidity shortage and its consequences", appearing in the issue of 8th October, that the SBP should reduce the Cash Reserve Requirement (CRR) of scheduled banks from nine percent to seven percent to inject more liquidity in the system.
The CRR, it may be noted, is an important credit control instrument at the disposal of a central bank. It is raised to drain excess liquidity from the system, curtail credit and slow down the growth in money supply in order to suppress inflationary impulses in the economy, and it is reduced when the opposite objectives are desired to be achieved.
It seems that the SBP was able to assess that the root cause of the current malaise was the sudden drain of liquidity arising from the abrupt shift of deposits of public sector enterprises from the banking system to SBP. SBP, therefore, announced a reduction of two percentage points in CRR the same day, ie 8th October, 2008. The reduction was to be effected in two phases.
The CRR for deposits up to one-year maturity was to be lowered from nine percent to eight percent with effect from 11th October and from eight percent to seven percent with effect from 11th November, 2008. CRR is zero for deposits of over one year maturity.
It may be recalled that it was the Economic Advisory team led by Shaukat Tarin that had advised utilising PSE's deposits to fund the Public Sector Development Programme instead of releasing the funds from the Federal Budget, in order to contain the fiscal deficit. This did not mean withdrawing the liquidity and transferring funds to SBP.
It would have maintained the liquidity within the banking system. SBP supposedly had also agreed with the proposal, provided the amount was kept under Rs 30 billion. It appears that the sudden withdrawal of liquidity was much larger. And, it was further compounded by cash withdrawals by the public to meet Eid shopping needs.
The detailed justification of cutting the CRR by 200 bps was given in our editorial comment on 8th October and there is no need to repeat the same arguments once again. However, we are pleased that the State Bank was convinced and acted in time to avoid the negative fall-out of the liquidity and credit squeeze. The decrease in CRR is expected to release over Rs 60 billion that the banking system can utilise for expansion of credit, particularly for cotton financing and the export sector.
In the absence of such a move, the money market would have been tightened further and the productive sectors of the economy starved of the much-needed credit. This would have resulted in slower growth and increase in unemployment, which is a deadly combination in the prevailing conditions in the country.
A very encouraging aspect is that the SBP is also fully conscious of its responsibility to maintain a tight monetary stance and has vowed to review its policy in order to ensure monetary stability and keep the rising inflation in check. Hopefully, the CRR will be again revised upwards or some other restrictive measure would be taken when the situation so warrants.
In the meantime, it would help if the newly appointed Advisor, Shaukat Tarin, works out a mechanism to lower the budget deficit. A 4.7 percent deficit in a high inflationary environment is not sustainable. It needs to be lowered to below 3.5 percent. This will reduce government's dependence on the banking system for budgetary support.
SBP must also continue to press the banks to mobilise a higher level of domestic resources to fund their lending activities. The banking sector, in our view, needs to do a lot more to mobilise deposits of small savers through their field networks, particularly in the rural areas and also in the middle income urban districts, instead of cannibalising each other's deposit base in the metropolitan areas, which is very evident at present.
It certainly is expedient for banks to go after cash rich entities and entice them to place their funds with them, but this strategy has an in-built mechanism that militates against an overall rise in bank deposits within the banking system. Already bank deposits remain under a threat of migration to government offered national savings schemes that offer an increased rate of return, significantly above what is offered by banks.
A new strategy would provide more room for the expansion of private sector credit without encouraging inflationary impulses in the economy. Also, it is incumbent on the banking industry to channel its enhanced credit creating capacity, resulting from the reduction in CRR, into productive sectors of the economy.
Higher injection of credit to finance consumer durables and the share market in the past has not only led to sub-optimal use of credit but has also increased energy requirements of the country which are very expensive to meet, besides the possibility of an asset bubble.
SBP also needs to focus on banks whose asset to deposit ratio has touched a dangerous level and strictly monitor the per party limit as provided under Prudential Regulation. Both the government and the SBP need to reinforce public confidence in the banking system. This requires taking emergency measures to press ahead with exports and curtail imports, specially to reduce reliance on imported oil.