Freeing up liquidity
A new decision to lower the ratio of commercial banks' interest-free deposits with the Central Bank aims to free up more liquidity. Sherine Abdel-Razek
reports on the implications of the move
For several years now, the Central Bank of Egypt (CBE) has obliged banks to deposit 14 per cent of their local currency in its coffers, interest-free. This ratio, known by the term required reserves, is a worldwide practice. It enables central banks to set the minimum reserves each commercial bank must hold, rather than lend out of customer deposits. The ratio is normally in the form of cash stored physically in a bank vault, or deposits made with a central bank. The ratio varies from one country to another. While US banks must deposit 10 per cent, other countries' banks need only place one per cent with their central institutions.
In Egypt the decision became effective as of 20 March. "This move is meant to ease domestic liquidity pressures and stimulate lending activity, to jump-start the economy," according to a note issued by local investment bank Beltone Financial. The practice is a common monetary policy adjustment tool often used when the central bank wants to ease liquidity without lowering interest rates, the note added.
Participants in a related meeting, including CBE Governor Farouk El-Okda and a number of commercial bank heads, concluded that further reductions might be implemented should market conditions require them. The required rate of return (RRR) percentage in some countries does not exceed one per cent of the overall deposits.
In theory, higher liquidity should drive up inflationary pressures and further devalue the local currency. But Mona Mansour, macro- economy analyst at CI Capital, believes "the impact of the two per cent cut in RRR should be minimal -- as the resulting excess liquidity represents a mere one per cent of Egypt's money supply."
With the decision loosening the grip on liquidity, there was no reason for the CBE's Monetary Policy Committee (MPC) meeting on Thursday to change the lending and borrowing rates. The MPC decided to keep the rates at 9.25 per cent and 10.25 per cent respectively.
But what are the government's plans for the LE20 billion sum likely to be freed up by the decision? By freeing more liquidity, the government might be aimed at either increasing domestic borrowing or supporting more private sector lending, according to CI Capital's Mansour.
In the first scenario, the government would be allowing more liquidity for banks to invest in treasury, or T-bills. These funds could be used to pay government debts, or to increase government investments.
If this is the plan, the effects won't be positive on the long run, as the state budget will remain under pressure given high interest rate payments, hovering around 16 per cent. The pressure is more intensified by the drop of foreign contribution in T-bills to 2.2 per cent in December 2011 from 22 per cent a year earlier.
Meanwhile, expectations that the move would help lift the pressure on state finances on the short-term materialised. Two days after the decision became effective, Egypt witnessed the biggest drop in its borrowing costs since the onset of the 25 January Revolution. According to Bloomberg news agency, the average yield on one-year T-bills fell by 15 basis, the most since January 2011, to 15.768 per cent.
Another possibility is that the government is trying to strengthen the private sector, by offering more bank credit. The contribution of loans to banks' assets grew by just one per cent to 37 per cent in December 2011, while T- bills' contribution jumped to 27 per cent as compared to 22 per cent in December 2010. Expanding corporate lending and strengthening the role of the private sector will help increase investments and enhance economic growth.
At any rate, banks will benefit from the latest decision, as the reserves are non-interest bearing. As such, lowering the ratio will mean more liquidity and more income for banks. While it is true that the system is liquid in terms of the loans to deposits ratio, which is relatively low at 49 per cent, much liquidity is allocated to T-bills, which account for 27 per cent of the assets, as previously mentioned.