We continue from our discussion of “helicopter money” (see Point of View: Helicopters in a different form, 1 August 2016) with a description and analysis of the SA monetary system. The Reserve Bank of SA has not practiced quantitative easing. By contrast, SA banks rather than being inundated with cash and excess reserves, have been kept consistently short of cash in support of the interest rate settings of the Reserve Bank. SA banks borrow cash from their central banks rather than hold excess cash reserves with it.
The SA Reserve Bank has not practised quantitative easing (QE). SA banks have not been inundated with cash derived from asset purchases in the securities market as had been the case in the developed world. Rather, SA monetary policy in recent years has practised a pro-cyclical policy with interest rates rising and subdued base money supply growth.
SA banks do not therefore hold reserves in the form of deposits at the central bank in excess of the reserves they were required to hold. As may be seen in the figures below, by contrast with their developed world counterparts, the SA banks are kept short of cash through liquidity absorbing operations by the Reserve Bank and, more importantly, by the SA Treasury.
Also to be noted is the liquidity provided consistently to the banking system by the Reserve Bank in the form of repurchases of assets from them as well as loans against reserve deposits. Rather than holding excess reserves over required cash reserves, the SA banks consistently borrow cash from the Reserve Bank to satisfy their regulated liquidity requirements.
It is these loans to the banking system that give the Reserve Bank full authority over short-term interest rates. The repo rate at which it makes cash available to the banks is the lowest rate in the money market from which all other short term interest rates take their cue. Keeping the banks short of cash ensures that changes in the policy-determined repo rate is made effective in the money market – that is, all other rates will automatically follow the repo rate because the banks are kept short of cash and borrow reserves rather than hold excess cash reserves.
In the US, the Fed pays interest on the deposit reserves banks hold with the Fed. The ECB, by contrast, applies a negative rate to the reserves banks hold with it. In other words, European banks have to pay rather than receive interest on the balances they keep with the ECB.
The cash reserves the banks acquire originate mostly through the balance of payments flows. Notice that the assets of the Reserve Bank are almost entirely foreign assets. Direct holdings of government securities are minimal, as reflected on the Reserve Bank balance sheet. When the balance of payments (BOP) flows are positive, the Reserve Bank adds to its foreign assets and when negative runs them down. The Reserve Bank buys foreign exchange in the currency market from the banks (and credits their deposit accounts with the Reserve Bank accordingly) or sells foreign exchange to them and then draws on their deposit accounts with the Reserve Bank as payment.
And so when the BOP flows are favourable, the Reserve Bank will be adding to its foreign assets and so to the foreign exchange reserves of SA via generally anonymous operations in the foreign exchange market. In so doing it is acting as a residual buyer or seller of foreign exchange and as such will be preventing exchange rate changes from balancing the supply and demand for foreign exchange. In a fully flexible exchange rate no changes in foreign exchange reserves would be observed, only equilibrating movements in exchange rates. The exchange rate will strengthen or weaken to equalise supply and demand for US dollars or other currencies on any one trading day. The Foreign Assets on the Reserve Bank balance sheet have increased consistently over the years. Hence the balance of payments influence on the money base- on the cash reserves of the banks- has been a strongly positive one.
Without intervention in the money market, these purchases of foreign exchange by the Reserve Bank would automatically lead to an equal increase in the cash reserves of the banking system. Their deposits at the Reserve Bank would automatically reflect larger deposit balances as foreign exchange is acquired from them and their clients. This source of cash however has been offset by SA Treasury operations in the money and securities markets.
To sterilise the potential increase in the money base of the system (defined as notes plus Bank Deposits at the central banks less required reserves) the Treasury issues more debt to the capital market. The debt is sold to the banks and their customers – they draw on their deposits to pay for the extra issues of debt – and the Treasury keeps the extra proceeds on its own government deposit account with the Reserve Bank. Provided these extra government deposits are held and not spent by the Treasury – as is the policy intention – the BOP effects on the money base (on bank deposits or reserves) will have been neutralised by increases in government deposits. (The money base only includes bank deposits with the Reserve Bank. Government deposits are not part of the money base.)
It is to be noted in the figure representing Reserve Bank Liabilities, how the Government Deposits with the Reserve Bank have grown as the Foreign Assets of the Reserve Bank have increased – extra liabilities for the Reserve Bank offsetting extra foreign assets held by the Reserve Bank. It is of interest to note that about half of the Treasury deposits at the Reserve Bank are denominated in foreign currencies.
The net effects of recent activity in the money market has meant much slower growth in the money base and the money and bank credit supplies over recent years. This slow growth has been entirely consistent with weak growth in aggregate spending and GDP. Note below how rapidly money and credit grew in the boom years of 2004-2008.
One test of monetary policy is its ability to moderate the amplitude of the business cycle. The strength of the boom between 2005 and 2008 and the subsequent collapse – and the persistently slow growth in money credit and spending after 2011 – indicates that monetary policy in SA has not been notably counter-cyclical. Nor can it claim much success in limiting inflation.
The problem for monetary policy in SA is the independent (of monetary policy settings) role played by the exchange rate in determining prices. Inflation has followed the exchange rate rather than money supply and interest rates. And the exchange rate movements have been dominated by global events- flows into and out of emerging market currencies (of which the rand is one) in response to global risk.
Economic activity picked up when inflation subsided between 2003- 2005, because the exchange value of the rand recovered strongly and because interest rates declined with less inflation. Inflation accelerated in 2008-9 as the exchange rate weakened and remained high with persistent exchange rate weakness. Interest rates were moved higher after 2014 as inflation picked up and the economy slowed down, further weakening demand without appearing to do anything to slow down inflation. These dilemmas for monetary policy will persist if exchange changes remain largely driven by global forces rather than SA interest rates.
An influence on this money multiplier in SA has been changes in the banks’ demands to hold notes in their tills and ATMs. The ratio of notes held by the banks to all notes in circulation fell away sharply after 2000, thus adding to the money multiplier. This ratio has increased more recently, so reducing the money multiplier. The Reserve Bank influenced this demand for notes by the banks by deciding in the early 2000s not to include notes held by the banks qualifying as required cash reserves.
