Economy, Business And Markets

Lowering Bank Reserves and Its Implications

Lowering Bank Reserves and Its ImplicationsLowering Bank Reserves and Its Implications

T he equity market has showed a spurt it has not experienced since July. In less than a week, the market thundered away from the slump it has been in for over a month and added more than 2000 points to reach 74133 on Wednesday, an increase of about three percent.

Investors and commentators were right to be rather surprised by the sudden jump in stock prices. Seemingly no significant event occurred that could have raised hopes or optimism. The nuclear talks are showing good signs but an agreement is not definite, according to negotiators from both sides – Iran and the six world powers known as the P5+1.

Growth in the Chinese and European economies remains damped. And there was a lack of other major economic news, apart from perhaps one small update from vice president, Es’haq Jahangiri, on the occasion of the National Exports Day. That was on Sunday, just when the TSE started accumulating.

Jahangiri stipulated that the minimum requirements for bank reserves held at the central bank would decrease.

Currently, Iran’s formal boundaries of reserves are one of the highest in the world. Reserve requirements ought to be between 10 to 30 percent of total deposit holdings. In Western countries, this limit is much lower. For example, the European Central Bank (ECB) stipulates that the union’s central banks should hold at least 1 percent of the total bank deposits. The US, though with special regulations, also has very low reserve requirements. Some countries, like Sweden, the UK or Australia, do not even have a reserve requirement at all and constrain money supply only through capital requirements.

 Capital Requirements

In developing countries, central banks often require a higher percentage, as volatility and central banks’ ability to combat financial crises and bank runs is lower. For example, India requires a minimum of 4 percent, while Mexico has put the number at 10.5.  However, actual requirements in Iran are much lower than the set limits. Vice President Jahangiri promised last week that rates would drop to the lower official limit of 10 percent from 13.5 percent currently. On top of that, 2 percent of these reserves should be held in cash, rather than deposits. Specialized banks already followed the 10 percent requirements.

According to calculations, taking into account that reserves held at the Central Bank of Iran totaled 637.8 trillion rial ($23.9 billion based on the official exchange rate) by June 21, 2014, the amount of money that would be added to the active money supply is between 9.5 trillion and 22.3 trillion rials.

Proponents of the government’s plan argue that diminishing reserve requirements would have a positive impact on the balance sheet of private banks; increasing their lending capacity and lowering costs for borrowers. They would also be more capable of competing with government-controlled banks, as these have often been practically exempted from the official reserve requirements.

A study looking at government banks interaction with the CBI between 2005/6 and 2009/10 shows that the real amount of deposits held in reserve was always much less than the required rate. The study, as quoted by Donya-e Eqtesad newspaper, argues that one of the main reasons behind this ‘reserve discount’ has been the ability to secure large and cheap overdrafts from the CBI. On occasions, and particularly in the Persian year 1388 ending in March 2010, these preferential overdrafts were even larger than the reserves these banks held. They were thus holding negative reserves; the CBI was paying a premium to create money rather than establishing financial security. Clearly, this policy led to the rapid expansion of liquidity, which many have blamed for the high-inflation rates Iran experienced ever since.

 Liquidity Growth

However, another view on liquidity holds that a lowering of reserves would result in non-inflationary expansion of the money supply, and could thereby kick-start a lingering economy in which high household debt is seen as one of the keys to stagnation. While government banks had previously added to mostly unproductive liquidity, such as the still unfinished Mehr housing project, the government’s new reserve rates could actually turn this into productive liquidity. The idea is that when private banks start lending more, their lending requirements would be competitive and goal-focused. In turn, this would push up the real value of shares and liquid assets such as money.  

However, there is a fear that the government is acting too soon as continued high inflation would diminish the effect a decrease in reserve requirements has on the economy. Proponents of this view argue that the government should stop pursuing this policy until inflation is lower.

Total liquidity in the Iranian economy increased drastically with the coming to power of former president Mahmoud Ahmadinejad in 2005. While in 2005 total liquidity amounted to 800 trillion rials, in 2014 the number had reached 64,000 trillion rials; an increase of 800 percent. Although in the beginning a significant part of the rapid expansion in the money supply was directed at increasing asset prices, later, in combination with tightening Western sanctions on Iran’s economy, price inflation outpaced growth in real asset values.

In an interview with  Fars news agency on October 6, Abulfazl Akrami, CBI’s vice governor stated that the latest (August) statistics show that the monetary base has actually shrunk by 4.9 percent in the five months preceding August while the volume of liquidity increased by 7.7 percent. In other words, most money was created by banks, as opposed to the CBI’s printing press, through the multiplier mechanism. This rate implies that on a year-on-year basis, liquidity has grown by 30.3 percent, of which 3.8 percent is due to new calculation methods. Akrami declared that the CBI would do its best to keep this year’s liquidity expansion between 23 to 25 percent.  

However, taking into account that currently total liquidity stands at more than 64,000 trillion rials, the impact of a further reduction in the monetary base on total liquidity through the new reserve requirements would be rather small; liquidity would increase by a maximum of 35 percent. However, the final outcome will likely be larger as the multiplier effect of a smaller monetary base affects banks’ creation of money through deposits and lending. The government might thus still have some room in lowering reserve requirements if it believes that will lead to healthier lending.