What is Liquidity?
When one talks of liquidity, one is usually referring to the ease at which assets can be converted to cash in order to make payments in a timely manner. Therefore, for both individuals and financial institutions, an asset is considered liquid if it can be easily converted to cash and as such these liquid assets are kept to meet financial obligations.
In Fiji, when the central bank talks about the level of liquidity that is available in the banking system, the RBF is referring to the excess reserves, which are otherwise known as banks’ demand deposits (BDD). This is the ‘liquidity’ we refer to in the rest of this article.
How does the RBF influence Liquidity Conditions?
There are a number of ways that the RBF is able to influence the level of liquidity.
- Commercial banks are required hold a certain portion (currently 10 percent) of their deposits and similar liabilities with the RBF as Statutory Reserve Deposits (SRD). Hence, the central bank can influence the level of liquidity by changing the required SRD. An increase in SRD rate would mandate commercial banks to increase their SRD with the RBF which would result in a reduction in BDD. In contrast, a lower SRD rate would be deemed expansionary as this allows for higher liquidity.
- Additionally, in its conduct of open market operations (OMO) via buying/selling its own securities (known as RBF Notes), the RBF is able to influence the amount of liquidity available in the banking system. In practice, the RBF first sets the Overnight Policy rate (OPR), its key policy rate via which the central bank communicates its monetary policy stance. The Bank, then conducts OMO to add or withdraw liquidity from the financial system in order to influence short term commercial bank and money market interest rates in the same direction as the movement in its key policy rate, the OPR. For instance, if the RBF raised its OPR and sold its Notes/securities to commercial banks, money moves from commercial banks to the central bank, which is equivalent to the central bank withdrawing liquidity from the banking system. When the securities mature, the RBF pays the holder of the RBF Notes which results in an increase in liquidity as the central bank adds funds back into the financial system.
- The RBF also has various credit facilities including its lender of last resort facility to commercial banks and Government. If the RBF lends funds to the banks or Government, liquidity is added into the banking system and the opposite happens when the funds are repaid.
What are the other factors that affect Liquidity?
Liquidity is also affected by currency in circulation (CIC) and foreign exchange reserves. CIC is the total amount of money that is outside the banking system i.e. money in the hands of the public to pay for goods and services, which usually increases during peak spending periods such as Christmas. Foreign reserves represent the income we earn from our exports of goods and services such as sugar, mineral water, garments and tourism, and inflows of aid or loans, which are used for the payment of our imports like mineral fuel, machinery & transport, food, profits & dividends, etc.
While SRD and CIC are inversely related to liquidity, foreign reserves have a direct and positive impact on the level of BDD. This means that an increase in the level of SRD and CIC will lead to a decrease in BDD, while an expansion in foreign reserves would result in a rise in liquidity and vice versa.
Movements in Government’s central account, an operational account held with the RBF also have an impact on BDD. Inflows into the central account include funds raised from issues of Government securities and direct deposits, while outflows include Government’s payments on redemption or interest payments for its securities. Outflows from the central account generally have a positive impact on BDD.
How does Liquidity affect the Economy?
Since liquidity is outside of the RBF’s SRD or reserve requirements, the level of BDD is essentially what banks can use to make loans to the public or for their own investments. A reduction in liquidity would not only affect banks’ willingness to make loans but also the price or interest rate it would charge on a loan. If businesses and private individuals are unable to access loans or the interest rate is relatively higher, then they would defer expansion and/or investment plans and purchases such as a car or house and consumables. This would affect a number of factors including consumer and business demand and confidence, spending in the economy and eventually overall economic activity. In other words, the level of liquidity in the banking system has a bearing on the level of consumption and investment activities in the economy, which feeds into Fiji’s total output or income in a year or the country’s gross domestic product or national income, and ultimately affects economic growth.
Recent Developments
Fiji has registered ample liquidity levels over the recent few years, dominated by increased inflows of foreign reserves. The highest level of liquidity of $772.9 million was recorded in November 2013. Currently, at an aggregate level, banking system liquidity remains adequate given that foreign reserves, a key determinant of BDD, is expected to remain sufficient in 2017 and into the medium term.