In the banking system of Guyana, Caribbean economies and many developing economies there is a surfeit of liquidity. This column examines this phenomenon so as to set the stage for a later issue that will interpret the idea of Caribbean convergence that was recently revived by Mr Winston Dookeran, Minister of Foreign Affairs, Trinidad and Tobago. Excess liquidity is seen as a puzzle because instead of earning a higher interest rate on loans or some other domestic or foreign security, commercial banks hoard large amounts of liquidity in excess of the amount they are required to hold. Economists have invoked the concept of risk as a primary determinant of excess liquidity, which is made up of excess liquid assets (Treasury bills) and excess reserves – which in most countries including Guyana pay zero interest rate. The idea is an increase in risk – whatever its source – would motivate banks to hold higher levels of liquidity. This is obviously plausible, but it does not tell the whole story.

In spite of the fact that commercial banks could earn over 11% by lending to prime borrowers (according to BOG data), they still at some point find liquid assets just as attractive as lending. It may sound counter intuitive, but remember banks also have a cost of production when it comes to lending. They incur all kinds of costs such as monitoring, screening, security and overhead costs. Therefore, after adjusting for marginal costs and risk sometimes it is as attractive to hold T-bills or cash as lending. The point being made here is there is some lower lending interest rate in a small economy at which point holding cash is as good as lending. For profits to be made, the lending rate has to sufficiently cover costs associated with the extra loan contract. Hence, this is the first explanation related to why banks may demand excess liquid assets and be unwilling to lend out all excess reserves.

Of course, commercial banks invest in a portfolio of assets that includes various classes of loans, securities and foreign assets. Once there is no more profitable lending opportunities, banks could invest excess cash into a safe foreign asset, for example US Treasury bills or deposit funds in a relatively safe foreign counterparty bank. Should the exchange rate depreciate banks will not only make the interest on the asset, but also earn more in Guyana dollar terms. Nevertheless, it is not always possible to gain sufficient hard currencies at the same time there is desire to invest on foreign assets. There is usually a mismatch between availability of hard currencies and the desire to invest abroad for proprietary reasons. The banks also serve their customers, many of whom have loans from the banks and also need to partake in foreign transactions. Therefore, not granting these borrowers hard currencies could imperil their ability to repay their loans. Although the temptation is there to invest in foreign assets for the sake of investing (for proprietary reasons), the commercial banks also serve their customers out of the need to protect their loan exposures.

Moreover, the Bank of Guyana also holds sufficient amounts of foreign currency reserves to cover several months of imports. This means it draws from the scarce pool of hard currencies, thereby enhancing the mismatch between the banks’ desire to invest in foreign assets and the availability of foreign currencies. Therefore, although some excess reserves could be invested in foreign currency assets, not all do find this channel of profit making. Hence, the shortage of foreign currencies is a constraint on investing all remaining excess reserves into foreign assets. This foreign currency constraint is the second reason why banks tend to hoard zero interest excess reserves.

Excess liquid assets – banks’ demand for Treasury bills – are part of a system of central bank monetary policy that helps to stabilize prices and exchange rate. Treasury bills are also part of the central bank’s assets. As at Dec 2013, the Bank of Guyana held G$3.5 bill in Treasury bills thus partly helping to finance the central government’s deficit. As noted above, when the central bank holds foreign assets it sequesters foreign exchange that could otherwise be available in the domestic foreign exchange market. Since this sequestration removes a profit opportunity from the commercial banks, they are compensated with Treasury bills. This is the compensation mechanism whereby restive commercial banks are provided with an alternative profit making centre. This compensation system – known as the compensation thesis in heterodox economics – represents the third reason for excess liquid assets. If the Bank of Guyana is going to be the largest holder for foreign currency assets, then it has to provide another avenue for commercial banks to make money. This it does by supplying ample Treasury bills.

Excess liquidity also helps to diminish the volatility (or variance) of the portfolio of assets held by the banks. It therefore serves as a major stabilizing force in the system. This compensation mechanism was recently in operation in the reverse. As noted in the previous column, there is a reduction in the flow of foreign currencies through the banks and non-bank cambios. The Bank of Guyana has stepped up its sales intervention into the market, thereby using up some foreign exchange reserves. But in so doing it diminishes non interest paying excess reserves that fell from G$16.7 billion in Jan 2013 to G$6 bill in Dec 2013. To maintain the overall level of excess liquid assets – thus reducing volatility – the Bank of Guyana allowed commercial banks to increase their holdings of Treasury bills from G$70.9 billion in Jan 2013 to G$79.4 billion by end Dec 2013. The interest rate on Treasury bills increased to over 2% in Dec 2013.

The mechanisms above are all illustrated at the theoretical and econometric level in my forthcoming book (http://www.e-lgar.co.uk/booken...ency=US&id=15473): Money, Banking and the Foreign Exchange Market in Emerging Economies. For now a natural question to ask is whether this stabilization mechanism is consistent with development and poverty reduction. Some folks might balk at the high level of liquidity in the system that could instead be loaned out to generate economic growth and employment. My short answer is this system is consistent with a growth strategy. An unstable exchange rate generating inflation will not help the cause of poverty reduction and employment creation.

The problem is not the way the commercial banks are operating or the central bank’s monetary policy. The problem appears to be a lack of a state development bank that could help to synchronize lending with the private banks, thus allowing them to earn sufficient economies of scale and pushing the minimum lending rate downward. The lending rate cannot be regulated downward, as that will result in the kind of distortions associated with the old regime of financial repression. A second system could be specialty institutions focusing on microfinance. Since micro enterprises stand the greatest chance of failing, we should expect only a limited role for microfinance. A third important system that is needed is to make sure more companies are listed in the local moribund stock exchange. NICIL has to be blamed for not having the strategic vision to ensure more privatizations took place through the stock exchange. The stock exchange has the added virtue of promoting information disclosure and analyses that can edify the society. As we know, transparency in Guyana is very scarce.

Comments and suggestions: tkhemraj@ncf.edu