Excess liquidity and the foreign currency constraint: the case of monetary management in Guyana

Abstract

This article examines why commercial banks in Guyana demand nonremunerated excess reserves, a phenomenon that became even more widespread after financial liberalization. Despite the removal of capital controls, banks do not invest all excess reserves in a safe foreign asset because the central bank maintains an unofficial foreign currency constraint by accumulating international reserves. The findings suggest that commercial banks do not demand excess reserves for precautionary purpose–which is the conclusion of several other studies–but rather because of the maintained constraint. The estimated sterilization coefficient is consistent with the hypothesis of an enforced constraint. The results, moreover, suggest an alternative way of looking at the monetary transmission mechanism in developing countries. The central bank maintains price and exchange rate stability through the accumulation of foreign reserves.

Acknowledgements

This article represents a modified version of Chapter 4 of author's PhD dissertation. It has benefitted from comments and criticisms from Professor Duncan Foley of The New School for Social Research. Any remaining errors are, of course, my responsibility.

Notes

¹ The issue of global excess liquidity has occupied several researchers in recent times. See for instance D’Arista (2005, 2006). Also, in a fairly recent issue of The Economist (13 August 2005), the magazine sought to explain the decline in long-term bond yields, in the presence of a series of successive short-term rate increases by the Federal Reserve, by proffering two hypotheses–a global savings glut and a situation of global excess liquidity. The latter was seen as being more consistent with the existing situation of low long-term bond yields and high output growth rates. However, this article seeks to address the issue within a developing country context and in so doing adds to a scarce literature on the phenomenon in the developing world.

² A key prediction of the model is the notion that banks demand excess reserves for precautionary purposes. This article finds no evidence that this is the case.

³ According to Saxegaard (2006) several variables that account for involuntary reserve accumulation include inflows of foreign aid, newfound oil revenue, weak demand for bank loans (resulting from high loan rates), and government deposits in commercial banks.

⁴ Caprio and Honohan (1993) noted that the money overhang hypothesis is more applicable to former planned economies in which there was a period of goods rationing in the commodity market. Credit rationing, on the other hand, is likely to occur in both advanced and developing countries.

⁵ In 1991 the Guyanese authorities merged the parallel foreign currency market with the official market. Since then there has been no misalignment between the official rate and the ‘street’ rate. The exchange rate is determined freely by market traders in foreign currencies–mainly commercial banks and other authorized nonbank traders who must obtain a license from the central bank. The Guyanese central bank (the Bank of Guyana) defends the rate by accumulating international reserves. On several occasions the central bank sells from its reserves. However, most times it must buy United States dollars and other currencies from the local market since the domestic currency cannot be traded in the main global international financial centres.

⁶ Alexander et al. (1995, p. 2) define direct versus indirect monetary policy instruments. Direct instruments set or limit prices (interest rates) or quantity (credit). The quantity-based direct instruments often place restrictions on commercial banks’ balance sheet. Indirect instruments, in contrast, operate through the market by influencing the demand and supply conditions of commercial bank reserves. Embedded within the International Monetary Fund's (IMF's) financial programming framework is the view that the reserve position of the banking system determines bank credit and broad money supply.

⁷ Nonremunerative excess bank reserves have also been on the rise in Barbados, Jamaica, Trinidad and Tobago, Belize, The Bahamas and the Eastern Caribbean Currency Union (Khemraj, 2006).

⁸ Mainly the US currency is traded in the Guyanese foreign currency market. As at the end of 2005 US$674 million was purchased, while £23.8 million was bought by traders. At the same time US$651.9 million was sold compared with £21.7 million. Small amounts of the Canadian dollar and the Euro were bought and sold during that period.

⁹ An earlier version of this article included the volatility of the exchange rate. However, it was found to be statistically insignificant.

¹⁰ The excess reserves and foreign exchange market purchases and sales data were obtained from the Bank of Guyana Statistical Bulletin, while all other series were obtained from the IMF International Financial Statistics.

¹¹ Experimentation with GARCH(1, 1) models as a measure of volatility of different series could not change this conclusion.

¹² An earlier version of this article tested for whether a change in international reserves of the central bank influences the level of excess reserves. It was found to be statistically insignificant. The high sterilization coefficient in this section would tend to corroborate this finding.

¹³ The Bank of Guyana notes that the NDA is its instrument which it manipulates to achieve the objectives of stable prices and exchange rate stability. To enable the day-to-day management of excess reserves the central bank utilizes a reserve money programme, which is itself rooted in the financial programming framework. See Tarp (1993) for detailed discussion of the financial programming framework.

¹⁴ Lags beyond the first period lag were insignificant. Hence, only contemporaneous and one period lag for the respective independent variable was included in the reduced form equation.