BEHIND THE NUMBERS
'Something has gone wrong with the monetary transmission mechanism," Paul Krugman, a Nobel laureate in economics, wrote back in December 2001 after the US Federal Reserve, led by Alan Greenspan, had cut the federal fund rate 11 times that year but failed to produce any results.
"People often say that the Fed controls interest rates, but what it actually controls is only the interest rate. And this interest rate is, in itself, of very little economic importance."
Heretical as it may sound, is this what is going on in Thailand right now? Similar to the Fed, the Bank of Thailand conducts transactions at the policy rate _ financial institutions submit bids for the amounts they wish to borrow (or invest) from the central bank at that rate. Hence, a reduction by the rate-setting committee should lower the funding costs of commercial banks, which in turn could decide to rely a little less on deposits, thereby slashing their quotes. The fall in deposit rates normally brings lending rates down too and effectively "transmits" monetary policy to the broader economy.
But that is not what happened in the latest attempt to stimulate economic growth by the Monetary Policy Committee (MPC). Commercial banks barely responded to the MPC's decision to cut the policy rate at its May 29 meeting. Neither the minimum lending rate nor the minimum retail rate moved. Only the Bangkok Interbank Offered Rate or Bibor _ the average at which banks lend to each other _ tracked the policy rate changes closely.
The same goes for deposit rates. Interest rates on time deposits have actually picked up since late last year. Among these, the three-month rate has increased the most since January, by more than 50 basis points. The use of shorter-term instruments implies commercial banks are not certain about liquidity and funding prospects.
The trend did not go unnoticed by the MPC. In the minutes to last month's meeting, it said the central bank's action, or lack of it, reflected "concerns about the liquidity outlook amid intensified competition in the deposit market".
The committee also mentioned the government's need to raise funds for infrastructure megaprojects through its specialised financial institutions (SFIs) as a key contributing factor to such inaction. We tend to agree, but no one knows for sure.
If this perplexes you, don't worry. You are not alone. Last weekend, we had the privilege of presenting our research at the Bank of Thailand's fourth annual research workshop in Pattaya. The same questions preocuppied many of the 50 professional and academic economists in attendance.
The lack of movement in commercial banks' rates aside, let's come back to the bigger question we posed in the beginning _ is monetary policy still effective at all in this environment? Or has it now become irrelevant due to the factors discussed above?
If we define "transmission" more broadly, then we believe we may have at least a partial answer. But this transmission mechanism must mean more than just lending and deposit rates following the direction of the policy rate. It needs to encompass how changes in monetary policy variables such as the policy rate affect economic activities through other things as consumption and investment.
This is the crux of the research we presented last week. We measure this by looking not at interest rates but the quantity of loans themselves and how it is influenced by changes in the policy rate. Using "regime-switching models", we find that for monetary policy to be transmitted effectively through the quantity of loans, liquidity in the commercial banking system must be tight. This translates into two conditions.
First, the loan-to-deposit (LD) ratio, or the proportion of deposits used in granting credit, in the commercial banking system must exceed about 115%. The higher the ratio, the tighter the liquidity.
Second, SFIs have to raise funds relatively aggressively at a monthly deposit growth rate of more than 8% year-on-year. Since SFIs share the same pool of deposits as commercial banks, their activity affects the latter's liquidity directly. Simply put, one baht raised by SFIs is one baht foregone by their commercial competitors.
So our empirical results show tighter liquidity is good for monetary transmission. But why? Commercial banks have a choice between raising funds conventionally by deposits, or by issuing debentures or simply borrowing from the interbank market. Suppose the central bank decides to cut the policy rate. Raising funds via these channels will become relatively cheaper than deposits as yields fall, lowering the need to rely on deposits for liquidity. As liquidity constraints ease, commercial banks can go on lending without worrying too much about the liquidity outlook.
Now let's say that liquidity in the deposit market gets tight, as reflected by high LD ratio. In this case, it gets more difficult to attract additional baht from depositors. Deposits become more expensive, consequently reducing the appetite to lend. Lowering the policy rate will put commercial banks at ease, giving them access to cheaper bond and interbank borrowing, thus relieving the liquidity constraints on the quantity of loans released into the market.
The latest statistics from the Bank of Thailand show that in May, deposits with SFIs grew by just over 10%, while the LD ratio was about 113%. Only one of our conditions is met, while the other is on the borderline. As all commercial banks now expect liquidity to grow tighter in the future from government borrowing, monetary policy should have more bite via the channel described above.
So while lending and deposit rates remain elevated despite the MPC's attempt to lower its policy rate, this merely reflects the fact that deposits are now expensive. However, it doesn't in any way mean monetary policy is no longer being transmitted to the economy. The transmission is there, just under a different channel than the one we are used to.
TMB Analytics is the economic analysis unit of TMB Bank. Behind the Numbers is co-authored by Benjarong Suwankiri and Warapong Wongwachara. They can be reached at TMBAnalytics@tmbbank.com
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Writer: TMB Analytics