L8 Money and Banking PDF

1 Monetary Policy and the Exchange Rate Monetary policy is a technical word that means how to manage the amount of money in the economy to serve it best. – There are three main questions: ∗ What do we mean by money? how to measure the level of money in the econo...

1 Monetary Policy and the Exchange Rate Monetary policy is a technical word that means how to manage the amount of money in the economy to serve it best. – There are three main questions: ∗ What do we mean by money? how to measure the level of money in the economy? ∗ How do we know the right amount of money the economy needs each period? ∗ And, if answered, how we can maintain that level? How Do We Measure the Money Level We know from Macro 102 how economists measure the money level in the economy. Money, that we care about here, is anything can be used in the payment for products and services. There are broad definitions and narrow ones. – The narrowest one is M1 which consists of currency in circulations and demand deposits (both can be used to pay for P&S). Notice, that most of M1 is deposits not currencies. Demand deposit is a sort of money because we draw on them to pay for products and services. – Adding saving accounts (deposits that earn you interest but put some restrictions on withdrawing) to M1 we get M2. – Saving accounts, though not as liquid as demand deposits, are potential source of pur- chasing power. Adding other quasi-money deposits (mainly demand deposit in foreign currencies) we reach to the broadest measure of money M3. Figure 1 the level of each in Saudi Arabia How central banks affect the amunt of money? For banks, in any country, to be able to create deposits for customers and in turn add money to the economy, they have to hold certain level of what we call reserves. Reserves are the total sum of notes they keep in vaults and deposits they keep with SAMA. Notes in vaults are in low amount and most of reserves they hold is deposits with SAMA. Reserves are the highest level of money in the economy. Other forms of money expand if reserves expand and shrink if reserve shrinks. Because Reserves are mostly deposits accounts with the central banks, central banks can manage their level and, in turn, the level of all sorts of money (more on this later). SAMA and Riyal Stability Managing the level of money is responsibility of central banks. Saudi Arabian Monetary Agency SAMA is our central bank and it is the one that is responsible for conducting monetary policy. The main goal of SAMA is to maintain the stability of the value of Riyal internally and externally – internally, by containing inflation in the Kingdom. In other words, by making sure the purchasing power of Riyal is stable and not deteriorating. – externally, by maintaining stability of the exchange rate of riyal with other currencies 1  Figure 1 Let’s first talk about the stability of the exchange rate of Riyal and what SAMA is doing to achieve that goal. But before talking about Saudi exchange rate, let’s see how an exchange rate is determined in a typical economy A typical economy would have a floating exchange rate. – That is, the exchange rate of its currency with other currencies is determined by the demand for and the supply of the currency. ∗ Assume Din are foreign currencies (in dollar) flowing in a country A, Say Saudi Arabia, and Lout is local currency, say Riyal, flowing out of the country. · Sources of Din could be: exports, factor income (labor or investment) from RoW, transfers flowing in from RoW, borrowing from RoW or reducing foreign financial assets owned by people of the country A. · Sources of Lout could be: imports, factor income (labor or investment) to RoW, transfers flowing out to the RoW, lending to the RoW or adding to the stock of financial assets owned by people of the country A. ∗ In any period, we should have 1 Din = Lout · e where e is exchange rate in local currency per Dollar. That is e is how many of local currency you need to get one dollar. 1 ∗ That is, Din gives you the supply of dollar in the economy and Lout · e gives the demand for foreign currency by the economy. ∗ Thus, during any period, if Din > Lout · 1e (i.e. supply of dollar is larger than demand of dollar) then e has to go down for the supply to equal demand. That is, Riyal would appreciate (less of local currency is needed for one Dollar). ∗ On the other hand, if Din < Lout · 1e then e has to go up for the supply to equal demand. That is, Riyal would depreciate (more of local currency is needed for one Dollar). 2  Figure 2 Figure 2 shows the demand and supply of foreign currencies in a typical economy where exchange rate is free. In the chart, I assume that most of Din is coming from export and neglect other sources. Likewise, I assume that most of Lout is because of imports and neglect other sources. This is somehow a fair approximation of many countries. Exports and imports are the main factors affecting the supply and demand of foreign currencies in many countries. The figure says, the exchange rate of the local currency against foreign currencies changes with value of exports (which result in supply of foreign currencies) relative to the value of import (which results in demand for foreign currency). The figure shows that central bank and commercial banks interact to negotiate the exchange rate of the local currency against foreign currencies. Now, let’s see what will happen if Riyal is not pegged to any currency and let move freely according to supply and demand conditions. – We know that most of our foreign currency revenues are coming from exporting oil. – Thus, in periods of good oil market, we get a lot of dollars from oil revenues that exceeds 3  Figure 3 the amount of Riyals flowing out due to imports or any other transaction that requires Riyal to flow out.(i.e. Din · e > Rout ). Therefore, Riyal has to appreciates against dollar. – On the other hand, in periods of bad oil market, we get few dollars from oil revenues that fall short of the amount that is needed to finance our imports and other transaction requires Riyal to flow out. (i.e. Din ·e < Rout ). Therefore, Riyal has to depreciate against dollar. – Thus, Riyal value, if floated, will move hand in hand with the boom-bust cycle of oil market. We know that oil market is highly volatile. Just look at figure 3, which shows our revenues from oil production. Do you want an exchange rate to behave as volatile as oil market? – An exchange rate moving crazy like this will create huge instability in the economy given the fact the no one can predict where the oil market is heading to This boom-bust cycle, to be mitigated, is dealt with in two ways: – Countercyclical fiscal policy1. That is when oil revenues are high, the government does not spend all dollars that come in. It keeps part of them into a reserve account for bust cycles. In bust cycles, it draws down from the reserve of dollars accumulated in boom cycles. In this way it dampens the effect of oil boom and bust cycle on the economy. More about fiscal policy later. – Pegging the exchange rate to the dollar, i.e. fixing e at a certain level, say e∗. For this to happen, SAMA would says: I will create e∗ Riyal for each dollar enters the economy (e.g. if oil dollars enters the economy) and I will require 1/e∗ Riyal for each dollar exits the economy (e.g. to buy imports or invest in foreign assets). What SAMA has to do in order to fix Riyal to dollar exchange rate? – To do so, SAMA would say: I am willing to exchange e∗ (now 3.75) Riyal for one dollar. If any one in the market (banks or money changers) is giving a dollar for more than e∗ , no one would deal with him or her because SAMA is cheaper. On the other hand, if any one is giving dollar for less than e∗ riyal every one will be dealing to him or her until the amount of dollar he or she has is exhausted and by then she can’t maintain a cheaper exchange rate. – Only SAMA can do so because SAMA has unlimited supply of Riyal and accumulated a very large amount of dollar that covers much more than the demand for it in the economy. 1 ”Fiscal policy” is a fancy phrase to mean how government spending is managed 4  Figure 4 ∗ For Riyals, this is no problem because SAMA can create the amount of Riyal it wants. That is, SAMA, as any central bank does, has an infinite amount of local currency. ∗ For Dollars, SAMA has to maintain a large amount of dollars. How? by accumulating the oil dollars that is coming from oil revenues. Because we export large amount of oil in dollar we are able to accumulate large amount of dollars. In 2016 the level of dollars (or precisely foreign reserve) is worth of 2 trillion Riyal. The value of our import in 2016 is 530 billion Riyal. That is the level of dollars SAMA maintain is enough to finance four years of imports of the same size as that of 2016. – Figure 4 shows how dollar is supplied to our economy to support the peg and to finance imports (Explained in the class. I expect you understand how it works. Let me know if you don’t) – 5  Pegging the exchange rate has important implications – The most important one is that, to maintain the peg, the interest rate on Riyal has to follow that of Dollar. If there is mismatch between the two rates the peg can’t be maintained ∗ If U.S. Rate is higher than Riyal rate, then investors will sell Riyals and invest in Dollar deposits. This creates large demand on dollar that SAMA has to meet in order to maintain the peg. If this continues, SAMA will run short of Dollars and thus can’t supply the needed amount of dollars at 3.75 SR per dollar. ∗ If Riyal interest rate is higher, then investors will buy Riyals and sell dollars. In order to meet this demand of Riyal, SAMA has to supply large amount of Riyal than the economy needs and therefore a pressure on Saudi prices is created. If this continues, inflation rate in Saudi Arabia will shoot up. – The other implication is that our exchange rates with other currencies than dollar have to follow that of the exchange rate of U.S. dollar. So, if dollar loses value against yen for example, riyal has too to lose value against yen by exactly the same size. ∗ That has to happen even if level of trade between us and Japan does not change. In a typical economy, the level exchange rates reacts to the level of trade between the country and its trading partners. In our case, the level of trade between us and our trade partners is irrelevant to the value of the exchange rate. This may has an adverse effect on our non-oil exports because if US dollar appreciate against other currencies, Riyal has to follow and thus non-oil exports become more expensive 2. ∗ For example, dollar value appreciated by 20% against all major currencies since 2014. Because of the peg, Saudi Riyal also appreciated 20% against major currencies. ∗ From 2000 to 2007, dollar rate depreciated by around 30% against major currencies. Again, because the peg, Riyal depreciated by the same amount during that period which made imports more expensive. An Important question is why we peg Riyal to US dollar not any other major currency or basket of major currencies? – Because oil is sold in the international market in dollar and thus by the design of inter- national market our revenues from oil exports are in dollars. – Another factor also is the fact that around 43% of international trade is done with dollar. Even between countries where non of them is US. Thus, if you have dollar, around 43% of the international market is ready to trade directly with you. – Another sign of the dominance of dollar is the fact that around 63.8% of currency reserves central banks all over the world hold is in held using dollar. This implies that all countries trust dollar as a store of wealth than any other currency. When it is the best time to break the peg? – If our exports are diverse. That is, if our economy is able to export a variety of products and services that generate large and enough amount of foreign currencies. Put it in other words, if there is enough demand for riyal (which come from exports). 2 This impact is not so large because our non-oil exports to countries of major currencies are very very small. 6  – In 2016, the value of our exports was 688 billion Riyal. 511 billion is from oil and only 177 billion is coming from non-oil exports. Thus, a very small fraction of our foreign currencies is sourced from non-oil exports. – Without a meaningful base of non-oil exports that helps us generate foreign currencies, we will be depending on the dollars generated from oil exports and, in turn, the exchange rate peg may be our best choice. Why we don’t sell oil to Japanese in yen, Chines in yuan and European in euro and then use these currencies to finance our imports from those counties? – This is possible but to avoid the boom-bust cycle of oil market that we talked about we need to peg Riyal to certain combination of yen, yuan and euro. This means we need to hold reserves in those currencies in certain combination. Managing a peg to one currency is much much easier than a combination of currencies. Especially if this currency is the dominating currency in the international market. – The idea is that as long as we receive most of our foreign currency from one source in dollar, pegging Riyal to dollar is the preferable choice until we reach a point where our private sector is able to export large amount of products and services other than oil. By that time, floating riyal may be considered. Last question about the peg, why it is at 3.75 SR per dollar? – this rate was chose in 1986 where it was deemed reflecting the fair value of Riyal. Liquidity and Money Supply Now back to monetary policy in Saudi Arabia. Like I said, monetary policy is a fancy term that means how to manage the quantity of money in the country In Saudi Arabia, the exchange rate peg has a crucial implication for monetary policy inside the kingdom. Before we explain the particularity of monetary policy in Saudi Arabia, let’s see how a typical central bank would manage the amount of money in the country. – Money level is controlled by the central banks (CBs). ∗ It is true that any CB can control the quantity of local currency but this does not mean it can control the value of of the currency. ∗ If the CB allows for creation of more of local currency than needed by people and businesses, then its value decreases (i.e. prices of products and services become higher) ∗ On the other hand, if it absorbs a lot of local currency that is needed by people and businesses, then the currency value increases (and prices of product and services decrease). If prices are decreasing, businesses lose and people postpone spending. The result is a recession and, if persists, a sever depression. ∗ The point is that having control on the amount of local currency does not mean having control on the value of the local currency (i.e. how much products and services one unit of the currency can buy) – given this responsibility, how does a CB know whether the amount of local currency in the economy is at good level? ∗ By looking at certain indicators about the level of activities in the economy. 7  ∗ Among these are: inflation, employment and interest rates. – If, using such indicators, a CB think that a certain level of interest rate would serve the economy best (let’s call it a target rate), it can direct interest rates in the financial system to be at the target rate. – How? it does this through the intervention in the interbank market. That is, the market where banks lend to and borrow from each others. ∗ If CB thinks that the economy is booming and the money level is expanding more than needed, it would set a higher target interest rate than that seen currently in the market and it would announce that it will be willing to borrow money at the target rate. Because the target rate is higher than the market, banks with surplus funds are better off lending to the CB than to the market and the CB will keep borrowing (i.e. absorbing money out of the economy) until the market rate adjusts upward and matches the target rate. ∗ If CB thinks that the economy is falling behind and wants to make people and business spend more, it would set a target interest rate that is lower than that seen currently in the market and it would announce that it will be willing to lend money at that target rate. Because the target rate is lower than the market rate, borrowers will go to the CB (i.e. more new money will be in the economy) until the market rate adjust downward to matches the target rate. ∗ How they calculate the target rate? they have very sophisticated models designed by experts to calculate that rate. ∗ Once the rate in the interbank market changes, all other interest rate change. Be- cause, banks set their rates according to the cost of funding they incur in the interbank market. This is how typical CBs increase or decrease the amount of money in the economy. Now, what about our central bank? Can SAMA target an interest rate and borrow or lend to reach it? The answer is NO. Because, as we mentioned above, SAMA can’t maintain the Riyal-Dollar peg if the interest rate on Riyal is significantly different than that on dollar. SAMA has either to fix the exchange rate or have independence in setting the interest rate. It can’t have both at the same time. This is why you see SAMA change the interest rate right after any change the Federal Reserve Bank announces. Check this for example There are three main interest rates in the kingdom – Saudi Inter-bank Offered Rate (SIBOR). This is the key inter-bank rate in the Kingdom, and the benchmark for commercial and consumer lending rates. That is, commercial and consumer rates are set with reference to SIBOR. By the end of each day, because of deposits and withdrawals, there will be deficit banks (those which the amount of deposits coming in is less than the amount of withdrawals going out) can cover their deficit by borrowing from surplus banks (those which the amount of deposits coming in is more than the amount of withdrawals going out). The interest rate charged by the surplus banks and accepted by the deficit banks is SIBOR. ∗ SIBOR is the barometer of liquidity in the banking system, a rise in SIBOR means a relative decrease in liquidity, i.e. borrowing pressures are more than available funds 8  for lending at the current level of SIBOR. Thus to clear the marker SIBOR has to increase. A decline in SIBOR means a relative increase in liquidity, i.e. funds available for lending are more than borrowing needs at the current SIBOR rate. Thus to clear the marker SIBOR has to decline – SAMA lending rate known as Repo Rate. This is the rate that SAMA announces it is willing to lend to deficit banks at. This will create a ceiling to SIBOR. SAMA effectively says to the banks in the interbank market: ”I am willing to lend at this Repo Rate”. Thus, no bank will be able to lend at a higher rate because SAMA is offering lower rate. – SAMA borrowing rate known as Reserve Repo Rate. That is the rate that SAMA an- nounces it is willing to borrow from surplus banks at. This will be a floor to SIBOR. SAMA effectively says to the banks in the interbank market: ”I am willing to borrow at this Reserve Repo Rate”. Thus, no bank will lend at a lower rate because SAMA is offering to accept a higher rate. Thus, because SAMA is willing to intervene in the interbank market at the above lending and borrowing rates, SIBOR will fall between SAMA lending rate and SAMA borrowing rate. Saudi and US Interest Rates We have mentioned that SAMA, to maintain the exchange rate peg, can’t set the interest rate in the economy at any level it wants. It has to make sure that interest rates in Saudi Arabia follow the interest rate on the US dollar. To achieve this, SAMA use the Reserve Repo (the borrowing rate). Whenever there is a change in the US rate, SAMA right away change this rate accordingly. – SAMA wants no interest rate in our financial system to go less than the interest rate that can be obtained on U.S. dollar. If there is one, then one can borrow at it and exchange the borrowed Riyals to US dollars and get higher rate than the rate he borrowed at. This opportunity will cause a lot of Riylas to exit the economy putting a lot of pressure on the exchange rate until it breaks. Thus, to rule out such opportunities, SAMA set the borrowing rate (which sets a floor rate as we showed) at a level very close to the interest rate on US dollar. Sometime following the US rate is not in our favor. Consider what will happen if the economy in US is in recession and it needs to reduce the interest rate to motivate spending while it is booming here in Saudi Arabia. Reducing the rate here more may cause overspending and then inflation. To maintain the peg, we have to do it even if the cost is inflation. However, inflation could be dealt with in this case using other tools than the interest rate. Examples: rising the reserve ratio, rising deposit to loan ratios or any other tool that make lending more restrictive. The reverse might also happen. If the US economy is doing well while, du to low oil cycle, we run into a weak economy. If the US Fed raise the interest rate we have to follow even this may result in less spending and reinforcing the weakness of our economy. However, to address any possible reducing in spending, SAMA may use other tools that make lending less restrictive. The point is that SAMA can’t set the interest rate independently from US interest rate if the peg is to be maintained. Even if directing of the US interest rate change runs against us. This is the major cost of pegging Riyal to Dollar 9 Factors Affecting Money Level in Saudi Arabia We have seen that SAMA, to maintain the exchange rate peg, can’t use interest rate targeting as a tool to manage the money level in the economy. However, the interest rate level is not the main derive of the change in money supply in our economy like it is in other economies. To understand this, we need first to understand the factors that affect money supply in Saudi Arabia – Now we want to understand what are the factors affecting the change in money level in Saudi Arabia. Let’s use M3 as our measure of money. Figure 5 shows the factors contributing to the change in M3. The important ones are (Ignore the other items): ∗ Net domestic government expenditure in riyal: this is basically government spending inside the kingdom. Note that the government can spend outside the kingdom in dollars directly (e.g. buying defense systems from France) but this spending will not affect money level in Saudi Arabia. That is why we care about ”domestic spending”. The word ”net” means net of any revenues the government get from Saudis. ∗ Change on banks’ claim on the private sector. This cause deposit expansion and this is what interest rate changes might affect directly. ∗ Deficit in the private sector balance of payment. This is basically the BoP we ex- plained above but without revenues of oil exports, hence the words ”private sector”. Since without oil revenues, the private sector balance of payment will be in deficit because as you saw oil exports constitutes the bulks of our exports and without them we will have large deficit in BoP. – The total of these factors gives us how much M3 change in each years. That is, how much more (or less but in the table it happens not to be the case in these periods) money we see during each period. Figure 5 10  – The figure is clear in telling us that the most important factors affecting the amount of riyal in our economy is government spending and the deficit in the private sector balance of payment (i.e. riyal flowing out for import payments and other transfers). Each dollar eared to the government by selling oil is automatically credited as 3.75 riyal in an account with SAMA. The government then uses this account to pay for its domestic expenditures and hence new money enters the economy. Because government spending is very large here, it has large effect on the change in money level. The deficit private sector BoP is considered money out of the system. To finance imports or any other fund flowing out (e.g. remittances), people would present their riyals, exchange them for foreign currencies and then use them for their payments (through banks and SAMA). Any riyal converted to foreign currency is considered money out of the system. – Banking lending also contributes to the change in money level as you know in Macro 102. Any amount lent by banks tend to create more deposits and hence new money in the system. In fact, this channel is the main one in other economies. But it is not the main one in our economy as seen from the table. The net effect of the above is either increase in the amount of money in the system or decrease. Note that interest rate affects (directly) only the third one, banks’ lending. So, if SAMA wants to increase money level of decrease it, it can do that through this channel. However, SAMA can’t change the interest rate independently as you know by now. Moreover, the table shows that the net effect of government spending and imports are the most important factors that affects money supply in our economy. Other Roles of SAMA SAMA has other important roles SAMA maintain the foreign currency reserve and manage it. by investing in certain combina- tion of bonds and equity aborad. The goal is to get a decent return on that reserve with the minimal risk possible. This reserve is the money we use to finance our imports now and in the future. Thus, its level is verey important indicator of the helat of Saudi arabia as long as we depend on oil as the main source of our foreign currencies. 11