Liquidity Crisis: What could Central Bank and the Government do?

-This article was originally published by Ashesh Shrestha in The Himalayan Times on January 21, 2018

Yet again, the Banking system of Nepal has been hit by shortage of liquidity. It was struck by a similar situation in the second half of the previous fiscal year. The reasons cited by economists and experts in both of the instances are very similar. High revenue collection and low spending capacity of the government, bank deposits being dependent upon remittance money (which has been declining lately) and massive lending to the unproductive sectors are reasons that have been commonly recognized.

The major problem associated with liquidity crisis in the banking system is manifested in the form low lending capacity of the banks. Due to scarcity of loanable funds, banks would be unable to meet the investment demand, resulting into stagnation of economy. These kind of supply shocks in the banking system limits the capacity of private sector in increasing the productivity of the economy.

Therefore, it becomes imperative to solve this problem in order to stop economy from getting derailed. However, before putting forward the solutions, the intensity of the problem should be carefully analysed. The solutions usually prescribed seeks for the role of Central Bank intervention into the financial system. The measures desired by banks also have been refinance facility (under which central bank offers credit to banks and financial institutions at 4 percent interest and banks are allowed to lend at interest of up to 9 percent) and reduction of the reserve ratio. However, the Central Bank should be very careful in using these monetary tools. Like mentioned above, we should make proper study, if the problem is of high intensity and whether the problem is a short- run or it is persistent. If the problem is intense and is not tenacious, the intervention by the central bank is not desired. This intervention will set the precedence and make banks habitual of the central banks interventions when the problem hits them providing more space for them to act haphazardly. The banks should try to attract more deposits instead of expecting support from the central bank.

In the current scenario, where the Central Bank does not perceive current situation to be serious, Ministry of Finance (MoF) has come up with a plan to rescue banks. Low government spending, especially capital spending, has raised government’s savings creating a huge surplus in treasury. Moreover, banks have also been complaining about that low government spending as the main factor that has adversely affected deposit collection. In order to address the problem, MoF has claimed that out of total money available in the government’s vault, 70 billion to 80 billion rupees can be made available to banks and financial institutions facing shortage of loanable funds.

This is really weird that MoF has itself come up with the idea of rescuing banks and financial institutions. A body whose responsibility is only to look after fiscal matters and use fiscal policy instruments in order to correct economic problems is trying to meddle into monetary matters, which is not its prerogative. This can infringe into autonomy of the monetary authority (the central bank), whose sole duty is to look into monetary and financial matters.

Now the question may arise, should not the government do anything about this issue as it may slowdown entire economy and may have unfavourable effect on economic growth which is not desirable. The answer to the question is if the government cares so much why does not it simply use fiscal policy measures to pacify the problem without going beyond its jurisdiction. The very first thing to do would be to increase pace of the capital spending. This will transfer the excess liquidity from the government’s vault to market and banks and financial institutions.

But, given the previous record of dismal state of government’s ability to make capital spending, this recommendation might not be easy to implement. The government has always been successful in raising revenue and has always lagged behind in making capital spending. Given these circumstances, a possible thing that government can do is use taxation policy- a fiscal policy tool. Milton Friedman, in his seminal work on consumption theory has said that when the transient income of the people increases, it is rather saved by people and not used for consumption. Government by bringing this theory into practice can help increase deposits in banks and financial institutions. Instead of directly providing money to the banks from its reserves, if the government reduces the tax rate or gives tax exemption to the individuals for a short period of time, it increases their income temporarily. According to Friedman, the amount of income that has risen due to this policy, will be saved by people, increasing the deposits in banks and financial institutions.

Milton Friedman’s theory has been empirically verified and has been used for policy analysis. His theory can provide an additional policy option to government in order to deal with current crisis and similar crises that may arise in the future without affecting the autonomy of the central bank.