The liquidity glut: Risks and remedies

Bad loans. Weak balance sheets. Political interference. Inadequate risk-management practices. Lack of customised financial products. Yes, this is the interminable list of problems long plaguing the banking sector in Bangladesh. And in more recent times, that list has a new item: a liquidity glut.
A combination of low investment appetite in the absence of adequate infrastructure and stable politics, fall in commodity prices, tightened commercial lending policies, access to foreign loans and incomplete sterilisation of capital inflow has driven up excess liquidity to Tk 1.3 trillion (1.3 lakh crore) in September 2016 from Tk 600 billion (60 thousand crore) in January 2013. Anyone familiar with Bangladesh's money market trends will recall that interbank (call money) market rates would shoot up during religious festivals sparked by seasonal increase in money demand. It is a testament to the sheer magnitude of surplus liquidity that even interbank rates are defying this age-old seasonality. This year, the call money rate remained subdued at 3.0-4.0 per cent and hardly exhibited any volatility. More generally, excess liquidity pushed down interest rates across the board. In the two years ending in August 2016, one-year risk-free rate fell by 3.5 percentage points; bank lending and deposit rates (weighted average) fell by 2.5 and 2.2 percentage points respectively.
Finally, borrowers can don their party-hats. For years, entrepreneurs complained that high borrowing costs got in the way of greater investment, growth and profitability. And now, lending rates have come down to around 10 per cent from levels in excess of 15 per cent only a few years ago! In fact, some banks are lending at single-digit rates to its best clients. Small wonder that growth in private sector credit rocketed to 16.5 per cent in Fiscal Year (FY) 2016 after languishing at 12-13 per cent for around three years. More encouragingly, data from Bangladesh Bank shows that industrial loans to the private sector grew by 21.1 per cent in FY 16. One would think this is just what the doctor ordered: cheaper credit financing more private investment, leading to greater profitability, more taxes to spend on much-needed public goods and ultimately, higher and more inclusive GDP growth. Sounds good in theory, but the ground reality is quite different.  
For one thing, growth in industrial loans to the private sector was led by short-term working capital loans (grew by 28.1 per cent) rather than term loans (grew by 13.9 per cent) in FY 16 as shown in the table above. In other words, credit flow to the industrial sector was driven more by everyday operational needs like settling accounts payables or paying wages, and not purchase of fixed or long-term assets. There is also growing incidence of large, cash-rich firms playing nifty games of interest rate arbitrage: borrowing at low rates from some banks and investing at higher rates in other banks or non-bank financial institutions, earning a useful spread. So the evidence that private investment is about to pick up or excess liquidity will sustainably come down is still mixed and unconvincing.
Then consider the downsides. Small savers are earning negative returns on their deposits if we take inflation into account. Inevitably, lower-income families with little or no asset holdings feel the pinch of negative real interest disproportionately more, amplifying social inequality.  
It should also come as no surprise that monetary policy is weakened. Because excess liquidity pushed down interest rates, BB reduced policy rates to realign monetary policy with markets according to its January policy statement. But lower return from policy instruments makes it harder for the BB to mop up liquidity, undermining sterilisation objectives and leading to more liquidity in a vicious feedback loop. So if the central bank cannot fully control growth in money supply, bad loans and inflation may shoot up again. Asset market bubbles cannot be ruled out either.
The matter does not end there. The decline in government bond yields could thwart BB's efforts to bring down the banking sector's interest rate spread. Other things equal, a bank is unlikely to reduce its intermediation spread if it is forced to invest gargantuan amounts of money in government treasuries which cannot earn more than what a bank pays to its depositors. Needless to say, it is the ordinary people who pay the price of a high difference between deposit and lending rates.
So what can be done to turn things around? For starters, syndicated loan products, loans to Small and Medium Enterprises and branching out to rural areas are viable options. But more transformative changes are in order. Excess savings, as reflected by current account surpluses year after year, are not worth writing about in an economy which also has a financial account surplus (through foreign direct investment, portfolio investment, aid disbursement and corporate borrowings). In an optimal setting, Bangladesh can run a small current account deficit that is financed by a financial account surplus, ensuring no undue pressure on reserve position, balance of payments or the exchange rate.
For this to happen, either the private sector or the government (or both) has to spend much more. At current debt-GDP ratio of 34 per cent, Bangladesh has an ample space to expand the fiscal deficit to 6.0-7.0 per cent from its current level of 4.0 per cent of GDP. The idea would be to increase spending on capital formation within a fixed period, and then reduce fiscal deficit gradually. A key question that should come to mind is what will be change in GDP due to an increase in government spending (or what is the fiscal multiplier, in economics jargon)? While research is still limited in Bangladesh's context, a study by the Asian Development Bank in 2006 found short-term fiscal multiplier of a temporary increase in government spending to be 0.79 for Bangladesh. To put it in context, the same study found that fiscal multiplier for China was 1.57! So the key to utilising surplus liquidity in a growth-maximising manner will rest squarely on stronger public sector project-implementation capacity to capitalise on whatever resources we generate and provide better infrastructure. That public investment worth 7.0 per cent of GDP has hardly eased infrastructure constraints (serviceable land, electricity supply, and efficient transportation routes) is evidence of low spending quality: this, along with other impediments to doing business, needs to change.
Infrastructure needs aside, a corporate bond market would also help. A deep bond market could drain out some of the liquidity from banks, facilitate better capital allocation, attract foreign investment and improve monetary policy transmission. But deepening the bond market still remains a formidable task.
Absence of an enabling regulatory environment with proper financial incentives, a benchmark bond, robust trading platforms, simple trading procedures, a liquid secondary market and appropriate financial hedging instruments are just some of the obstacles to a vibrant bond market.
On the trade policy front, Bangladesh can increase growth-enhancing imports (reducing current account surplus) by embarking upon gradual tariff liberalisation on selected products. Increasing the import component of our consumption basket can also help reduce inflation given that many of our trade partners are experiencing prolonged slowdown or decline in inflation. For instance, according to the World Bank, China's inflation declined from 5.4 per cent in 2011 to 1.4 per cent in 2015. Japan, despite massive quantitative easing programmes, is still unable to escape deflationary clutches. We need to take advantage of these depressed price levels so that depositors receive positive real returns and the reduction in nominal interest rates is sustainable. But can we overcome political resistance and slowly liberalise trade? That remains to be seen.
It would be remiss not to mention that bankers are unanimously blaming the government's policy of borrowing more through national savings certificates (NSCs) for the liquidity glut. Does this argument hold water? We are aware that at current levels of budget deficit, the government does not need savings flowing into both NSCs and those in banks. With this in mind, consider a scenario where the government significantly slashes return on NSCs or eliminates them all together. In all likelihood, an enormous amount of household savings would then flow into banks. Bank deposit growth would most likely surge back to its 10-year historical average of 16-17 per cent from its current low of 12-13 per cent. True, a small share of savings may flow into stocks and real estate. But ordinary citizens, lacking confidence in domestic asset markets, would still put the largest share of their hard-earned money in banks. It follows logically that unless the government increases budget deficit, banks would still be left with large quantities of surplus funds. To bottom-line it, as long as the real economy is in a state of under-investment and domestic asset and financial markets remain underdeveloped, a liquidity glut will persist.
Unless BB drains liquidity out of the system by tightening monetary policy, which is not a sustainable solution, or if it lets capital flow out a bit, to be sure, capital account liberalisation would put the brakes on rapid rise in net foreign assets (by extension, reduce risk of incomplete sterilisation). But perhaps this should be of second-order priority, if we want to spend our resources on our own economy first before financing other countries. And spend we can in plenty if we improve infrastructure and business climate, deepen the corporate bond market and gradually liberalise trade.   
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Sharjil Haque is a macroeconomic research analyst for an organisation in Washington D.C. and a Research Fellow for the Asian Centre for Development in Dhaka. Views expressed are his own.
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