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

Abstract

This paper examines why commercial banks in Guyana demand non-remunerated excess reserves, a phenomenon that became even more widespread after financial liberalisation. 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 sterilisation 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.

Foreign Exchange Pressure in Barbados: Monetary Approach or Monetary Dependence?

“…The coefficient estimate of LIQ has the expected sign and is statistically significant. This is consistent with the finding for Guyana by Khemraj (2009). It implies excess reserves from money printing do not make more loans, but they are used to purchase foreign currency assets.…”

“…For example, it is clear that an opportunity cost variable, such as the domestic prime lending rate, would determine the commercial banks' demand for NFA, but not the central bank's demand for international reserves. The excess reserves of the commercial banks should increase their demand for NFAs as found by Bakker(1993) andKhemraj (2009), but not the demand for central bank's FX reserves and so on.The first model to be estimated is in the spirit of the monetary approach and somewhat in the absorption approach. The main determinants of CBB's demand for FX reserves would be (i) a foreign interest rate that captures a speculative dimension of demand (which we proxy by the 3-month US Treasury bill rate), (ii) a precautionary motive (which is measured by the negativerating outlook of Moody's and Standard and Poor and volatility), and (iii) factors exerting downward pressure on demand for foreign reserves.…”

“…This is measured by prime loan rate in Barbados, L r , which would also indicate the speculative motive once we subtract the foreign interest rate mentioned earlier. One unique factor that should influence the demand for NFAs by banks is the amount of excess reserves in the banking system (Khemraj 2009, Bakker 1993). We do not have the excess reserves data, but we do have total reserves, which is indicated by LIQ.…”

“…This is why all the excess non-remunerated reserves are not eliminated via the automatic Nurkse-ian reflux mechanism as outlined by Lavoie (2001). In the case of neighboring Guyana, for example, the banks have a tendency to purchase excess liquid assetsprimarily domestic treasury billswhen there is a shortage of foreign currency and make investments in foreign assets when there is a surplus of foreign exchange in the local market (Khemraj 2009). Therefore, the demand for government securities reflects the persistence of the foreign exchange constraint or friction.…”

Size and Liquidity Effects in Nigeria: An Industrial Sector Study

“…It is worth noting that these characteristics of liquidity are derived from the development finance literature definition of this phenomenon which is based on stock market trading activity and associated transactions costs. As such these are distinct from other unrelated definitions of liquidity effects in economic literature in relating levels of money to interest rates (see Carpenter and Demiralp, 2008) or from banking literature in terms of the completeness of credit markets and ability of commercial banks to convert excess reserves into investment (see Khemraj, 2009). O'Hara (2003) in undertaking two principal functions: facilitating price discovery and the provision of liquidity.…”