AT the end of a business day, banks sometimes face a cash shortage owing to their lending and withdrawals by their customers. The rate at which banks lend money overnight, from the reserves kept at the central bank, to banks that experience a cash shortage is the overnight policy rate (OPR). In Malaysia, Bank Negara Malaysia (BNM) determines the OPR.
After keeping it at three per cent since 2011, BNM increased its OPR in July 2014 to 3.25 per cent. At its last Monetary Policy Committee meeting in September, BNM decided to maintain the rate. So, should the OPR be revised?
Economists have long been castigated for their equivocation. So much so, in exasperation Harry Truman (US president from 1945 to 1953) asked, “Give me a one-handed economist. All my economists say, on the one hand on the other.” To answer categorically, we must examine the influence OPR has on the economy.
Governments influence economic growth through two fundamental polices: fiscal and monetary. While fiscal policy relies on public expenditure and taxation, monetary policy relies on money supply and interest rate.
To boost economic growth a government either increases public expenditure to pump more money into the economy or lets its citizens do so by reducing income taxes. The increased demand, consequent to more money circulating in the economy, should spark increased production and employment. Additional employment will create further demand and the virtuous multiplier effect will kick in to cause greater economic growth.
Conversely, when the government wants to cool an overheating economy, it tightens its belt and/or increases taxes thereby reducing demand in the economy. And the multiplier effect operates this time in reverse.
Similarly, governments influence economic growth through changes to their money supply. Between November 2008 and October 2014, the Federal Reserve — the central bank of the US — instituted its quantitative-easing programme (QE). Under the QE the Federal Reserve “printed” (read electronic cash) as much as US$85 billion (RM287 billion) to buy long-term government bonds. With that money the United States government was able to pump stimulus into an economy reeling from the 2008 global financial crisis.
And in October this year, Japan expanded its QE to 80 trillion yen (or RM2.3 trillion) annually to spur economic growth. The EU, too, has embarked on a similar QE to jump-start its sputtering economy.
Another way of injecting more money into the economy is by revising the statutory reserve that banks must keep with the central bank as a proportion of their customers’ deposits.
Banks create money through lending and relending many times over the money that is deposited with them minus the mandatory reserve. When a bank lends, it does not lend cash. Rather, it merely credits the loan electronically to the borrower’s account. If more money is to be pumped into the economy, the central bank has only to reduce the statutory reserve, thereby, giving banks greater excess reserves from which to create money.
The OPR is another instrument of monetary policy. Changes to OPR signal parallel changes in the base lending rate (BLR) — the interest rate that banks charge their customers. For example, before the OPR increase, the BLR was 4.5 per cent. Now it averages 4.7 per cent. OPR changes also trigger changes to the interest and savings rates, credit creation, economic growth, employment and foreign exchange rate.
The OPR reflects expectations about future inflation. Should inflation trend higher, OPR can be expected to be set higher to curb inflation. For example, expecting a spike in inflation to eight per cent at year-end, as a result of removing petrol subsidies partially, Indonesia raised its OPR to 7.75 per cent in mid-November.
The reduced borrowing and increased savings consequent to the interest rate rise will suck money out of the economy. That will dampen inflation and curb credit — the twin aims behind the recent increase in the OPR. Before BNM raised its OPR, inflation was 3.3 percent. Now it is 2.6 per cent. However, lower investments from higher borrowing costs can negatively impact on production and employment growth.
The OPR can also impact upon the country’s foreign exchange rate. An increase in the OPR can quickly bring about an equivalent appreciation of the foreign exchange rate of a currency. This is because, all else being equal, investing in a country with a higher interest rate will result in a surge in demand for that currency and cause its exchange rate to rise. For an exporting country such as Malaysia that will make its exports more expensive.
Given the far-ranging impact of changes to the OPR, we now confront the question: should the OPR be revised?
The world is hurting. Ukraine is in totters. The Ebola epidemic overhangs. Geo-political worries abound — Palestinian conflict; Western sanctions against Russia; territorial disputes in the South China Sea; Islamic insurgency; North Korea’s belligerence; Iran’s nuclear programme. The European Union economy is creaking, China’s is slowing down while Japan’s has slipped into recession.
The domestic front, too, offers little cheer. There are fears of twin deficits in our budget and trade. At four-year lows, oil price falls will damage the government’s financial position as it relies on oil for one-third of its revenue. Oil and gas constitute 20 per cent of our exports. Palm oil and rubber prices have fallen by about 16 per cent and 25 per cent respectively this year. Our ringgit has depreciated by 10 per cent against the US dollar this year.
These deflationary tendencies may portend an OPR cut as the central bank of China did recently, seeing its growth rate fall to 7.3 per cent from the heady days of double-digit growth. China cut its rate from six per cent to 5.6 per cent in mid-November.
However, a cut to our OPR will compound the anticipated inflation arising from the Goods and Services Tax and fuel consumer credit which, at 87 per cent of Gross Domestic Product, is among the highest in the world. Erring on the side of caution it might be best to keep the OPR intact.
Setting the OPR is like walking a tightrope. The balance is a fine one. It will require all the skills that a central bank can muster.