A picture is worth 10,000 words #25: Monetary Liquidity, Central Bank CD’s and Reserves

January 30, 2007


(Version en espaol aqui
)

Well, this picture is going to need some words and explanations as it is part of the difficult problem facing the authorities.

This picture is all composed of data from the Venezuelan Central Banks webpage, converted to US$ at the official exchange rate of Bs. 2,150 to the US$. The red curve represents the monetary liquidity (M2) composed of all of the bolivars in circulation, including all savings accounts, repos and CD’s at banks. The first thing to note is the rapid expansion of M2, which has gone from US$ 20 billion at the beginning of 2005 to US$ 55 billion at the end of 2006. This is an increase of 175% in two years and 69% for 2006.

This growth in the money supply is a problem for the Government. Too much money in circulation pressures inflation and, given the deeply negative interest rates (savings rates~4-6%, inflation 17%) it pressures the parallel exchange rate as people seek that market in order to protect their investment. Similarly, too much money in circulation within an exchange control system, also drives merchants to the parallel market.

Now, yesterday, I noted that the country’s debt was manageable. This is true, but the Central Bank can also go into debt independently of the Government. And it has big time! As M2 grew too much, the Venezuelan Central Bank began issuing CD’s (Certificate’s of Deposit) to local financial institutions in order to absorb part of the excess monetary liquidity or “sterilize” it in the jargon of monetary authorities. The orange curve shows the growth of these CD’s in time, they were almost non-existent in 2003 and now the stock has increased to the amazing amount of US$ 18.2 billion. Most of these CD’s are 30 days and receive an annualized rate of 10%. (Some receives only 6% but it is a small fraction).

In addition, banks have to place as reserves 30% of all their deposits, half of which gets paid interest. This is the green curve. The blue curve is what I call Abs in the graph for Absorption=CD’s+ Reserves, which currently stands at US$ 30 billion, since it represents all of the liquidity absorbed by the Government.

The problem for the authorities is that M2 has grown too much and the Central Bank cannot continue issuing CD’s at will. Why? Simple, because it may go bankrupt. You see, the Central Bank pays interest from the return it obtains from the country’s international reserves. Currently reserves are at US$ 36 billion and while it is not known how they are being invested, we know an important fraction (~25%) is in gold, which receives no interest. The remainders we are told is mostly invested in Euros, which means it get a return between 3.5-4%. If we are generous and say 4% (we could say 5% and the argument would not change), that means the Central Bank has income of about US% 1 billion from this.

But you see the problem? The Central Bank receives US$ 1 billion in interest but has to pay 10% on about US$ 18 billion, or US$ 1.8 billion plus about 10% on bank reserves which is an additional half a billion US$, for a total of US$ 2.3 billion.

And that is why the Central Bank can no longer increase its absorption operations; it is already losing too much money by issuing these CD’s. Last year, reserves were increased to 30% and the Central Bank has maintained roughly US$ 18 billion in CD’s, but it cannot issue more. The problem is that M2 keeps growing as the Government spends, spends and spends,

Why does this happen? Simple. Monetary liquidity comes from the Central Bank issuing Bolivars against the international reserves it has in US$. But some fool (the current Minister of Finance?) came up with the idea of giving part of the reserves to the Development Fund Fonden. Thus, international reserves have remained constant, while monetary liquidity has expanded dramatically in the last two years. Thus, if they had not taken the reserves from the Central Bank, it would be able to finance itself, but they have done it twice and Chavez intends to do it a third time to the tune of US$ 8.7 billion, leaving US$ 27.5 billion in reserves or less if oil stays where it is today.

Why doesn’t the Central Bank go bankrupt? Because so far they have used extremely creative accounting such as the Government paying back debts nobody remembered and allowing the Central Bank to have foreign exchange gains. But they know it cannot increase.

And that is one of the main reasons why the parallel exchange rate is under pressure. As the monetary liquidity has gone up, the absorption has remained constant and more money is in circulation looking to get out. Unfortunately, the Government does not have as many weapons to fight this, precisely because it created so much inorganic money.

Let’s see the options:

1) It can’t increase the stock of CD’s, the Central Bank would be in trouble
2) It could increase bank reserves, but that could create profit problems for some banks.
3) It could issue a dollar denominated bond to soak up liquidity. However, if a year ago a US$ 3 billion issue was 20% of the excess liquidity, today it would only be 12%. Thus, it would have to issue a US$ 6 billion bond to have an impact, which may be too large for current international markets. In any case, in a couple of months new liquidity would erase the effect.
4) It could devalue. This would devalue the country’s internal debt as well as the BCV’s CD’s making it easy to pay. It would give the Central Bank new foreign exchange gains. It would also relieve pressure in the parallel market and provide more Bolivars to the Government.
5) It could limit withdrawals in bank accounts, “Corralito” style.

Not a pretty picture, no matter how you look at it. As I have said before, you can temporarily ignore the laws of economics, but it catches up with you. It is a phenomenon intimately related to the Devils’ Excrement and its corollaries.

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