Banks will start implementing the decision of the Central Bank of Egypt (CBE) to raise the reserve ratio of deposits in the local currency from 10-14% on Tuesday.
The mandatory or legal reserve ratio is one of the tools used by the CBE to influence the bank liquidity ratio, inflation rate, credit granting rates, and so on. Banks have to waive 14% of their deposits in pounds, except for 3 years and more, for the CBE without a return.
The mandatory or legal reserve is a percentage of the deposits of customers deposited by banks with the CBE without obtaining a return.
Under the regulations set by the CBE, banks operating in the Egyptian market are obliged to calculate the average balances of their deposits within 14 working days, with the exception of savings certificates’ balances of three years or more and calculate the reserve ratio according to a fixed equation.
In other words, if a bank has EGP 100m of deposit balances within two weeks, the mandatory reserve ratio is EGP 14m. Therefore, the bank must deposit with the CBE EGP 14m for one day, and because banks may be unable to provide this balance at once, the amount is distributed spanning 14 days, and so the rate is reviewed every two weeks.
The CBE decided on Wednesday to raise the rate by 4% at once, stressing that this decision comes in the light of strong financial indicators of Egyptian banks, and the growing performance indicators and profitability, which reflected the financial and monetary stability. Therefore, it is appropriate to restore the ratio again to their previous rates.
The CBE has started reducing the legal reserve ratio of its deposits on 17 April 2012, where it was reduced from 14% to 12%, and then again on 22 May 2012 by the same percentage to 10%, which was the lowest level reached.
This ratio has stabilised at this level for more than five years to support the banking sector and to enable banks to cope with increased demand for liquidity.
According to the CBE, the total amount of liquidity deposited by banks in the framework of the legal reserve ratio amounted to EGP 125.546bn by the end of June 2017.
The volume of liquidity deposited by public banks in this framework amounted to EGP 51.321bn, compared to EGP 68.215bn for private banks and EGP 6.01bn for branches of foreign banks.
Increase the cost on banks
According to Mohamed Abdel-Aal, a member of the board of directors of the Suez Canal Bank, the decision of the CBE to raise the mandatory reserve ratio on banks from 10% to 14% carries many indications.
He pointed out that the increase in this percentage represents an increase in the cost of banks as a result of not using the balance of that ratio within the liquidity invested by them, taking into account that this percentage is originally deposited by banks at the CBE to ensure the safety of banks in case they faced any liquidity issues.
Abdel-Aal noted that the rise in the mandatory reserve ratio could prompt banks to gradually cut interest rates on short-term deposits for up to one year, which could, in turn, increase the demand for high-yielding savings certificates.
“The raising of the mandatory reserve ratio comes within the framework of the CBE’s use of its tools and an extension of the implementation of its monetary policy by targeting inflation. This time not by raising interest, but by partially withdrawing the liquidity of banks and limiting the liquidity available to the banking system. This indicates an improvement in liquidity rates and growth of deposits, and it also improves the profitability of banks,” according to Abdel-Aal.
He pointed out that banks that finance small and medium-sized enterprises (SMEs) within the framework of the CBE’s initiative are exempted from compulsory reserve ratios. Therefore, the CBE’s decision to raise the ratio is expected to encourage banks to increase their funding for these projects, which will lead the next economic boom.
According to Abdel-Aal, the outcome of this ratio will support the CBE’s ability to compensate banks for the high interest rate differential they incur during the implementation of the CBE’s inflation-targeting policy.
Abdel-Aal said that the chain of successive decisions of the CBE since the flotation of the pound and the raising of interest rates and mandatory reserve all aimed at taming inflation and stabilising the exchange rate.
(Photo Handout to DNE)
Target inflation control
According to Ahmed Salim, the general manager of a private bank in the local market, the CBE may have wanted this decision to fight inflation by withdrawing part of the liquidity of banks.
However, Salim believes that there is a misconception in the state that inflation in Egypt is caused by a large liquidity in the market.
He pointed out that the increase in liquidity is not the only reason for the inflation that is witnessed, but it is also mainly because of the state’s dependence on importing 70% of its food and 60% of the production requirements.
According to Salim, there is a major advantage in this decision, and that is to encourage banks to finance SMEs.
As for the shortcomings of this decision, Salim explained that it will increase the burden of the cost of obtaining funds on banks. Therefore, banks may have to reduce the interest rate on deposits, which is a violation of the objectives of the same decision, as it will result in a decrease in the volume of bank deposits and Increase liquidity in the market.
Salim believes that this decision will raise the cost of direct investments, as banks will be forced to raise the price of lending to investors.
The interest of obligating banks to the reserve ratio
According to a report prepared by the Financial Advisory Group (FA Group), banks use their customers’ deposits by lending them to other customers in different sectors for a return that covers the cost of the deposits they hold, creating new money each time they lend depositors’ money.
The group, which is headed by Mahmoud Abu El-Oyoun, the former CBE governor, said that this does not come free of risks. On the one hand, borrowers’ defaults may harm depositors’ funds when they withdraw their deposits. On the other hand, creating money affects liquidity. This can, therefore, affect inflation, he stressed.
According to the FA Group, the CBE cannot stand as a tight-fisted spectator against the lack of protection of depositors’ funds or the need to confront rising prices. Therefore, they are obliged by law or by their regulatory authority to keep banks under their supervision. This is what is known as the “mandatory reserve ratio” in order to protect the funds of depositors wishing to withdraw their money from banks on the one hand and to limit the ability of banks to expand the creation of money on the other hand.
The application of the mandatory reserve ratio
The FA Group explained that every bank has under the supervision of the CBE an account known as the “reserve account” so that each bank has a “credit” consistently with this account, equivalent to the percentage determined by the CBE of bank deposits.
Commercial banks are obliged to keep these funds liquid for the CBE without interest. Typically, the CBE deprives these banks of the funds they hold and, thus, deprives them of the proceeds of such employment.
It added saying that the compulsory reserve ratio is a fixed-tax metaphor that costs banks.
If the total balance of bank deposits is equivalent to EGP 200m, and if there is no mandatory reserve ratio, the bank will employ the same amount at a rate of 10% for example, thus achieving a return of EGP 20m annually. Of the total deposits of this bank, it can only lend EGP 160m, with a return of EGP 16m. This means the bank has been denied a profit of EGP 4m a year.
The FA Group noted that the banks consider the mandatory reserve ratio an additional cost to be borne by them, in addition to the interest they pay from depositors.
The group explained that if the bank pays its depositors a return of 5% per annum, this means that it bears the cost of EGP 10m a year for keeping deposits of EGP 200m.
However, the bank pays EGP 10m for the amount that it can dispose of after paying the mandatory reserve ratio at the CBE, which means that the bank’s effective cost is 6.25%.
The decision on banks’ profits was confirmed
With regards to the effect of raising the reserve ratio on the profitability of banks, the FA Group stressed that the higher the CBE raises the reserve ratio, the lower the profitability of banks from the use of deposit funds, noting that raising this ratio leads to a reduction in the ability of banks to create money. This, effectively, means that raising the reserve ratio is an action in line with the impact.
“There is no doubt that raising the reserve ratio restricts the growth of the money supply and, therefore, expresses restrictive monetary policy,” according to the FA Group.
In response to a question about which is more effective in the face of inflation, whether to raise interest rates or increase the reserve ratio, the FA Group said that there is a need to distinguish between two types of inflation: the first is caused by an increase in demand (demand-pull inflation), and the second is caused by an increase in costs (cost-push inflation).
The FA Group explained that raising the interest rate and raising the reserve ratio plays a good role in reducing the inflation of demand expressed by economists “as a lot of money chasing a few commodities.” So limiting the rate of growth of the amount of money will have a good impact on inflation, but in the case of inflation caused by high cost, neither instrument will have any significant impact on it.
