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The Potential Impact of Increased Minimum Required Reserves on Mozambican Economy

The Potential Impact of Increased Minimum Required Reserves on Mozambican Economy

  • Klaus Nielsen • Head of Financial Risk Management Department at Standard Bank

Klaus Nielsen – Head of Financial Risk Management Department at Standard Bank

The Monetary Policy Committee of the Bank of Mozambique (BoM) decided on 25 January 2023 to increase the reserve requirement ratio for local and foreign currency deposits from 10.5% to 28% and 11.5% to 28.5% respectively.

The aim of this article is to explain what MRR are, how changes to this metric impact monetary policy, why the BoM may have chosen to increase RO and not market interest rates and what implications this decision will have on customers and banks.

What are Minimum Required Reserves?

MRR are the minimum reserves that commercial banks or depository institutions must hold against their liabilities in the form of balances held at the Central Bank. For example, for every 100 meticais a bank receives in customer deposits, 28 meticais will have to be deposited at the Central Bank, as opposed to the previous 10.5 meticais.

Because of the increase in MRR, all commercial banks must increase their mandatory deposits with the BoM by about MZN 92bn, making a total of MZN 156bn against the current MZN 64bn reported at the close of January 2023.

How do the changes in the MRR impact monetary policy?

The logic behind the BoM’s decision to increase the MRR was to use them as a monetary control tool to absorb excess liquidity in the interbank market that could potentially be converted into credit and thus increase inflation in the future.

The excess liquidity in the market can be reflected by the 11.6% year-on-year increase in the stock of bank placements in liquid instruments which totalled 34.8 bns MT in December 2022. Simply put, the funds that a bank lends to customers result from the difference between all its deposits and the regulatory reserves that it must build up.

The negative impact from the increase in MRR will be especially relevant for banks with a high loan-to-deposit ratio, known as the transformation ratio, as they will have to attract more depositors by offering deposit rates above market rates

The extra funds that a bank holds are known as excess reserves. Therefore, when MRR increases, commercial banks will have less money to lend to customers.

This first-order impact is amplified by the fact that when banks lend their excess reserves to customers they deposit their loans with a second bank.

The second bank in turn lends the same deposits to its customers, and the cycle continues until the excess reserves are exhausted.

The amount of money the banking system can create through this loan/deposit cycle is found using the money multiplier, as it determines how many times a loan will be multiplied through the excess reserves mechanism.

The important thing to note is that an increase in the MRR coefficient reduces the money multiplier and vice versa.

Recently, the Bank of Mozambique decided to considerably increase the Required Reserves coefficients

When the Central Bank decides to increase the MRR, it creates a reduction in excess reserves and also in the money multiplier, thus reducing the rate of monetary expansion.

When this happens, it is referred to as a contractionary monetary policy as it reduces the amount that commercial banks can lend and create new money. On the other hand, when the central bank reduces MRR, it increases the money supply in the economy – this is called expansionary monetary policy.

By increasing the MRR and, consequently, reducing the amount of credit that can be made available in the economy from excess reserves, the BoM is able to contain potential inflationary pressures by reducing the demand for goods and services in the economy.

Why did the BoM decide to change the MRR instead of raising interest rates to reduce inflationary pressures? What implications does this decision have for customers and for commercial banks?

The answers may lie in the fact that if the BoM increases the Monetary Policy Interest Rate, commonly referred to as MIMO, this: 1) make it more expensive for the BoM to fight inflation as Treasury Bill rates will increase; 2) make it more expensive for the Government of Mozambique to raise funds as Government Bond rates will increase; and 3) in a context where people’s finances are already under pressure due to the high cost of living driven by post-Covid supply chain pressures and the war in Ukraine, any increase in interest rates may generate high levels of non-performing loans.

See Also

By increasing the MRR, the Bank of Mozambique is not only able to reduce excess liquidity in the interbank market to lower inflationary pressure, but is also able to do so without increasing its costs and, to some extent, safeguard existing borrowers, even if an increase in the MRR also implies an adjustment in the Prime Lending Rate via the risk premium.

The benefits associated with using MRR as a monetary policy instrument come at a loss for commercial banks and customers seeking new loans.

For commercial banks, the reduction in excess reserves resulting from the increase in MRR translates into a reduction in the loan portfolio with a consequent loss in associated revenue.

In monetary terms, the increase in MRR for local currency will lead to a loss of revenue for commercial banks in 2023 in the order of MZN 12.8 bn, while for foreign currency the loss of revenue will be between MZN 90m and MZN 950m.

The negative impact arising from the increase in MRR will be especially relevant for banks with a high loan-to-deposit ratio, known as the transformation ratio (ratio between credit and deposits), as they will have to attract more depositors by offering deposit rates above market rates to comply with the BoM’s MRR.

For example, commercial banks with a transformation ratio of 73% or more will be forced to attract new depositors to comply with the BoM’s obligations and, consequently, will be forced to offer more attractive rates, which in turn causes other banks to increase their deposit rates to protect their deposits.

On the other hand, commercial banks with transformation ratios of 50% or less may not be forced to increase their deposit rates, but may experience some deposit outflows as customers seek higher yields.

In conclusion, increasing MRRs will protect the economy from possible inflationary pressures as excess liquidity in the interbank market is eliminated and credit portfolio growth is contained.

On the other hand, the disadvantage that arises from the increase in MRR is the slowdown in the economy due to reduced aggregate demand and additional pressure on the banking sector through reduced revenues and potentially increased liquidity needs.

This disadvantage is offset by the fact that the cost of living is stabilised as inflation is contained and potentially avoids considerable interest rate increases in the future.

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