Maintaining banking liquidity may not be inflationary

Friday, May 16, 2008
Liquidity shortages are becoming more severe in Viet Nam's banking system, as citizens withdrew funds in increasing amounts to seek higher returns. This situation gives control of the economy to the informal lending sector and removes a major macro policy tool from the State Bank of Viet Nam (SBV). As a result, the government is under mounting pressure to ease the policy of capping deposit rate. Removing such caps may not have significant marginal effects on inflation, since lending continued outside the banking system.

The measure to curb credit growth by capping deposit rates has been a failure in two main fronts. First, sources and uses of funds were able to find each other outside of the banking system, so credit growth continued to power demand and inflation. Because more lending is done outside of measurable avenues, policymakers lose the precious little visibility that they have. Without banks to intermediate, lending becomes inefficient, as most lenders and borrowers have limited scope to find counter parties arid to measure risk. As a result, curbside funding can cost up to 50% a year, which implies that market pricing for capital can serve to tighten credit growth as well.

Secondly, and more importantly, informal lenders and squeezed small banks could exacerbate a banking crisis if economic conditions worsen. Banks now face mounting withdrawals by depositors, especially the smaller and thinly capitalised banks. This further forces borrower to seek other sources of funding, adding pressure on the informal market, which likely would not be accountable to depositors, as they probably receive less backing from the government. Should economic conditions deteriorate as feared, informal financial institutions and the smaller banks could more easily default and cause a run not only on themselves, but also on healthier institutions.

Allowing banks to compete with deposit rates would unlikely add inflationary pressure on the margin, since lending was still being done. Capped at 12%, current deposit rates are so deeply negative after accounting for the 21% inflation. Under these conditions, many individuals can probably tolerate risks that would normally be unacceptable. But a positive real deposit rate is not completely unthinkable, given the enormous gap between the official deposit rate and the informal lending rate. Additional funds at the banks would partly serve to meet reserve requirements that are becoming increasingly difficult, especially for small banks. The rest would be a substitute for current informal lending, leaving little room for net credit expansion.

Firms would also benefit from a lower rate and more reliable lender. Under the capped system, firms accepted curbside usury because liquidity issues are threatening solvency. With mounting profitability problems, firms would be well served to find alternative funding sources. The government's 7.2% growth target would significantly depend on business continuity, and inflation may be a lesser evil in front of a banking crisis.

This information is given by Citigroup. (SGT)