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Monetary ‘drag’: Why the BSP should conserve firepower

If there is a “fiscal drag,” we also have a “monetary drag.”

There is fiscal drag when the tax system becomes so progressive that extra earnings are penalized. Another example is when someone gets promoted but ends up taking home less income on account of being in a higher tax bracket.

In such a case, a rational individual will be forced to reduce his consumption expenditures. On a magnified scale, this impacts aggregate demand. In the same way, lower corporate income after a tax restructuring could also lower investment spending. In such a case, the increase in public revenues will be insufficient to compensate for the decline in aggregate demand.

A fiscal drag could cushion the economy from demand-pull inflation, but the more serious impact is on economic growth and employment.

In another column, we wrote that banks choose to be pro-cyclical. This is why we suggested that by continuously lowering policy rates, the central bank is pushing on a string. Instead of expanding loan portfolios in response to monetary easing, banks are instead tightening lending standards and are placing the public’s deposits and their own freed reserves in government securities. The Bangko Sentral ng Pilipinas (BSP) is also a risk-free investment choice. Thus, by cutting policy rates in this climate, the BSP ultimately absorbs and compensates for the liquidity it released into the system to lower the cost of money and increase the volume of credit.

The goal to inspire more business activities is impeded in the credit channel of monetary policy.

More rigor on this issue was recently provided by the BSP through its Working Paper Series. Two very competent bank officers at the Department of Economic Research, Carolina P. Austria and Bernadette Marie N. Bondoc, wrote about this in their article, “The Impact of Monetary Policy on Bank Lending Activity in the Philippines.”

Austria and Bondoc premised their research on the various channels of monetary policy. These are the interest rate, exchange rate, asset price, and bank lending channels. In recent years, the expectations channel has also gathered potency. The research’s goal was to check how these channels transmit monetary policy to the real sector and affect domestic demand.

Focusing on the bank lending channel, the BSP senior economists stressed that monetary policy impact on bank lending depends greatly on the substitutability of the sources of credit. If bank loans are the dominant source of credit, the effect of monetary policy is more potent on bank lending.

The economists admitted that undoubtedly, “measuring the sensitivity of bank lending behavior to monetary policy changes is… fraught with challenges.”

One challenge is simultaneity. This means it is difficult to establish the effects of policy when an economic shock is addressed by a monetary action. High economic growth is often accompanied by tight monetary policy because down the road, with a lag in monetary impact, central bankers should anticipate a potential run-up in consumer prices. It is the role of central banks to worry and watch out for risks.

In a downturn, like what we are experiencing today following the COVID-19 pandemic, excessive monetary easing could trigger future high inflation and financial instability due to mispricing of risks.

Because the channels work together, another challenge is the difficulty of isolating the impact of bank lending from other channels. For instance, while tightening monetary policy could result in lower bank lending, ascertaining how much is due to a decline in demand following an interest rate increase or to a decline in loan supply will be a tall order.

Austria and Bondoc were correct in adopting the methodology used by Kashyap and Stein (2000)* who squarely addressed these empirical issues. In their paper, Kashyap and Stein argued that the lending channel assumed that banks cannot leverage on uninsured sources of funds to make up for a central bank-induced shortfall in insured deposits without cost. This implies that monetary policy affects bank lending differently depending on the liquidity position of each bank. This will determine how they will react to monetary policy.

The BSP paper builds on the Kashyap and Stein model to determine the existence and strength of the bank lending channel in the Philippines. They tested two hypotheses. First, bank lending in the Philippines increases (decreases) as the monetary policy of the BSP eases (tightens). The effect is magnified when banks have weaker balance sheets. Second, the effect is strongest for smaller banks.

The BSP senior economists found very little evidence of monetary policy transmission through the bank lending channel in the Philippines.

Despite trying different ways of generating other possible results by increasing the sample size, using various proxies to the BSP’s policy rate and changing the banks’ composition and groupings, their conclusion held through these different configurations.

One possible explanation for this is loan portfolio rebalancing. Tighter monetary policy could motivate a shift of portfolio from say, real estate and consumer loans to commercial and industrial loans.

Another explanation is some banks’ superior balance sheets and liquidity which allow them to sustain their loan programs despite BSP monetary initiatives. These banks could choose not to increase their lending operations during a downturn by selective lending. According to the BSP quarterly survey of senior loan officers, instead of easing their loan standards, some banks even tightened them. Thus, the BSP’s goal of inspiring more lending operations is frustrated.

Beyond the tendency to be pro-cyclical, banks have behaved differently: bank lending turned out to be a weak monetary policy channel.

They quoted our own 2008 paper where we found that the weak bank lending channel may be attributed to financial market liberalization in the Philippines. This began in the early 1990s and weakened the impact of monetary policy on bank lending. The surge of alternatives to bank loans; the opening up of financial markets; and increase in securities trading have weakened the link between the real economy and the bank lending channel. Moreover, the rise of conglomerates involving cross ownership of banks and real estate development, has allowed the banks to override monetary policy intent because banks have alternative fund outlets.

It is precisely because of this weak bank lending channel that the BSP decided in 2016 to establish the interest rate corridor system to influence short-term market interest rates to move closely with the BSP’s policy rate. This would hopefully strengthen this channel of monetary policy.

Their findings could also be explained in terms of the banking regulatory framework. The BSP imposes a penalty on banks co-mingling regular peso and foreign currency deposits (FCDs). Liquidity coming from the external sector, whether from foreign investments or current account surplus, is kept with the banks’ FCD units and is invested abroad or lent to exporters or non-residents. External flows are immaterial to local lending by banks unless the BSP buys those dollars for pesos.

The other explanation is the abnormal period of 2008-2015. With very high credit growth at the time, the BSP increased its policy rate twice in 2014 alone. But these increases were not enough. Higher rate adjustments were required to even temper credit growth. This irregular period was due to one, the global financial cycle which led to more dollar inflows to emerging markets with higher interest rates; and two, higher dollar inflows that constrained monetary policy regardless of the exchange rate regime.

Concluding that the bank lending channel is a weak channel of monetary policy, Austria and Bondoc proposed two policy implications. The monetary authority should consider using a combination of its policy rate, required reserve ratio (RRR), auction volumes for deposit facilities and macro-prudential measures. Good coordination of policy and operation is important.

We observe that precisely, the BSP has been doing just that. Given the deep recession for the last three quarters of 2020, the BSP has brought down the policy rate to negative in real terms. RRR was brought down by 200 basis points. Auction volume has been adjusted periodically but given the enormous injection of liquidity in the system, the BSP has been constrained to also mop up almost the same volume of liquidity amounting to around P1.9 trillion. The banks’ modest lending leaves them with so much liquidity which they park with the BSP itself. Macro-prudential measures have been resorted to including the incentive for banks to support small business.

Yet, the latest monetary condition continues to support the argument that bank lending remains a weak channel of monetary policy. In October, while money supply expanded by 11.8%, bank lending net of placement with BSP, barely rose by only 1.9%.

Are we seeing instead stronger evidence of monetary drag?

It’s about time the BSP considered conserving its firepower for when it is really necessary.

* Kashyap, Anil K., and Jeremy C. Stein (2000). “What Do a Million Observations on Banks Say about the Transmission of Monetary Policy?” American Economic Review, 90(3): 407-428.


Diwa C. Guinigundo is the former Deputy Governor for the Monetary and Economics Sector, the Bangko Sentral ng Pilipinas (BSP). He served the BSP for 41 years. In 2001-2003, he was Alternate Executive Director at the International Monetary Fund in Washington, DC. He is the senior pastor of the Fullness of Christ International Ministries in Mandaluyong.

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