At last the Bank of Mauritius (BoM) decided to increase the cash reserve ratio (CRR) with effect from 15 August 2008. Just before announcing it, Governor Rundheersing Bheenick took great pains to make it clear that he would rather have liked to abolish the CRR altogether. This came as a surprising statement at a time when leaders in the world are harping on the monetary and financial abuses of the international banking system in the wake of the sub-prime mortgage crisis. In a recent editorial, the French daily Le Monde raised the question of “the regulation of the regulator.”

Fractional reserve banking is the root cause of inflation 

So the CRR goes up from 4% to 6%. Along with the key interest rates and the banking prudential rules, the reserve requirement is one of the three tools which a central bank has at its disposal to control money creation depending on the quantity of liquidity in circulation. Having failed on two occasions to make the Monetary Policy Committee (MPC) accept an increase of 100 basis points in the Key Repo Rate, the Governor exercises his exclusive power as the regulator of the banking sector in imposing a hike in the CRR: banks are now required to maintain cash balances at the BoM equivalent to 6% of their average deposits and other liabilities in the two-week period preceding the maintenance period; and the minimum CRR on any day during the maintenance period is 4%. 

The quarter point rise in the interest rate decided at the last MPC meeting left a bitter taste of “too little, too late”. To correct it, albeit partially, the management of the BoM has been right to act on the reserve requirement ratio in order to avoid in the future bigger adjustments that could be more harmful to the banking industry. 

Monetary tightening will be effective in so far as an increase in CRR goes hand in hand with a rise in the Repo Rate. But with the Repo Rate at 8.25%, the BoM monetary policy is still behind the curve. The Reserve Bank of India has moved up not only its Repo Rate by a half point to 9%, but also its CRR to 9% in a bid to stop inflation which has risen to 12.4%. 

In Mauritius too, the year-on-year consumer price index jumped by 11.5% in July 2008. Double-digit inflation is likely to stay in view of the liquidity hang-over. Alarmingly, credit to the private sector has nearly trebled its annual growth rate to 24% in the year ended July 2008. 

This figure makes a mockery of the notion of monetary stability. It is probable that the entry of new competitors in the banking sector has whetted bankers’ appetite for risk-taking in their loan policy. The 100 billion rupees surge in the total balance sheet of our banks in just one year (March 2007 to March 2008) does not bode well for the quality of credit. It is the role of the Governor to take a sanguine view on the soundness of our banking system, but the BoM needs to gear up its supervision vigilance on bad debts and defaults of payments. 

While the central bank issues fiduciary (fiat) money in the form of notes, a commercial bank too creates money, called deposit money, at the very moment that it grants a loan to a borrower. The loan is credited by a simple accounting entry to the account of the debtor who, in turn, draws cheques. Hence, the money circulates into other several banks and becomes their deposits, thereby increasing their capacity to lend. By virtue of this money multiplier effect, credit money is being created ex-nihilo (out of nothing). 

This is how credit fuels an inflationary process thanks to a banking system based on fractional reserve: banks constantly keep a fraction of their deposits and they lend the rest against collateral and remuneration. The whole structure of the contemporary banking system hinges on the trust of depositors that they will recover their initial money, for they can withdraw their deposits at any moment. In that respect, the method of calculating the reserve requirement ratio is crucial. The BoM defines the CRR as a percentage of total deposits, which comprise demand deposits, savings deposits and time deposits. 

Controlling money requires one hundred percent reserve 

The problem of fractional reserve banking system is that it will always tend towards a more or less uncontrolled expansion of money. If the BoM is seriously concerned about controlling it, it should consider establishing the condition that banks keep, at all times, a reserve of one hundred percent of the amount of money obtained as demand deposits. The rationale behind it is simple: money received in a current account is fungible money (also called irregular deposit) as it can be withdrawn at any moment through a cheque. 

It is unacceptable that a bank considers the funds deposited in a current account as belonging exclusively to itself. If banks were not allowed to lend something which had been deposited with them as a demand deposit, then they would give credits on the basis of real savings according to the relative scarcity of capital. This would put a stop to banking abuses and, consequently, to high inflation. 

The old Roman Law had a long standing principle that custody, in irregular deposits, consists precisely of the obligation to have always an amount equal to that received at the depositor’s disposal. This means that all acts that grant credits against fungible money are a violation of that principle and an illegitimate act of undue appropriation. 

The eighteenth century witnessed a convergence of theory and practice on the one hundred percent reserve requirement. David Hume defends it in his essay “Of Money” (1752) where he affirms that “no bank could be more advantageous than such a one that locked up all the money it received, and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce.” 

At that time, the prestige of the Bank of Amsterdam was based on the belief that it held a reserve of one hundred percent. Adam Smith reported that in chapter 3, book 4, volume 2 of The Wealth of Nations (1776): “The Bank of Amsterdam professes to lend out no part of what is deposited with it, but for every gilder which it gives credit in its books, to keep in its repositories the value of a gilder, either in money or bullion.” 

The proposal to establish a banking system with a one hundred percent reserve was mooted by Ludwig von Mises, founder of the Austrian School of Economics, in the first edition of The Theory of Money and Credit (1912) written in German. In the English edition, published in 1953, Mises expressly states that “the main thing is that the government should no longer be in a position to increase the quantity of money in circulation and the amount of checkbook money not fully – that is, one hundred percent – covered by deposits paid in by the public.” 

Mopping up liquidity is a sine qua non for a return to monetary stability 

The Austrian business cycle theory describes how the fractional reserve banking system generates economic recessions endogenously and recurrently. When a central bank sets short-term interest rates at such a low level that it causes credit to expand artificially, businesses overestimate the value of long term investments and generate a boom led by what Friedrich Hayek calls “malinvestment”. 

Such an investment-led boom, where a plethora of money is locked into excessively capital intensive projects, sows the seeds of its own destruction. It ends in bankruptcies, a crash in capital spending and an inability for producers to increase prices. Banks call in bad loans and are reluctant to extend credit. Firms liquidate wrongly induced investment projects while households scramble for cash and government securities. Overall, investment and consumption fall. 

The Mauritian economy appears to be experiencing this artificial boom. That is why the authorities must take further corrective actions to remove liquidity out of the banking system. The severe correction of the Mauritian stock market over the past months, after a long bubble phase, constitutes an eye-opener. 

Mopping up liquidity is a sine qua non for a return to monetary stability. The BoM can achieve it only if the CRR becomes a function of one hundred percent reserve on demand deposits. Since the latter represent 9% of total deposits, the CRR should be raised further to 9%. At the same time, the BoM should regularly conduct repurchase transactions to keep the market buoyant. 

Hardly had the BoM raised the CRR to 6% when our commercial banks inched up their prime lending rate by 25 basis points. Instead of reducing their profit margin, they compensate for the incremental operational cost due to the hike in the CRR. They have actually widened their interest spread as deposits rates remain the same. They also keep non-interest charges high.

While I reckon that greed is a natural feature of capitalism, what worries me is the apparent reliance of our banks on the greed motive for the successful workings of their industry. True, a bank cannot engage in a cost-cutting exercise that dents the quality of its services. But it will reap efficiency gains in applying lean management techniques rather than poaching staff with a handsome salary package. 

As the Governor of the BoM is not a firm believer in cash ratio, he would support additional increases in the Repo Rate instead of the CRR. He had argued for 100 basis points but got only 25 last time. As a two percentage point hike in CRR is equivalent to a quarter point rise in the lending interest rate, he is likely to propose 50 basis points at the next MPC meeting on 29 September. The quantum seems justified to me although I would prefer to have it in two consecutive steps.

By Eric Ng Ping Cheun

Director, PluriConseil Ltd