Saudi anti-inflation measures may hit banking sector

Saudi Arabia's decision to force its banks to increase their deposits with its central bank within measures to curb soaring inflation could hit the profitability of those banks, a leading Saudi bank said yesterday.

The Saudi Arabian Monetary Agency (Sama) resorted to such a measure in the absence of other effective fiscal tools to fight inflation, the National Commercial Bank (NCB) said in a study sent to Emirates Business.

Sama, the Gulf Kingdom's central bank, lacks other fiscal measures to reverse accelerating inflation because its monetary policy is constrained by the long-standing peg between the Saudi riyal and the US dollar, NCB said.

"Monetary policy in Saudi Arabia is constrained by the riyal's peg to the US dollar, given open capital account movements. The long-standing policy of linking the riyal to the dollar has worked well in the past," the study said.

"However, recent monetary policy easing in the United States has forced Sama to lower interest rates, leading to increasingly negative real interest rates at a time when the economy is already expanding… a higher reserve ratio is associated with an opportunity cost for banks, i.e. the amount of interest income forgone if these reserves were invested in higher-yield assets. They are in effect a direct tax on banks, which will affect the profitability of the sector."

Since early November 2007, Sama has cut the reverse repo rate in tandem with the US Federal Reserve by a cumulative 300 basis points to two per cent, while keeping the official repo rate unchanged at 5.5 per cent.

Moreover, the persistent weakening of the dollar has implied a real effective depreciation for the Saudi currency, while the surge in oil revenues has placed more pressure on the government to increase public spending.

All these factors added to domestic demand pressures, where inflation has reached unprecedented levels in the Kingdom over the past few months.

In order to offset the expansionary impact of lower interest rates on liquidity, while maintaining the exchange rate peg, Sama has resorted to changing the reserve requirements for commercial banks.

In the period between November 2007 and May 2008, Sama raised the reserve requirement on demand deposits four times, from seven per cent to 13 per cent, and for the first time lifted the reserve requirement on time and saving deposits to four per cent from two per cent. In theory, a higher reserve requirement reduces the supply of money available to banks for lending activity, thereby slowing down the growth in domestic credit and eventually money supply growth.

According to NCB, Sama's decision to raise the reserve requirements for the banks has several implications.

"First, banks already hold reserve assets in excess of statutory requirements, which reached up to 50 per cent in April 2008. Instead of cutting back on lending, banks opted to reduce other deposits with Sama," it said.

Its figures showed statutory deposits at Sama surged to SR50.4 billion (Dh49.5bn) in May from SR28.8bn in November 2007, while other deposits at Sama fell by SR35.3bn, over the same period. Flush with liquidity, banks accelerated private sector credit, which rose to 33.4 per cent in May 2008 over the same month of 2007. Consequently money supply (M3) growth advanced to 21.6 per cent over the same period.

"Second, frequent changes in the reserve requirements can be highly disruptive to the operation of individual banks in the Kingdom. Banks have already set aside around SR31bn since November, which is equivalent to three per cent of their total assets," the study said.

"Now that the monetary easing cycle in the US is reaching an end, Sama might not be forced to cut interest rates again this year. This will certainly provide some relief for Sama for some time… however, this does not omit the possibility of another hike in reserve requirements. The ceiling for reserve requirements is 15 per cent, according to Basel II regulations, but legally Sama reserves the right to hike up to 17.5 per cent… either way, Sama should stay focused on guarding against asset price appreciation and a possible build up in related vulnerabilities on bank financials through appropriate prudent measures.

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