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A RIDDLE OF LIQUIDITY AND INTEREST RATE

Chumphol Mahattanakul
B.Econ (Quantitative), B.Eng (Electrical) and
M.S. (Operations Research)

The article is divided into two parts. The first Part illustrates a certain money
market mechanism through which additional supply of money is schematically
siphoned out in order to salvage the sinking financial institutions via the
lending of Financial Institutions Development Fund about three years ago. It
has dried up a liquidity available for the real sector with an embedment of
higher interest rate. A certain part of this article is to show that there remains a
room in case of no additional fund received that an interest rate could be
brought down without affecting the FIDF operation, and also benevolent to the
real sector. The latter Part is concerned about the about-face situation where
interest rates have been brought down continually for the sake of capital re-
structuring of the financial institutions, while leaving the real sector at random
with lending malfunctions. This Part also suggests a minimum deposit interest
rate pegging strategy, a way of compelling the banks to drain their liquidity.

PART I
CHARACTERIZATIONS
With a limited additional source of fund as characterized by SS curve of
which the vertical portion is reflecting its scarcity. A curve of FIDF demand
for money, DD(FIDF), is something positioned upper and right-hand-side a
demand for money curve of the real sector, DD(real sector), and then bent
downward as if it is meeting a saturation point along the salient part of
inelasticity.
Interest Rate
S S1

D (FIDF)
A*
i*
S
i1 D(real sector)
S'
i1' S'' A1' A1
i2' A2'
i2 S1 D(real sector)
A2
S2
D (FIDF)

O M* M1 M2 M
Money Supply

Empirically-constructed curves of demand of and supply for money


to explain how a money-siphoned mechanism works
IMPASSIVE SCENARIO
An artificial rate of interest i* enables the FIDF to draw on the additional
money supply out of the money market at the intersection A*. Given the fixed
additional supply OM*, it is useless to even command a lowering of interest
rate by way of shifting a concave portion of such a unique money supply
curve straightly downward towards S'S curve or S''S curve. As far as the
intersection of DD(FIDF) curve and the money supply curve is struck at A*,
prominently kept above those corresponding levels of interest rate; where a
DD(real sector) curve could intersect the respective money supply curves S'S
and S''S, FIDF could entirely suck it out.

MONEY INJECTION SCENARIO


Try ways and means of injecting an additional amount of money into the
market, for example, from OM* to OM2 by shifting a supply curve to S1S1,
an intersection remains at full satisfaction of FIDF as long as its demand
portion (beyond a range of slope-downward towards a kink) stays above a
demand curve of the real sector. Conspicuously, the intersection A1 is above
the intersection A1', permitting the FIDF to become at subdued satisfaction
by occupying a portion of OM1 at the rate of i1, while the remainder M1M2
(=OM2-OM1) would be taken for granted by the real sector at the
corresponding rate of i1'. Again, at the intersection A2', where a demand
curve of the real sector DD(real sector) struck a shifted supply curve S2S1,
and where a lower portion of DD(real sector) is now a little bit above that of
FIDF, it enables the real sector to grasp a whole amount of additional OM2
at the rate of i2'. (Please note further exploration should be made into
scenarios on which either condition of either an outward/inward shift of
DD(FIDF) curve or DD(real sector) curve or condition of those in
combinations is stipulated.)

ARTIFICIAL RATE - TO BE REVISED


Apart from a purview of money leveled-up crucible, it is needless to say that
market interest rate would slide down discretely as a result of incremental
fund to be induced. The above exhibition may elucidate an ardent debate
that, under an FIDF's eccentricity of money-siphon arrangement, none
among two monetary parameters is regarded as either a cause or an effect. It
commands, within the ambient complexity, an artificial interest rate, as
critically determined by the Bank of Thailand, be right away brought down,
perhaps step by step, towards a nominal one as long as the demand curve of
FIDF and the money supply curve SS are so artificially constructed and
confined to its limited source OM* respectively. The real sector will virtually
gain nothing from the foregoing but a lower cost of fund where a market
borrowing rate of interest would follow. To do this, all overstated cost
elements of financing of FIDF should be truncated as financial institutions
absorb nothing (e.g. no operating cost incurred, no need to gain a
considerable spread) in conducting a viciously-cycled transaction through a
repurchase window - that is benevolent to FIDF. Inflation rate which is also
regarded as interest rate determinant is likely containable unless the current
strict monetary policies ruin most of the national supply potentials. Despite
experiencing a chronic liquidity problem on one side, lowering of high interest
rate towards a nominal one is at least conducive to business survival chiefly on
part of financial cost on the other side!
PART II
ABOUT-FACE SITUATIONS
The foregoing scenario was pertinent to the past three years that the previous
administration had indulged in maintenance of high rates for a long time
before untimely letting it loose (leaving a number of bankruptcies behind)
with a view to surviving the financial institutions on capital upheaval side.
Both deposit and lending rates have been manipulated (not driven by market
mechanism as often cited) on a diving track (with a wide spread) for making
up for dwindling earnings from crippled lending.

It is remarkable that if the present administration let it be like the past


administration (as well as the naive monetary policies on stubborn low
interest rate and timid inflation-targeting of the Bank of Thailand), the end
result would be either one would go earlier between financial sector and public
(including a real sector) sector!

HOW TO HANDLE
A problem-solving is most likely to put more weight on boosting a purchasing
power (on the earnings side) than a debt settlement side. In other words, the
administration should strengthen and focus on the earning hand not the
debt-settling hand. No repayment can be made unless having money. On a
broad amount of five trillion baht national savings, every cut of one per cent
of deposit is equivalent to a yearly loss of fifty thousands million baht
purchasing power. Notwithstanding how low an interest rate would be,
interest-stimulated investment policy stays impassive in a liquidity-cum-debt
trap situation as no interest resilience can yield on investment.

It is requisite that the administration peg the floor (minimum) for deposit rate
at which the banks would suffer a loss unless injecting money into the economy
through their lending hands, a way of turning around the economy. By this, a
proportion of contributions to the economy is believed to account for much
larger than that of a set-back of the recurrence of non-performing loans with
which a national assets management corporation could appreciably cope. A
three-year attest of business strength of the survived business firms is likely
sufficient for the banks to restore their functional lending as usual. An afraid
of facing NPL recurrence should not be an excuse any longer.

Bangkok
May 13, 1998