Demand for Excess Reserves by Commercial Banks in Papua New Guinea

Abstract

This thesis consists of three self-contained chapters that empirically examine the excess reserves issue in the banking system of PNG. The accumulation of excess reserves may have undesirable implications on the financial system, macroeconomic stability and monetary policy implementation. Hence, Chapter 2 examines the factors that induce commercial banks to hold unremunerated excess reserves. The chapter employs an ARDL model to estimate the determinants of excess reserves using monthly time-series data for the period January 2002 to December 2017. The model includes three precautionary variables of volatility of demand deposits, discount rate and cash reserve requirement and four involuntary variables of foreign reserve inflows, private sector lending, private sector deposits and treasury bill rate. The selection of these variables is determined by data availability and relevance to the economy of PNG. The findings suggest that the discount rate, volatility of demand deposits and private sector deposits significantly contribute to the accumulation of excess reserves. In contrast, foreign exchange reserves, private sector credit and the treasury bill rate effectively reduce excess reserves pressure in the banking system. However, the cash reserve requirement is not effective in influencing the demand for excess reserves. The empirical analysis concludes that involuntary variables are the leading determinants of excess reserves in PNG. Chapter 3 explores the impact of excess reserves on the transmission of monetary policy. The chapter employs a structural VAR model to measure the flow-on effects of positive shocks to excess reserves and the lending rate on private sector loans, the exchange rate, the CPI and real GDP using quarterly time-series data from March 2001 to December 2020. The study uses quarterly data since high frequency data for some variables are not available. The shocks are measured by the orthogonalized innovations to the monetary policy variables. The impulse response results show that the lending rate and excess reserves shocks have unanticipated effects on the exchange rate and the CPI in the short run. Similarly, in the long run, the response of GDP to the shocks is not consistent with monetary theory. Furthermore, the variance decomposition results indicate that excess reserves account for minimal components of the shocks to all variables in the short horizon. The historical decomposition results suggest that the excess reserves shock contributes weakly to the fluctuations of the CPI and GDP over the sample period. The findings determine that excess reserves reduce the effectiveness of monetary policy transmission mechanism in PNG. Chapter 4 investigates the effectiveness of monetary sterilization operations. The central bank uses sterilization policy to mitigate the monetary effects of foreign capital inflows, a source of excess reserves. The effectiveness of the policy depends not only on the conduct of open market operations, but also on the raising of cash reserve requirement. Thus, this chapter estimates the sterilization and non-sterilization coefficients by using the monetary policy reaction and money supply functions. The empirical analysis uses quarterly data from March 1998 to December 2020 under the 2SLS framework. The estimated coefficients indicate that the central bank highly sterilizes the monetary effects of foreign capital inflows. However, the intensity of sterilization is not perfect through the monetary policy interventions. Hence, the unsterilized reserves positively influence the monetary base and money supply in the domestic economy. Furthermore, the findings establish that the open market operations are more effective than cash reserve requirement regarding the success of monetary sterilization in PNG. Show more