Reserve requirements and capital flows in Latin America

Summary

Focus

Central banks in Latin America have actively used reserve requirements. During economic booms and periods of large capital inflows, central banks have increased reserve requirements and kept policy rates unchanged. This policy can be effective when it tightens monetary conditions and does not attract further capital inflows. While raising policy rates would have increased loan and deposit rates, increased reserve requirements have asymmetric effects: loan rates increase and deposit rates do not. If short-term capital flows are sensitive to the deposit rate, then adjustments in reserve requirements can be a better option than adjustments in policy rates.

Contribution

We investigate how banks adjusted their loan and deposit rates in response to changes in policy rates and reserve requirements. Our study is the first to investigate this on the bank-level for a large part of the Latin American banking system. We allow in our model for differential responses across banks of different types and periods of large capital inflows. We calculate reserve requirements for each bank and consider the required reserve ratios for different types of deposits and reserve remuneration.

Findings

We find that higher reserve requirements are associated with higher loan rates. Deposit rates remain unchanged during normal times and decrease during periods of large capital inflows. We find that increases in policy rates lead to higher loan rates and higher deposit rates. This finding holds during normal times and during periods of large capital inflows. Our findings suggest that adjustments in reserve requirements may have helped to stabilize domestic credit growth in a way that moderated capital flows.

Abstract

The experience of a number of central banks in emerging economies indicates that capital flows can pose a dilemma. For example, raising policy rates can attract more capital inflows by raising deposit rates. It has been suggested, however, that raising reserve requirements instead of the policy rate can address this dilemma, as deposit rates will not necessarily increase, even if lending rates rise. To investigate this possibility, this paper examines how banks adjust loan and deposit rates in response to changes in reserve requirements. We use data on 128 banks from seven Latin American countries over the period 2000-14. Our results indicate that higher reserve requirements are associated with higher loan rates, whereas deposit rates remain unchanged during normal times and decrease during periods of large capital inflows. Reserve requirements may therefore be a way to mitigate the dilemma posed by capital inflows in some Latin American economies.

JEL classification: C53, E43, E52, G21

Keywords: reserve requirements, monetary policy, capital flows