Central banks often use reserve requirement to manage liquidity in the banking system. Generally, when the amount of liquidity in the banking system increases, central banks increase reserve requirement to drain out some surplus liquidity. When the banking system is short of liquidity, central banks reduce the reserve requirement.
Over a short span of time (roughly October 2007 – April 2008), Qatar experienced a sharp rise in liquidity in its banking system, largely as a result of increasing short-term inflows to stress test the dollar-riyal peg. To mop up some surplus liquidity, the Qatar Central Bank raised the reserve requirements three times in a span of five months.
Reserve requirements are like a tax on the banking system since commercial banks in Qatar receive no return on their reserves. However, the economic implications of this tax depend on how the tax burden is ultimately shared between depositors and borrowers. Intuitively, an increase in reserve requirements to keep the money stock constant would potentially make deposits less attractive (if depositors pay the reserve tax) or loans more expensive (if borrowers pay the reserve tax). A reserve tax is borne by both depositors and borrowers if they have poor substitute for banking products.
The following Table presents the evolution of key deposit and lending rates of interest, spread and money multipliers around the time of the changes in reserve requirement in Qatar. Monthly data are used to trace out the path of each variable from the month prior to the increase in reserve requirements (labeled t-1) until 2 months following the event. The data presented in the Table reveals two important regularities.
First, both depositors and borrowers pay the tax (albeit differently); in all three cases deposit rate of interest fell on the month of the change in reserve requirements as well as 2 months following the event. In contrast, in one case only the lending rate rose on the month of the change in reserve requirements while in two episodes it declined. In two
episodes, the deposit-to-lending interest rate spreads widen in the following months (t+1, t+2) in the wake of an increase in reserve requirements. Second, in two instances the narrow money multiplier fell on and in one case in the month following the change in reserve requirements. Similar pattern is observed with the broad money multiplier, which possibly indicate that during this time period foreign-currency deposits accounted for a small share of total bank deposits.
Taken together, the evidence presented in the above Table suggests that the policy of hiking reserve requirements was partially effective, at least in the short run, in curbing the monetary expansion. Nonetheless, the increases in reserve requirements did not produce the expected effect due to very high level of excess reserve held by commercial banks. Besides, the creation of nonbank institutions (e.g. the Qatar Financial Centre) contributed to domestic credit expansion, thereby weakening the central bank’s monetary control.