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The legal required reserve is an effective monetary policy tool

Feb 27,2021 - Last updated at Feb 27,2021

The Jordanian experience proved that the legal required reserve was and still is one of the effective monetary policy tools that the Central Bank of Jordan used during the past monetary, financial and economic crises that the Jordanian economy experienced over the years and decades. It used, at times, to intervene in the market to affect the volume of liquidity, increase foreign reserves, and affect interest rate levels in the economy. It was used, of course, with other monetary instruments, such as open market operations, using government securities or certificates of deposit issued by the central bank, and rediscounts and repurchases operations. It has proven its success in achieving the goals for which it was used in Jordan.

The legal required reserve is the amount of money that a bank keeps in the Central Bank of Jordan without interest to ensure its ability to fulfil obligations in the event of a sudden withdrawal of deposits. At the same time, it is a tool used by the Central Bank of Jordan, as mentioned, to influence the level of liquidity in the economy, reducing it in the event of recession to revitalise the economy by providing more liquidity to banks to enable them to expand the granting of credit facilities to various economic sectors that need financing, or increasing it in the case of economic boom to control inflation.

In March 2020, the Central Bank of Jordan reduced the required reserve ratio from 7 per cent to 5 per cent in response to the repercussions of the corona pandemic. As a result of this reduction, an amount of JD550 million was provided free of charge to banks, especially small ones, to enable them to provide credit facilities to the economic sectors that have suffered from a lack of cash flows as a result of the closures. These sums were responsible, among other factors, for the increase in the banks’ liabilities shown by the banks' consolidated balance sheet for the year 2020. It is the first time that the Central Bank of Jordan resorted to this tool with a reduction since 2009.

This step was successful par excellence. Reducing the required reserve ratio for banks provided them with idle funds that enabled them to invest for return, which helped alleviate slightly the decline in banks’ profits during the year 2020.

The clear and successful experience of the Central Bank of Jordan resorting to this tool was at the beginning of the nineties of the last century. The required reserve ratio was raised to its upper limits, 35 per cent, permitted by law on foreign currency deposits, following the financial and monetary crisis that erupted at the end of the eighties. It also served its purpose excellently. As the main dilemma that the central bank suffered from at that time was the depletion of its foreign reserves, and due to the increase in the required reserve ratio on foreign currency deposits, the central bank’s reserves increased significantly in a record period.

It is wise for the Central Bank of Jordan to use this ratio with a greater margin of freedom, so that it is 10 per cent, for example, on large banks that have unused excess liquidity, and 5 per cent on small banks that need liquidity. Data on the interbank market in Jordan, which averages 100 million dinars per day, indicates that usually there are a limited number of banks selling liquidity, which are the big banks, and a larger number of small banks buy liquidity to meet the requirements of the central bank and other short-term liquidity needs.

The legal required reserve is a monetary tool par excellence, which the central bank uses in light of the aforementioned set of factors, and the reduction of the ratio in normal conditions should not be in close periods, especially when there is excess liquidity with banks that are bankable, reflecting the availability of certain projects that are eligible for borrowing.

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