This article first appeared in The Edge Malaysia Weekly, on December 7 - 13, 2015.

THE banking system is no longer as flush with liquidity as it used to be.

Some of the signs include banks having to compete harder for deposits and looking for alternative avenues to raise funds for working capital. (See main story.)

A surplus in liquidity can no longer be taken for granted. Currency, credit and liquidity risks are increasingly coming into focus amid a tougher operating environment, rising cost and sluggish economic growth.

While a credit crunch isn’t expected any time soon, a continued diminution in liquidity will lead to rising cost of funds. This will pose a challenge for monetary policy management.

The possibility of a falling trend going into 2016 is real, given domestic developments and as the US begins to normalise interest rates. The reading is that the US Federal Reserve Board will very likely raise short-term interest rates when it meets on Dec 15 and 16, as economic indicators that have emerged in recent weeks such as non-farm payrolls in recent months have shown good growth.

US rates have stayed near zero for seven years since the 2008 global financial crisis to help the economy recover and grow.

Market players and investors are looking beyond a one-time interest rate hike by the Fed. In fact, a Dec 16 rate hike of 25 basis points has already been priced into the market, industry observers say. Since last year, a substantial amount of foreign funds have flowed out of the country — from the stock and bond markets.

In this regard, the direction of US monetary policy in the next two Federal Open Market Committee meetings after Dec 16 will be critical ones to watch. If US rates show a sustained uptrend, liquidity could become a lot more stressed.

Inevitably, as liquidity ebbs, the cost of funds will go up. Already, we are seeing signs of this happening. Banks’ deposit rates and lending rates for some market segments have begun to creep up.

The prevailing view is that Bank Negara Malaysia may not have the policy option of allowing higher rates, given the fact that the Malaysian economy is already in a lower gear.

Barclays Research, for one, has projected 2016 gross domestic product (GDP) growth at 4.7%, down from around 5% in 2015. AmResearch is of the same view, looking at a growth rate of 4.6% in 2016, down from 4.9% in 2015.

Higher interest rates could compress growth and exacerbate the slowdown. Indeed, even spark a recession.

In recent months, consumption spending has been impacted by a combination of factors, among them the rising cost of living. Higher tolls and the implementation of the Goods and Services Tax (GST) in April have begun to take its toll on consumer spending. In 2016, inflation will likely rise substantially as the economy feels the full-year impact of GST.

The last thing the man-in-the-street needs is having to pay higher interest rates to service his loans. It is a cause for concern because household debts remain high at above 85% of GDP. This is not withstanding that the central bank has implemented a series of measures in the last few years to reduce household debts.

With unemployment on the rise (we saw a series of job cuts in 2015 especially in the banking sector), the banking system’s asset quality will be negatively impacted. And as the cost of funds rise, banking margins will be squeezed because bank rates are generally guided by the overnight policy rate (OPR).

Economists do not expect Bank Negara to raise the OPR, which stands at 3.25% currently, any time soon. Barclays, for example, in a 2016 outlook report, is looking at a rate rise of 25 basis points only in the second quarter of 2017.

Here you have it. Liquidity is shrinking and rates should rise. But this is not a prudent policy option at this point in time. In the short term, when the situation warrants it, the central bank can inject funds into the banking system; it has done this before.

However, it is not a long-term solution. It is more effective to ensure vibrant and sustainable GDP growth as well as making Malaysia an attractive investment destination.

Investor confidence has taken a beating during the year. The priority is to rebuild this confidence, and this is where the challenge lies.

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