Foundations
Liquidity Constraints
What are we talking about?
Some combinations of the monetary problems discussed above can lead to limited availability of good quality notes and coins of a specific currency. Beyond the availability of physical currency, there can also be constraints to the liquidity of the economy in electronic transactions.
Liquidity constraints can happen for the local currency as well as for a foreign currency used in the economy. Liquidity constraints in USD can result from dollarization in an economy with limited supply of fresh bills and coins. Liquidity constraints in local currency typically result from inflation and depreciation spirals and / or from the sudden freeze or collapse of the banking system. The more the same bills are used over and over again, the more currency becomes in bad shape and some denominations become hard to find.
Why do we care?
The existence of liquidity constraints is usually the sign of more serious problems in the economy. The lack of physical liquidities is usually a sign that the Central Bank or the government is not functioning well. Constraints on digital transactions can point to structural weaknesse of the formal financial sector.
People will go to great lengths to find the liquidities they need. Situations of liquidity constraints thus tend to significantly increase the likelihood that people will resort to more damaging negative coping strategies. In particular, the risk of exploitation of the most vulnerable increases.
Depending on the extent of the liquidity constraints in the economy, some to most business may not operate at full capacity. Some businesses and value chains that depend on cashflows will more affected than other.
Situations of liquidity constraints also surprisingly present opportunities for transformation and innovation in the economy. In particular, they tend to prompt faster digitalization of finance.
As humanitarians, we will often need to adapt the design of our programs in such contexts, and start thinking about details like rounding the amounts or thinking about the denomination of the bills that we use.
Liquidity constraints can also make our operations substantially more difficult. It is essential to identify the nature of the liquidity constraint to understand which types of transactions will be most affected. You will often have to use multiple systems and multiple intermediaries to make what would otherwise have been a single transaction.
How do we monitor it?
To monitor liquidity constraints you will typically look at the availability and easy access to specific denominations of bills and coins (in either local currency or in a hard currency).
Rapid signs of wear and tear on bills are also a good sign that the same currency is exchanged a lot of time and / or that no fresh currency is coming in the economy.
A specific type of liquidity constraints that affect humanitarians is related to transactions in the international banking system. Correspondent banks can often block international transactions coming into our areas of operation if there are concerns about anti-money laundering (AML) or counter-terrorism legislations (CTL). It is important to document and monitor such problems.