Many countries faced with the global economic recession have been resorting to both fiscal and monetary expansion to stimulate aggregate demand.
Sri Lanka had little space for fiscal expansion as the government expenditure had already escalated at an alarming rate during the past few years. Nevertheless, the recent decline in domestic inflation provided room for monetary expansion to bring down the interest rates. Having exploited this opportunity, the Central Bank continued to relax its tight monetary policy stance since last year. The domestic interest rates are still much higher in Sri Lanka compared to the international levels, but these rates together with an improved investor confidence encouraged foreign investment in the country’s portfolio assets. However, the interest rates are much lower now compared to their high rates around 20 percent in the past.
Falling Interest Rates
What do we expect from lower interest rates? Because interest rate is the cost of borrowings, in response to lower interest rates there should be a credit expansion to the private sector. The resulting increase in private investment and aggregate demand stimulates the economy through business activities.
This will also help to mitigate the adverse impact of the recession on the economy. But what has been observed in the banking sector does support this type of argument because there was no credit expansion. They have also not reduced their lending rates in line with relaxed monetary policy measures by the Central Bank. In fact the banks were also in a better position to increase lending at reduced interest rates, but they did not. What went wrong?
Unlike the banks operating in the global financial centres, the Sri Lankan banks did not go through a hard time against economic recession. They did not feel a liquidity shortage or a credit crunch, but actually saw a rising excess liquidity position. It is true that the domestic banks experienced a contraction in their business and an increase in non-performing loans. Nevertheless, their deposits continued to rise at an accelerating rates since the late 2008.
The bank deposits increased from Rs. 1411 billion to Rs. 1538 billion during the first six months of the year, by 9 percent compared to 3.5 percent in the previous six months. The sudden increase in bank deposit may also be a result of an increased transfer of deposits from non-bank financial companies to the commercial banks. This was caused by the loss of public confidence particularly on private non-bank financial institutions due recent chaos in the sector caused by bogus and troubled financial companies. Consequently, the banks also experienced an increase in excess liquidity nearly by 7 percent during the first six months of the year.
Slowing Down Credits
In spite of all favourable developments, bank credit expansion was slowing down. However, total bank loans include lending to government institutions as well, so that it is a question whether the loans to the government institutions have declined or not.The total bank loans which grew by 6 percent in the first half of 2008 recorded a falling rate of growth by 4.9 in the second half of 2008 and by 1.2 percent in the first half of 2009.
Given the higher risks of lending caused by the economic downturn and the increase in non-performing loans, apparently the banks adopted a cautious lending practices in the recent past. Nevertheless, with increased deposit base and excess liquidity how could the banks make profits by constraining creadit expansion? It is because of the government which continued to be the biggest borrower of loanable funds at the expense of the private sector. The banks had the opportunity to divert their increased deposits to purchase government securities by lending to the government.
Bank investment in government securities increased by 20.2 percent in the second half of 2008 and by 48.9 percent in the first half of 2009. When deposits grew by Rs. 127 billion during the first six months of 2009, loans increased only by Rs. 13 billion, but investment in government securities by Rs. 103 billion.
Since the two state banks play a dominant role in the Sri Lankan banking sector, a large part of bank investment in government securities is also due to the state bank lending to the government.
Even the private banks that seek to minimize risks and maximize profits appear to have made the right choice by choosing safe investment in government securities against credit expansion to the private sector. The net beneficiery of the relaxed monetary policy stance is, therefore, the government and not the private sector.