A judicious mix of interest rates is what makes an economy tick and that is one of the main challenges of the Central Bank (CB). For an economy, savings is important to mobilise funds from the market which in turn could be lent to increase economic activity, create more jobs and put more money in [...]

The Sundaytimes Sri Lanka

Enigma of interest rates


A judicious mix of interest rates is what makes an economy tick and that is one of the main challenges of the Central Bank (CB).
For an economy, savings is important to mobilise funds from the market which in turn could be lent to increase economic activity, create more jobs and put more money in the hands of people.

Therefore for savings to increase, interest rates must be attractive enough. On the flip side, high lending rates will not attract borrowers, and in turn stifles economic activity. Lower interest rates also affect a significant percentage of the population; those dependent (mostly pensioners) on fixed income deposits. The ‘crisis in dependence’ facing many depositors in failed finance companies is an example of how many people rely on this income.

On the positive side, a low interest rate regime stimulates the stock market, with more investors preferring to invest in this sector than in low interest, fixed deposits. The performance of companies has also been boosted by reduced interest rate costs and both these factors have been seen in recent months in the Colombo stock market. Another positive is that low interest rates should drive more investments, more borrowings.

However, low interest rates have not attracted many takers with credit growth among banks declining sharply while thousands of pensioners and others depending on fixed income from deposits have seen their earnings shrink.

This mysterious developments (or is there a ‘catch’ somewhere?) has not only stumped commercial banks but even the regulator. No one can pin down the ‘actual’ reasons why there has been slow growth in credit so much so that commercial banks and finance companies may further cut deposit rates because they are flushed with funds and no one to lend to.

Some bankers argue that low demand for credit is due to lack of business confidence while others believe it could be lack of confidence in the CB’s ability to sustain these rates for a reasonable period or suddenly switch to reverse gear.

Interest rates have been falling with the CB imposing a maximum limit in April on savings deposits in finance companies to 7.58 per cent per annum, and reciprocally savings rates much lower at commercial banks.

“May be credit growth is slow as the Central Bank’s track record of sustaining long periods of low interest is not good,” noted a stock market analyst.

Many fixed income earners say banks now add all kinds of extra costs and in addition to lower interest rates, other costs further reduce their monthly interest earnings. The Business Times has received several letters from pensioners and fixed income earners over the past few months complaining about ‘hidden’ costs by banks and their reduced earnings that is affecting the day-to-day existence. The crisis facing some finance companies and troubled forestry management company, Touchwood, is aggravating the situation and dampening enthusiasm among Sri Lankans who have money to invest but are confronted with these low interest rate issues.
In the last 12 months, fixed income earners have seen their earnings slump by at least 50 per cent.

Banks have been discussing the slow credit growth crisis with the regulator but few solutions are on the table other than the banks being repeatedly told to raise credit disbursement levels to stimulate the economy.

Last month the CB approved a credit guarantee scheme on pawning (gold) advances to resurrect this sector, which has also slowed down considerably. Bankers said the new guidelines provide for a CB guarantee on pawning advances on 65-80 per cent of the value of the pawned article, mainly for small farmers and small industrialists to increase economic activity in these sectors.

The CB, while acknowledging that credit flows to the private sector and public corporations contracted earlier this year, said in March that the ‘deceleration’ in credit growth is a temporary phenomenon. But when the situation worsened, the CB last month offered further incentives to stimulate pawning advances.

In a February 16, 2014 article titled “Central Bank’s low interest rate policy and economic pitfalls” in the Business Times, renowned economist and statistician Prof. S.S. Colombage argued that the CB is likely to continue the low interest rate regime for some time. Being a heavy borrower in the domestic money market, apart from borrowings from foreign sources, the government is an obvious beneficiary of low interest rates.

He believes reducing the government’s debt service burden may also have been a determining factor for monetary authorities to keep interest rates down though it is not explicitly acknowledged.

What are the danger signals that would arise out of a low interest rate scenario? Income levels for pensioners and fixed income earners would further slide and with borrowings on the downside, banks may continue to cut interest rates on ongoing deposits and new deposits, or add more ‘hidden’ costs.

This would force investors to seek other options, which are few – stock market or finance companies – to invest at a higher return. In any event, the return on investments would be at a single (below 10 per cent) digit level, not enough for a sizable segment of the population who solely depend on interest income to run households.

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