If Not Managed Properly, Central Bank Led Interest Rate Reductions Will Be A Time Bomb

By W A Wijewardena –

Dr. W.A Wijewardena

Governments throughout the world supported by their central banks have been on a path to push interest rates down. The objective has been to stimulate the economies that have fallen into negative range by the ongoing COVID-19 pandemic. Since it has added to the misery of people cutting down both employment and welfare levels, the governments have thought that the best way to help people has been to flood them with bank credit at low interest rates. There is a point in this strategy: businessmen will borrow money at low interest rates, use it to pay salaries and other day to day bills, invest in plant, machinery and buildings to increase the production of goods and services. It will improve the economic conditions and take the economies concerned back to where they were prior to COVID-19 pandemic. 

However, the Central Bank of Sri Lanka had been on to a low interest path well before the onset of COVID-19 pandemic. It had started cutting down interest rates and flooding the economy with money from around the beginning of 2019. This was its response to the declining economic growth in the country in the preceding few years. This action was intensified by the bank under the worsening conditions of the COVID-19 pandemic in which all economic activities came to a standstill for a few months. Accordingly, the bank used two tools which were available to it to help economic recovery. One was the continued reduction of the ratio of deposits which commercial banks had to mandatorily maintain with the central bank based on their deposit levels, known as the Statutory Reserve Ratio or SRR. It released the money kept in idle form with the central bank back to commercial banks to enable them to increase their lending to customers. The other was the step by step reduction of the central bank’s policy interest rates to push the whole interest structure to a low level. There are two such policy interest rates used by the central bank. One pertains to the interest rate which the central bank pays to commercial banks when they temporarily deposit their excess money with it called the Standing Deposit Facility Rate or SDFR. The other is the interest rate which the central bank charges from commercial banks when they borrow money from it called the Standing Lending Facility Rate or SLFR. These interest rates are so connected to the other interest rates in the economy that they can be termed ‘mother interest rates’ in the country. Hence, when these policy rates are increased or reduced, all other interest rates too change in the same direction. 

Accordingly, SRR which was at 5% earlier was reduced to 2% by June 2020. This released about Rs 200 billion back to commercial banks. On the other side, the policy interest rates which were at 8% for SDFR and 9% for SLFR were brought down to 4.5% and 5.5%, respectively. The result was that all interest rates in the economy – deposit rates, Treasury bill and Treasury bond rates and commercial bank lending rates – began to move downward. Thus, one-year fixed deposit rate fell from 11.5% in December 2019 to 5.5% by June 2020. Similarly, one-year Treasury bill rate fell from around 8.5% to 4.8%. Providing a relief to borrowers, the average prime lending rate of commercial banks, that is, the rate applicable to the best customers of a commercial bank, fell from 9.7% to 7.4%. In the opinion of the central bank, and also of the government, such a general downward movement of interest rates appears to be a blessing. 

But fixing interest rates arbitrarily by a regulator should be done carefully. That is because there are two parties involved in the determination of interest rates and when the central bank reduces interest rates, one party is benefitted while the other party is harmed. No economy can move forward on a sustainable basis when one party is happy and the other party is distressed. Who are those two parties? On one side of the scale, we find people who save a part of their earnings without consuming them and make available to others for temporary use. These people are called savers who supply loanable funds to the market. On the other side of the scale, there are people who spend more than they earn and fill the gap by borrowing. These people who are called borrowers make a demand for loanable funds. In this system, savers insist on interest being paid to them and borrowers agree to make that payment. When both parties are contented, the system is in balance and no room for complaints.

In the present interest rate reduction programme, borrowers have been made happy but savers have been harmed. Many ask the question why savers should be paid interest. There are three reasons for paying interest to savers. 

First, when they make available a part of their income for use by borrowers, they sacrifice their current consumption in preference to a higher consumption when the borrower repays. Since everyone would like to have a benefit today rather than tomorrow, their time preference is for today. But when they make their savings available to borrowers, they sacrifice their time preference and expect a payment for it. That is one reason why interest should be paid to them. Therefore, when we disaggregate a market interest rate, we find that one segment of that rate is a payment for sacrificing time preference. If we deny this payment to savers, they have no incentive to save money and allow borrowers to use it. This part leads to increase a saver’s real welfare and therefore it is known as the real interest rate. For instance, suppose I save Rs 20 and allow a borrower to use it today. If the price of a coconut is Rs 20, all I have done is giving a coconut to a borrower without my consuming it. Hence, when the borrower repays, I should also get a little more than a coconut. That little more than part is the payment for sacrificing my time preference and serves to increase my actual welfare level.

Second, interest should be paid to savers to protect them from the harmful effect of inflation. Suppose that the price of a coconut in our previous example goes up to Rs 40. If this happens, I would get in return only half a coconut plus a little more. To establish me at the previous real welfare level of one coconut and a little more, I should now be paid an interest rate that would ensure that I would get one coconut and a little more. The additional payment is therefore a premium that is paid to savers to protect them from inflation. This is the second segment of a market interest rate.

A third reason arises due to the risk of non-repayment of the money which a saver has made available to a borrower. To recover this money, he has to incur a cost and it is normally included as a segment of the interest rate. This is called a risk premium. 

When we disaggregate a market interest rate, we, therefore, find these three segments: a premium for sacrificing the time preference, a premium to take care of inflation and another premium to cover the risk and uncertainty faced by a saver cum lender. Savers insist that they should be paid these three premia and borrowers agree to pay them to savers making both parties contended. But when the central banks reduce interest rates arbitrarily, we deny all these three premia or some part of them to savers. It discourages savers from making a saving and use that too for his current consumption. This would cause the savings flow to dry out and it would eventually harm the borrowers too. Those who live basically from interest income, senior citizens and pensioners, are specifically harmed by low interest rates. If somebody had a one-year fixed deposit of Rs 100 a year ago, he would have got an income of Rs 11.50. But today, he would get only Rs 5.50. His welfare level is basically cut by a half and as a result, he is driven to misery. 

Low interest rates benefit mainly the governments and large corporates who have access to loan markets better than others. With the reduction of one-year Treasury bill rate to 4.8%, the government’s interest expenditure has been cut by half. With the marginal fall in the prime lending rates, large corporates are also benefitted. But the same cannot be said of small and medium enterprises. Their access to bank credit markets is still at a premium. Worst affected are the micro and meso – meso are those between micro and SMEs – borrowers. They have no access to bank funding and therefore have to resort to informal money lenders for their credit needs. But that would be at unaffordable high interest rates.

Hence, the low interest rates have surely harmed savers. At the same time, they have not benefitted micro and meso borrowers. They have benefitted governments and large corporates in a big way and SMEs in a minor way. And these parties are not the whole economy. As such it is a time bomb set by the government and the central bank. Hence, if low interest rates are continued beyond COVID-19 pandemic, the time bomb would certainly explode harming all.

*These are the points raised in the first episode of the Economic Vlog – Ida, Space – Economic Wisdom with Dr W A Wijewardena aired on 3 Aug 2020 by Sampoorna Business Team