Rate cuts: The good, bad and the ugly

By FS

(November 01, Colombo, Sri Lanka Guardian) Last week’s decision by the President for state banks to cut interest rates to a minimum of 8% and maximum of 10% saw a mixed reaction from the public. Industry was overjoyed, banks grumbled as they have to bear some losses at least in the short term, and depositors, particularly those who rely on interest income for daily and annual expenses, were stunned. For the last category, within seconds their income had come down by half.

While this will not apply to fixed deposits as the interest rate is fixed for a specific period, it would apply to short term interest deposits and new deposits. While the intention of the government may be honourable in setting off signals to the private sector to invest in the economy, the reality is that Sri Lanka has still not reached a stage where the interest rates can be in line with international trends.

Interest rates overseas are much lower than those prevailing in Sri Lanka and has been the case for many years. Furthermore even though the rates were high last year – around 18 % by commercial banks to depositors -, tens of thousands of middle-class income earners and pensioners opted to invest their money in higher-bearing instruments at finance companies and companies like the now-defunct Golden Key Credit Card Co. The collapse of unregistered finance companies and the run on deposits in even the more stable finance companies is now well known and extensively reported in the media.

Most investor-depositors are seeking a higher rate of return not only to manage the household budget but also to fund their children’s education abroad. Last week during a discussion on education issues at the monthly meeting of the Sunday Times Business Club (STBC), Dr Athula Ranasinghe, Head of the Economics Department at the University of Colombo, explained how middle-class parents mortgage their properties to send their children abroad due to the shortages of places in local universities.

In the same way, dozens of depositors in the failed finance and real estates companies in the Ceylinco Group were banking on interest income to fund their children’s education abroad. And these are ordinary Sri Lankan families, not the wealthy or nouveau riche (new rich), struggling to provide their children a decent higher education due to the problems in the local university system.

The moment the government directive to state banks was announced, some commercial banks also followed suit though there is no compulsion to do so other than for competitive purposes. The way the system works, according to bankers, is that when interest rates fall, while fixed deposits are largely left untouched, short-term and monthly interest deposits get affected. However in the lending sector, all loans (lent at around 18-22% interest) will now be re-structured to the 8-12 % lending rate, which means banks would lose because interest on fixed deposits remain unchanged.

The Central Bank (CB) has been systematically reducing its treasury bill and bonds in line with a government policy to lower rates and lift investment particularly after the conflict ended in May. However commercial banks haven’t followed the CB signal and are not interested in increasing their loan portofolios due to a high rate of non-performing loans and no incentive for investments.

Commercial banks found it safer to invest in CB instruments. However that avenue too is gradually being shut with CB rates sliding with 364-day t-bills falling sharply to 10 % this month from 19.6% in November 2008. The rationale in reducing rates is to attract more investments which has slowed down and not even picked up after the May success in the warfront, due to the impact of the global financial crisis which is still hurting economic sectors in Sri Lanka.

Generally interest rates keep pace with inflation because a lower return on an investment is considered a negative return. While inflation is now down to a single digit and, naturally, interest rates must also come down, the case for a similar scenario in Sri Lanka has its share of problems. For example official inflation is not what it is when buying goods in the marketplace. However in the absence of other inflation indicators, one is compelled to swear by the Census and Statistics Department index – and there lies the problem.

Of course economists will tell you that inflation is just the rate of increase from yesterday’s prices to today’s prices but what is visible to the consumer in the marketplace is that the rate of increase is much higher than what the figures show. Maybe we need to get the housewives and house-husbands who know the actual price levels to slug it out at a forum with CB economists and statisticians for a real picture to emerge.

A low interest rate regime is good for the country as it encourages investments and entrepreneurship but not when inflation rates are lopsided. Furthermore a new element in interest income is the spend on education which is a sizable segment of interest income needs. The other arguable issue is that people are living beyond their means and basking in too many luxury goods and need more money for such a lifestyle, even for a middle-class family. But that’s more the exception than the rule – ask the dozens of investors in failed companies who are struggling to meet their daily expenses.

The main beneficiaries from rate cuts are the stockmarkets where prudent investors would find more value in stocks, on the longer term, than in bank instruments, and those shady dealers offering dubious investment schemes at high interest rates which may once again attract depositors desperate to receive a ‘decent’ rate of return.

Despite learning a bitter lesson from the collapse of Sakvithi and Golden Key, desperate depositors may opt for these investment avenues – at whatever cost – to meet urgent needs and once again the Central Bank will be called to save the day for the depositors!

-Sri Lanka Guardian