The Dark Side of the Low Interest Rate Regime

                                     

By Sandunika Lekamwasam

Cost of Borrowing

The Economics literature defines the interest rate as "the interest rate is the yearly price charged by a lender to a borrower in order for the borrower to obtain a loan. This is usually expressed as a percentage of the total amount loaned."

In general people talk about nominal and real interest rates which expresse the influence of inflation into the interest rate. In simple words, when people talking about interest rate they generally refers the nominal interest rate which is not been accounted for the inflation. Therefore the nominal interest rate always moves with the changes in the inflation rate. For an example, the lender will be compensated not only for delays his/her consumption but also for the fact that a rupee will not buy as much a year from now as it does today. The real interest rates are interest rates where inflation has been considered. This reveals in the Fisher’s theory of interest rate as well. Further in terms of theoretical explanations, classical theory of interest rate depicts that the natural existence of self‐adjustment mechanisms that the economy is always at or near the natural level of real GDP and the economy is self-regulating. Here the natural level of real GDP means the level of real GDP or the output that is obtained when the economy’s resources are fully employed. But is that practical? That is why intervention of the government taken place introducing the role of Central Bank.

Recent Trends in Interest Rates

Simply interest is the price paid for borrowed capital. There can be so many varieties of interest rate, but a country’s interest rate usually will be benchmark to interest on government securities. It is usually with short-term Treasury bill rate in Sri Lanka. According to the money regulating body, the central bank of Sri Lanka, the benchmark interest rate was last recorded at 6.50 percent and in average 8.20 percent from 2013 to 2014.(Trading Economics, 2014)We have been experiencing a declining trend in market interest rates since the latter part of 2012. The central bank is likely to continue lower interest rates as to support the economy to attain its growth potential since at the moment the country is a heavy borrower in the domestic market as well as from foreign sources. Thus setting lower interest rates makes the government an obvious beneficiary.  Government may seek a solution to loosen its debt service burden throughout this exercise.

Low Interest Rate Regime: Is It Always Good for All?

It is quite obvious that most developed nations are having low interest rates yet those are heading with low inflation and of course small, zero or surplus balance of payment which plays the exact opposite of the developing nations.

As a developing country there are both pros and cons in this prolonged period of low interest rates in Sri Lanka. According to the perspective of the authorities, low interest rate helps to enhance credit growth needed to boost investments and economic activities. But keeping interest rate low for a long period would generate inflation and thereby result a contradictory outcome which is opposing the purpose of expected economic growth and boosting investments. Other than to that, there is always a high chance of occurring an asset bubbles in low interest environment. In simple words asset bubbles are occurring when prices go way up, and suddenly they crash back down. This low interest rate environment is highly vulnerable to asset bubbles, because low interest rates can always create an over expansion of the money supply. For an example, in this sort of situation, investors can borrow cheaply but cannot receive much return on bonds they have invested, so that they use to look for another asset class. Meanwhile risk takers are inspired to engage in financial speculation leading towards asset bubbles that enhances the financial instability which was experienced by East-Asian countries during the financial crisis in 1990s. (Miller, M. and Luangaram,P. 1998)

There are also numerous adverse effects of low interest rates on household savings and balance of payment. This can be elaborated further as that the general public would tend to shift their savings from low return financial instruments to acquisition of valuable consumer goods such as luxury vehicles which of course would drive the traders to start importing such products by obtaining the real benefit of lower interest rates. Vehicle imports, which were on the decline since April 2012, began to increase from June 2013 and recorded a year-on-year increase of 109.1 percent in August 2013, becoming the main contributor to the increase in consumer goods imports.(Sirimane, S. 2013)This in one hand supports to create a gap in Balance of Payment and in another hand defeats the policy makers’ intention of improving economic activity by financing more on capital goods. Because this type of prolonged low interest rate environment inspire importing more of consumer goods which maximizes profit at the moment and avoid importing investment goods which is with less demand. This is an obvious negative impact on anticipated economic growth by the policy makers. This situation proves with the data published in 2013 as that the import of consumer goods have been increased by 7.2 percent meanwhile the export expenditure on intermediate and investment goods have been declined by 6.2 percent.(Colombage, S.S., 2014) This picture reveals that the nation is stepping backward in terms of capital investments which would initiate low productivity, lack of innovation, unemployment and etc. In brief all these would drive the economic growth further away.

At the same time as a result of high import demand initiated by low interest rate causes depreciation of Sri Lankan Rupee. So that pertaining a stable exchange rate and achieving economic growth would become a nightmare. The unstable exchange rate arising due to the differences in real interest rates, purchasing power parity or the relative rates of inflation, political and economic confidence have threaten the entire business sector since the exchange rate is affecting the business decisions in terms of marketing, production and finance. (Daniels, J.D , Radebaugh, L.H. and Sullivan, D.P. 2004)

It is already mentioned that boosting investment should be a key anticipation of keeping a low interest rate by the authorities. Even though the investment decisions are not merely based upon the interest rate or the Cost Of Capital (COC), yet it largely matters Return On Investment (ROI), trade openness, business confidence, technical know-how, fiscal sustainability, political stability and so on. So that I believe accelerating economic growth in terms of productive investments by reducing interest rate is something ends up with a big question mark.

According to the Central Bank data, average Treasury bill rate for the September 2014 for 91 days is 6.17 percent (Current Economic Indicators, Central Bank of Sri Lanka, 2014) whereas the ongoing annual inflation rate is 6.5 percent (Trading Economics, 2014) leaving a real interest rate of negative 0.33 percent. Always the near-zero interest rates have negative implications on savings. Obviously this reduces household savings since the interest rate and household savings are positively correlated. Further to that widening of saving- investment gap occurs with this situation which again restrain from reaching the potential growth level of the nation.

Conclusion

In conclusion, though the policy makers are assuming the reduction in interest rate would drive towards the potential growth level, it is not viable if simultaneous actions are not taken against these negative implications arriving. The economy might be able to sustain within the limits in black & white, due to huge foreign Direct Investment, Foreign debts and remittances and so on; yet revealing such a growth would merely become a financial manipulation and a misrepresentation. Actually the road ahead for sustainable development is to be of systematic process focusing the future than the present, thus productive investment and robust cash flow management is significantly important.

References

Miller, M and Luangaram,P (1998) Financial crisis in East Asia: bank runs, asset bubbles and antidotes, National Institute Economic Review July vol. 165,pp. 66-68

Current Economic Indicators, Central Bank of Sri Lanka, 2014,http://www.cbsl.gov.lk/htm/english/_cei/ir/i_3.asp

Sirimane, S. (2013-Oct) Economic potential for higher growth, Sunday Observer

Colombage, S.S. (2014- Feb) Central Banks Low Interest Rate Policy, Business Times

Daniels, J.D , Radebaugh, L.H. and Sullivan, D.P. (2004)International Business Environments and Operations, Pearson Education,Singapore, pp- 310