25 September, 2020

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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

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Latest comments

  • 5
    3

    Ever since 1956 when the Yakko’s took control of the in the black in surplus a pleasure to live in the country was haphazardly deliberately destroyed by S.W.R.D. Banda’s tribe.
    \
    Now after nearing 65 years it has the dubious distinction of being the world’s best biggest never to be rivalled beggar colony.
    \
    if these trends are to be corrected the intelligence of the Tamils have to be sought the obnoxious Sinhala only autocratic policy should be thrown into many as bin and Queen’s English should be with immediate effect be made the official language.
    \
    Recruitment to the entire workforce should strictly be on a merit basis, standardisation to the universities have to be abolished.
    \
    Monetary controls should be implemented with vigour, devaluing the rupee should be a thing of the past as once it is a have done the nation gets slightly more exports but as she’s dependent on imports the merits of such a move are negligible.
    \
    Corruption, crimes of all sorts should me made taboo and stringent punishments should be meted out to the perpetrators of such deliberate low deeds\
    \
    It’s not on the Central Bank that has to be involved but the whole country must work smart to get rid of the man-made ill’s.

    • 3
      1

      ‘if these trends are to be corrected the intelligence of the Tamils have to be sought the obnoxious Sinhala only autocratic policy should be thrown into many as bin and Queen’s English should be with immediate effect be made the official language.’
      .

      Come on CT admit it. This racist pig is allowed to post for his comedy value is he not?

      • 2
        1

        Stanley the obnoxious dude who’s fascinated with my antics –
        \
        1. Is it not a fact that Ceylon went downhill is all the facets after the 1956 Sinhala only petty racist election.?
        \
        2. Do we para Demala’s moan and groan we are without a valid reason are called tigers and downright falsely insulted.?
        \
        3. Has not the standards in every aspect of the English language deteriorated after the fateful year -1956.?
        4. English and Tamil are recognised international languages widely used globally.
        The yak’s lingo Sinhalese another import from Sanskrit – India is only used some of the time in this once upon a time rich pleasant to live beautiful much-admired island now sadly classified as a pariah petty racist country who sadistically enjoy bullying the minorities.?
        The Sinhala people who very soon will only have maioca [ manioc ] to eat like the good old 1970/1977 years are not themselves proficient in their imported kunu goda [ garbage ]
        5. I a pure well-bred original Ceylon Tamil have fathered an alluring lovely lady-like daughter with a Sinhalese lady and after the cessation of the first matrimonial alliance was again married to another high-quality Sinhala damsel.
        6. Most of my friends especially the female gender belong to the yak race, therefore I am not a racist pig.?

        • 1
          1

          Well that confirms it. It was St Joseph’s night school along with the orange Roundabout Premadasa. Lavaria still available in the Tuck Shop boys.

        • 1
          2

          Ammata hudu……
          Tamil international language…?

          • 1
            1

            Pasky the pest –
            Please do not display your yak ignorance and low class.?
            \
            Tamil is spoken in 80 countries.
            \
            How many lands are Yakko’s Sinhala spoken in.?
            \
            Even in this sad shitty sorry hellhole you buggers cannot read speak or write the so-called yak swabasha lingo but you want us to be proficient in this one hellholes lingo.

            • 1
              0

              rj1952 is right. If there is a single Tamil refugee in a country, then in theory one could claim that Tamil is spoken in that country. List the 80 counties rj.

      • 0
        0

        The problem with rj1952 is not with language alone.
        .
        Look at the fourth paragraph here of his comment on the parentage of Ravinatha Aryasena:
        .
        https://www.colombotelegraph.com/index.php/ravinatha-gets-the-boot-as-gota-takes-full-control-of-foreign-ministry/.
        .
        He had somehow got it into his head that Ravinatha’s father was a Police DIG and that the mother was a Dutch Burgher. Now in a comment (that I hadn’t seen when I wrote there) he stubbornly refuses to accept my telling him that I had actually taught Ravinatha (over a period of more than a year) and that the parents were different.
        .
        I have given you a link to that first CT “story” about Ravinatha. Please note that although I made five or six comments about Ravinatha, and I have said that he was intelligent (that is clear enough, surely), I had refused to vouch for his uprightness of character – or for that matter stated the opposite. I just don’t know what he has turned out to be.
        .
        As for his “Met-Dpartment” father, somebody else came up with confirmation and many other details – and his mother, to me, did not seem a “Dutch Burgher”. Had she looked anything other than a typical Sinhalese, I’d have noticed.

    • 1
      1

      “if these trends are to be corrected the intelligence of the Tamils have to be sought …………………………”.

      Intelligent Mahendran vanished after doing the corrections!

      • 2
        1

        What about Ajith Nivard Cabral of a cabal who robbed and helped the Alibaba rajapuka to rob by the trillions.?

        • 1
          0

          What about Cabraal? Is he Tamil? What is your point? Koheda yanne? Malle pol.

  • 11
    2

    Dear Writer,
    .
    as one who once worked for CB, who do you think in the current batch could do a good job. We perfectly know that Rajakshe ass kisser Ajitha Cabral knows nothing but to please them. Had he been a cleverer governer, why was that Wimal Buruwanse added then that Secretary to Ministry of Finance was an economic criminal. ?

    Who do you tihnk could help settling it better considering the new cabinet today ? We are very pessimitic and the situation would not be very different to the collapse of Greecee. However, Greece was lucky to have European Union to pump the funds, but srilanken will be left to be alone, if Ballige puthas would ruin it again.

    The dark cloud above SRILANKA is growing day by day, nothing good will be predictable at this stage at all.

    • 4
      7

      Mr. leela ge …..,
      .
      My dear,
      Brush your teeth first.
      .
      .

      • 2
        2

        SCP,

        I can brush my teeth but you try to complete your KinderGarten let alone the benefit of your family. Not just me, many on CT are in the view your IQ is lower to that of Chief monk at Kelaniya Temple – is that true ?

        That can help you and the circle for sure.
        Your are a stinky bastard who do that pannittu toilet basket holding. Remember, my elders narrated me such stories how they went on with such jobs in 60ties and 70ties in Colombo.
        :
        Sorry, this is not my nature to attack you this way, but the langague you would be familiar with that.. you deserve no polite counter comments.

        • 2
          3

          Mr. leela ge …..,
          .
          Yes.
          It’s obvious.
          Your “elders/parents” were “stinky bastards who do that pannittu toilet basket holding” job “in 60ties and 70ties in Colombo”
          Can see it from how you behave….
          Poor fella

          • 2
            0

            No sooner you will hear mouthful about your nature. Please take good care of Ms SCP.
            You have proved to be a bastard, that is clear to even my 10 year old nephew.

      • 1
        0

        SCP,

        This video will tell you more about your nature. Wedi nayakayas would want to continue their slave theories.
        Ballige puthas would ruin this nation no doubt about that.
        https://www.youtube.com/watch?v=p0sbdSq0Qjk

    • 1
      1

      If the local and world experts in economy know that we have elected donkeys to the job again – the outcome would be forseeble right ?

      Gotabaya may be press shy, but he should now act like a leader not being that submissive to his MEGALLO MANIAC brother who is the founder of the destruction of SRILANKEN economy. Just putting the blame on former govt, these buggers would never come an inch forward.

      Be it bond scam or various other issues in terms of CB was born during the MR terms rather than that of UNP govt.

      JVPrs touched it from the wrong side and now being marginalized alone that matter, since their unsubstantiated allegations costed UNP to defeat in every corners. The curse is JVP too ended up being destroyed not only UNP.

    • 2
      1

      leelagemalli.
      It is bellige puthas of ‘Jadapalanaya’ who ruined the economy. Wikunana Singham pretends that he is an expert in managing the economy. During the four and a half years that buffoon ruled, the economic growth fell down from around 7% to 2%. Yet, you dumbos think he is great. In election rallies that shameless guy told it is only UNP that can recover the economy affected by COVID-19. Voters in this country spit on his face.

      “if Ballige puthas would ruin it again.’

      • 1
        1

        Demented Eagle Evil@

        How can that be ? Can you please ask your GREAT GRAND SON to teach you the basics ? We are very sorry for you – your situation seems to be worsening ? Are that poor or left to be alone not being able to find some therapist though living on statefunds being cornered to Kangaroo land ?

        Was the GOOD goverannce that made the nation eternal debtors ? Not that i knew. They only iron out SRILANKEN botox boys deliberately ruined.
        .
        If not for the former GOVT ballige puthas would not have collection of funds to pay off the upcoming huge loans amouting 4.5 billions of US dollars.
        :
        As my 10 year old REMINDED me yesterday, not a single cent was earned by those gigantic projects for which ballige puthas took that huge loans during MR misadminsitration ( For Hambantota Harbour and Mattala Airport).
        :
        All these gigantic projects reminded me the ghost cities built by CHINESE investments in Angola – whose inflation rate is over 52% as of today.

        You may talk to your barber, please dont come to repeat your BAILA with us. We dont want to waste our precious time for a demented man who knows the little to argue it on and on. Basta.
        :

  • 3
    1

    As if this is the only time bomb! Debt trap is a massive time bomb which will go off pretty soon. Economic impact of Covid-19 is another. Hydro power dams are others. They have not been maintained and now they are too old. They will burst. So many time bombs waiting to go off in SL. With the misfortune of Rajapaksas they will go off within their term.

  • 5
    0

    It appears that there has been a drastic reduction of Interest Rates during the past eighteen months or so. Being rather fearful of these things that I don’t understand, I try to manage on my government pension.
    .
    I wonder whether rising prices (inflation?) that have already begun to be seen, will escalate by next year to such an extent that I will starve on my pension! Of course, there was that other blessing that was also given to senior citizens who could maintain a fixed deposit of one and a half million rupees. This sum of money may be peanuts to some, but it is a huge amount to many of us, relatively poor fellows. That interest augmented our pensions. Will that remain untouched by these interest reductions, I wonder?
    .
    You were saying more or less the same thing here yesterday, weren’t you?
    .
    https://www.youtube.com/watch?v=sY_eMCdUA5g&feature=youtu.be
    .
    Dr Wijewardena, we owe you thanks for two things: first, for trying to explain this to us as simply as possible. Second for discussing this in apolitical terms.

  • 1
    0

    I hv a fear whether monetary policy instruments will work in Srilanka like in a developed economy. Our economy in not well lubricated for policy measures to work. Although interest rates have been reduced from early 2019 there is no credit growth.

  • 2
    0

    WAW says “It had started cutting down interest rates and flooding the economy with money from around the beginning of 2019”. Wrong. To my knowledge it started in around 2010 by MR government. After that the CBSL’s only solution to the economic downfall was reducing interest rates. With GR’s threatning too what they did was to reduce the rates within 3-4 hours. Rates have gone down by 50%. when compared with 2010. One section most affected by this “solution” is the retirees who started fixed deposits with their EPF, ETF and retirement gratuity money. Very soon they will have to ask for Samurdhi benefits and Pin Padi. I think most of the borrowers who benefited by this “solution” did not contribute anything for the benefit of the country and some are the owners of “Non-performing loans”

  • 2
    0

    A short term reduction in the interest rates, at the expense of senior citizens living on interest income can be justified to accelerate economic growth. However, the savers must get a real return after inflation. The middle path should be considered to balance the interests of the borrowers as well as the savers.

    • 2
      1

      Lal de Mel

      “A short term reduction in the interest rates, at the expense of senior citizens living on interest income can be justified to accelerate economic growth.”

      Why should the Elderly suffer for the mistakes of both the crooked politicians and the inapt functionaries (maybe Pali graduates) ?

      The only alternative you could suggest is more of the same, punish the weaker section of the society.

      There is something called out of the box thinking. Have you ever tried it for change?

      The deposit takers should offer higher interest rates (in order to attract capital) than they charge their borrowers. The state should intervene and subsidise the deposit taker the differences. It worked elsewhere and should work here.

      Deposit taker:

      Organisations whose main function is to take deposits – this is the basis for the legal definition of a bank.

      PS
      Old Codger maybe able to advice the state on this matter.

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