Central Bank Governor Ajith Nivard Cabraal last week said directives would soon be issued to bring down bank interest rates in line with inflation.
"The margin between interest rates and the rate of inflation in many countries ranges between 3 to 5 percent and in Sri Lanka it is high at 8 percent. This is a matter we discussed at the Monetary Board meeting (last Thursday) and we hope to issue directives to bring down bank interest rates in line with inflation as in other countries," Cabraal said last Friday at the launch of the 2012 annual report of the Ministry of Finance and Planning.
The market was not enthusiastic by the Central Bank governor’s statement but said a better option was to improve fiscal policy and create enough space in the system for private sector borrowings.
"There is a reason why the margin between inflation and lending rates are high. Banks are clearly not in a position to reduce interest rates because there is massive competition to mobilise public deposits. Depositors and investors are not going to accept low interest rates unless they can trust the system. In Sri Lanka, policy inconsistencies have created short term cycles of boom and busts. There is too much volatility," a treasury dealer said not wanting to be named.
Another dealer said there was a mismatch between inflation and perception, which reflected in the high margin between the rate of inflation and interest rates.
"Inflation was 7.3 percent in May, this is low considering the high rates we used to have, but in realty people may not be too comforted by the inflation rate because the cost of living is high and many people have to struggle to make ends meet. So when they think of saving, they have to be satisfied with the rates banks and finance companies are offering, and given the competition for deposits, bringing down rates may not be what the market wants. You can force the issue and use moral suasion to bring down rates, but then interfering with markets tend to lead to not so favourable consequences," the dealer said.
The margin in question is also called the real interest rate, the difference between nominal interest rates and inflation.
"It is the prerogative of the market to decide the real interest rate. In a growing economy the real interest rate would increase otherwise there would be little saving. People may opt to invest in other instruments or even feel it is worthwhile to spend and this could put pressure on inflation. It would be better to stick to monetary policy and improving fiscal policy, forcing the issue may prove costly," another dealer said.
The market believes there has to be policy consistency in order to reduce premiums such as the real interest rate.
The recent monetary policy rate cut surprised many and analysts, such as the Standard Chartered Bank, believe the Central Bank would not cut rates any further.
The Central Bank has cut monetary policy rates by 0.75 percent from a year ago to 7 and 9 percent, but commercial bank lending rates have risen by 2.09 percent to over 16 percent.
After new loans totaled Rs.17.4 billion during the first two months of this year, private sector credit from domestic banks gained another Rs. 20.1 billion in March 2013, taking the total of new loans to Rs. 37.5 billion for the first quarter of 2013, latest data released by the Central Bank showed.
The government on the other hand borrowed Rs. 51.6 billion in total in March, and Rs. 150.5 billion during the first quarter from domestic banks.
Keeping interest rates low and manipulating the exchange rate have led to balance of payments problems followed by a round of monetary policy tightening and other corrective measures. IMF support was sought in 2008for a balance of payments problem and the programme was put on hold in 2011 because authorities allowed the problem to come up again.
In October 2011, the Central Bank denied there was a balance of payments problem, although data it published clearly pointed to one. In November that year, the President devalued the rupee by 3 percent against the US dollar when he announced the 2012 budget. In early 2012, the problem could no longer be ignored and the Central Bank was compelled to take several measures to contain the problem which did little good to its credibility, as Verite Research recently pointed out in an article published in these pages (Central Bank Credibility: Riding the Dragon? The Island Financial Review April 16, 2013).