The nature and nuances of interest rates

At a time when discussions and debate over the interest rates have reached a height, there is need to review certain factors considering that the demands, recommendations and commitments to reduce interest rates have failed to achieve the desired results. Actually, interest rates do not depend on any of this. We must keep in mind, when interest rates were gradually coming down in the banking sector, when these rates on bank loans fell to single digits, when big industries and businesses haggled with the banks and forced them to bring the interest rates on the loans down to 7 to 8 per cent, it was then that interest on deposits fell dismally low.

Just as there is dissatisfaction now over the high interest rates on loans, at that time the low interest on deposits had caused concern. The common people, retired persons who depend on the interest from their savings, were struggling. But truth be told, the fall in interests rates at that time, or the present rise in interests, hasn’t come about in accordance to anyone’s wishes.

It is common knowledge that interest rates primarily depend on the demand and supply of loans. When the demand for funds or loans is high, interest rates go up. When the demand falls, so do interest rates. It can be seen like this - if loans are easily available in the market, interest rates go down. When loans are hard to come by, interest rates are bound to go up. And that is exactly what has taken place in our economy. Due to easy availability of loans towards the end of 2017, interest rates plummeted to 7 or 8 per cent. But this year, with loans become difficult to avail, interest rates have shot up. The banks which had proffered one-digit interest rates at the time, are now paying two-digit interest rates on deposits.

Other than the demand and supply of loans, inflation too can have a direct impact on interest rates. The higher the inflation, the higher the interest rate. When the depositors get back their deposits, the purchasing capacity of that money decreases due to inflation. In order to make up for the eroded purchasing power of the money, interest rates have to be higher than inflation rates.

Interest rates are also linked to the rate of economic growth. If this rate is fast, the government tries to control loans by increasing interest rates in apprehension of inflation. Again, if there is a recession in the economy, initiative can be taken to revitalise the economy by reducing interest rates to increase investments.

Central banks around the world, including our central bank, take up various ways and means to control loans through their respective monetary policies. Interest rates also depend on the efforts to control loans by mean of cash reserve ratio (CRR) and statutory liquidity ratio (SLR), bank rates, etc.

The above-mentioned regulators in determining and controlling interest rates are part of the macroeconomic system and trend, so none of these take place as the result of efforts by any institution of individual. There is a regulator outside all of this that is not related to interest links in the macro-economy. This is the interest rates determined on the assessment and evaluation by the banks as part of their credit risk management. The banks which provide loans have varying degrees of credit risk in their loans. As part of that risk management, the banks may fix higher interest rates on the riskier collateral-free loans. That is why in our banking sector, interest rates are highest for collateral-free consumer loans and unsecured credit card loans.

There are two economic theories about determining interest rates. In classical economics, interest was seen as a reward for savings. Capital was supplied from the savings of the common man. And the demand for capital was created when entrepreneurs and businessmen took loans from those savings and invested these funds. According to classical economists, interest rates are determined by the market competition between the large number of suppliers and users in the capital market. If the supply of capital is high or if the demand is low, interest rates go down. If supply is low and demand is high, interest rates go up. Followers of this theory believe that interest is a reward for the savers who do not enjoy the benefits of their savings at present, but in the future. That is why if interest rates are high, more capital suppliers, that is the savers, will spend less and save more.

Keynes came along and completely changed classical economic theory. He said, interest is to be paid in order to encourage people to invest rather than keep their money idle. According to Keynes, people would want to keep their cash at home for security reasons and to protect themselves against the risk of loss if they invest their savings. Keynes dubbed this as the liquidity preference theory. This reason behind this propensity was perhaps that the banking system was not that organised at the time, the foundations of the banks were not that strong, and varied banking products and services were not that easily available.

As opposed to the classical theory of interest as a reward for savings, Keynes highlighted this as an important regulator of investment and economic growth. That is why the government and central banks of various countries try to control economic investment by influencing savings and credit flow through their monetary policies. Nowadays people do not stash their cash at home due to security reasons and also because there is a wide array of banking services available. So there is now scope for people’s surplus money to enter economic activities rather than remaining idle. That is why, in keeping with Keynes’ school of thought, much importance is attached to interest rates in the economy.

In keeping with the above fundamental concept of interest rates, we can enter a discussion on the state of our present interest rates. The sudden skyrocketing of interest rates from the beginning of this year had people naturally questioning why the private banks were suddenly facing such a liquidity crisis. Where had all the money gone? If the banks provide loans and even if they do so aggressively, these are provided in local currency, so the money remains in the financial market or in the safes of some other bank. But if the loans or investments are in foreign exchange due to imports, a large chunk of that is to be bought from the central bank, so the money will go from the fund banks to the central bank’s safe.

On the other hand, at a juncture when interest on savings has hit rock bottom, then the common depositors invest more in the government’s  saving schemes. This is another way that liquid cash goes from the banks to the government’s coffers.

As the repayment on large import loans is long-term, this money does not return to the banks very soon. The situation worsens when a large portion of these loans fall into default.

It is basically for these reasons that the private banks face liquidity crises. On the other hand, as state-owned banks only provide a limited amount of loans, this crisis has not affected them.

After the aggressive provision of loans by the private banks, the required loan-to-deposit ratio (85 per cent) in many of the banks has been violated due to the failure of the borrowers to repay their loans. In keeping with the normal mode of keeping inflation in control, the monetary policy called for the loan-to-deposit ratio to be reduced by 1.5 per cent in a short time limit. This drove the banks to desperately collect deposits, the supply-demand premise thus pushing the interest rates up high. The time limit was later extended twice and fixed to the first quarter of next year, but even so it has still not been possible to reduce the demand for deposits in the market.

On the basis of the banks’ demand to overcome the liquidity crisis and commitment to bring down interest rates, even after the CRR was brought down by 1 per cent, there are no signs of interest rates being lowered. As a result of the CRR being reduced by 1 per cent, liquidity of Tk 100 billion increased in the banking sector and the loan-to-deposit ratio decreased somewhat, but the banks’ capacity to provide loans did not increase.

With no increase of loans in the market, there is no possibility of interest rates going down any time soon. This symptom alone indicates that it is simply not possible in a free market economy to implement the demand or commitment to reduce interest rates in a specified short period of time.

Interest rates can only be brought down by increasing loan provisions and united efforts are now required to determine ways and means to do so.

* Faruk Mainuddin can be contacted at [email protected]. This article has been rewritten in English by Ayesha Kabir