Wednesday, May 27, 2015

Towards a sensible interest rate regime..

The interest rate in any economy plays a vital role in the financial sector. As it is the cost of borrowing money, or the compensation that we receive for the service of lending money. When we lend money to someone, we are obviously taking a risk, and that demands a price, or compensation. And, it is very important that this rate is determined in a sensible manner.

There are some factors that determine the interest rate in the economy. Like any other price, interest rate is also mainly determined by the demand and supply of credit. When there is a huge demand for credit, the rate of lending will tend to increase. Likewise, availability of funds is also a factor that determines the price. Excess liquidity in the banking system and the financial sector in general, shall lead to a lower interest rate, as there will be increased competition to provide credit.

As Maldives financial sector is dominated by commercial banks, bulk of lending is done by the banks, and the financial sector can be described as a ‘bank-based’ sector. For this reason, banks have exercised their ‘monopoly power’ and established a high lending rate which ranges between 8 – 13%. On the other hand, the deposit interest rate is as low as 2.25%. Despite the high interest rates in the banking sector, there is continuous frustration from the private sector on the issue of ‘access to finance’. The World Bank ‘Doing Business Report’ also always reports negatively on the issue. Any report on the financial sector of Maldives would highlight on it. In short, there exists a huge financing-gap in the real sector of Maldives, as the required, and desired amount of investments are not financed through the banking sector. And why should they?

The existing stock of Government Treasury Bills stands at MVR 11.7 billion. The risk-free one month T-Bill rate is 7.50%, while the 364 day rate is 9.0%.  So, if you can get 9% for one year, risk free government security, why would the banks ever think of lending to the ‘high risk’ private sector?

In order to make some sense out of this ‘outrageous’ interest rates, or in order to explain these high rates, we may need to look into certain fundamentals of the macro economy. In August 2010, the one-month T-Bill rate was below 4.50% while the 91-day T-Bill rate was below 5.50%. This was a time when T-Bills were auctioned in the market on a weekly basis. Hence, it is a rate determined through a market mechanism. The year 2010 was an year when Government budget had a deficit of 14.3% of GDP, and the annual total revenue of the Government was at MVR 6.5 billion. Fiscal dominance, fiscal discipline, high government demand, you can come up with all the technical terms to explain/justify.

However, at the end of 2014, the fiscal balance stood at only 3.4% of GDP, and total revenue for the year recorded almost MVR 15 billion. And yet, the one month T-Bill rate is fixed at 7.50%??? Do we still use the terms 'fiscal dominance', and 'lack of fiscal discipline', and high demand to justify these rates?

I think its time we moved towards a sensible interest rate regime. Its time MMA took the lead, and provide sound financial advice to the finance minister.