Revitalizing the Economy Through Interest Rate Policy Adjustments | Daily News

Revitalizing the Economy Through Interest Rate Policy Adjustments

Trading at Colombo Stock Exchange.
Trading at Colombo Stock Exchange.

With the incidence of entering the COVID-19 virus to the country and spreading it rapidly, economy started plummeting speedily resulting in losing many people’s jobs and sources of income. In this setting, Government thought that economy could be revitalized by increasing investment if market rate of interest was kept lowering.

Interest Rate as an Exogenous Variable

Hypothetically, investment (I) is considered as a function of rate of interest (i) as indicated by the simple model, I = f (i). Accordingly, it is assumed that investment is a decreasing function of interest rate and this functional relationship can be shown as follows.

I = d -ei

where, ‘I’ is the level of investment, ‘d’ is the positive intercept indicating that if interest rate is zero investment will reach some maximum level of ‘d’ while ‘e’ represents a negative slope and ‘i’ is the rate of interest and is considered as the independent variable whereas ‘I’ is the dependent variable. This downward linear relationship between investment and rate of interest highlights that investment and interest rates are negatively correlated to each other indicating that if the rate of interest is reduced the level of investment will increase.

Central Bank of Sri Lanka

Thinking in this line, at the outset, when the rate of interest was not slashed as instructed and expected by the Government the Central Bank leaders were summoned and forced to reduce it further. With this denunciation, the Central Bank immediately (overnight) took steps for making further reduction in the interest rate to be consistent with the Government’s direction for promoting investment assuming that thereby economy can be revitalized.

Central Bank of Sri Lanka

Accordingly, the Central Bank failed to convince the Government that its thinking was irrational and practically not be achievable due to a number of other reasons as shown through our past experience and as highlighted by researchers on this subject. Also, alternatively, at that time, the Central Bank could have shown the Government that it was wise to follow a selective credit liberalization like reducing bank rates only for a specific sector such as SMEs which was more affected by the pandemic rather than reducing the interest rate across the board for the entire economy.

In general, it is accepted that not only rate of interest but a number of other factors and conditions also will affect investment. Thus, in addition to interest rate, the level of investment does fluctuate on account of trends in inflation, future business prospects, economy’s level of savings, magnitude of income or output (as highlighted by the principle of acceleration), wage rate, standing of technology and corporate tax etc.

MacKinnon - Show Hypothesis

According to the seminal paper presented on investment promotion by MacKinnon and Show (1973) it highlights that what is effective for promoting investment is not the nominal interest rate, but the real rate of interest which is obtained by deducting inflation rate from nominal rate of interest (Real interest = Nominal interest - inflation). In this case, if inflation is higher than nominal interest rate, real interest rate becomes negative. Researchers have found that in a background of having a negative real interest rate, people are motivated more to invest in non-tradable rather than tradable assets discouraging channeling money to banks, and as a result, funds cannot be sufficiently directed to business, and consequently at the end, employment generation remains at a low ebb. Contrary, if real interest rate is positive investment in tradable assets tends to increase, and it is helping channeling more money to the financial system and thereby banks can advance more funds to increase investment.

However, experience shows that when following inward looking policies, prior to 1977, in most of the years, real interest rate was negative due to surpassing rate of interest by rate of inflation. As a result, sufficient amount of funds did not come to the banking system and financial market became highly repressed. Even limited funds accumulated in banks in that period were channeled to the public sector suboptimal projects at the cost of the optimal projects elsewhere resulting in having a low rate of economic growth which was around 2.9% from 1970 to 1977. Also, unemployment rate was categorically as high as 24% of the labour force in some years in this policy implementing era.

Interest Rate and Inflation

However, the Government that came to power in 1977, having guided by the concept of MacKinnon - Show hypothesis, steps were taken under financial market reforms to make real interest rate positive, but, in this case also, only by increasing rate of interest, without trying to reducing the rate of inflation. Thus, throughout the post-liberalization period after 1977 the rate of inflation was remaining high and volatile mainly due to following imprudent fiscal policies by all respective Governments throughout that period. Thus, the policy decision to maintain positive real interest rates in this era seems to have caused the both interest rates and deposit rates to rise above the extraordinary inflation rates, and these excessively high rates were welcome by money depositors while borrowers were made unhappy. Taking these trends into consideration, starting from 2007 bank rates have been reduced by more than 50% on the Central Bank’s directives by the year 2015. Then, again in the subsequent years, particularly after 2019 with the COVID influence bank interest rates were drastically reduced with a view to promoting investment.

In this background, based on past experience and research findings the Government and the Central Bank could have thought of not only reduction of interest rate but also for taking steps to manipulate inflation favourably for increasing investment. But, this kind of thinking was absent in the post pandemic phase when trying to promote investment in the economy. Further, Government did not take into consideration the weak business prospects prevailed in this period. If future business prospects are unfavourable investors, irrespective of their sizes, do not come forward to invest their money in business just looking at only lowering rate of interest. In addition, in a situation of abnormally low interest rates funds may be channeled to sub-optimal projects in both in the public and the private sectors. As such, some small investors may use the funds obtained at the lowest rate of interest for other purposes such as expanding their houses, buying vehicle etc. which in turn may increase the volume of bad debts ultimately in the banking system.

Interest Rate and Other Variables

Foreign Reserves

On the other hand, the reduction of interest rates has forced banking sector to keep the deposit rates also lower than that of loan rates which particularly has affected older people who are the majority of savers in the economy and are used to survive on their deposit income. Thus, senior citizens’ income in this period has reduced to more than 1/3 compared to their previous income levels. As a result, they have been forced to slash their consumption too causing the aggregate demand of the economy to be shifted downward. Also, in general, almost all other persons’ income in the economy has substantively reduced on account of the consequences brought about by the pandemic. These all reasons have contributed to reduce the aggregate demand of the economy lessening future business prospects further. In this setting, although rate of interest is slashed to a lowest possible level investment will not be forthcoming. Thus, with reducing people’s income their Marginal Propensity to Consume (MPC) increases while reducing their Marginal Propensity to Save (MPS) which, in turn, again lessens their savings going to the financial system. As a result, Aggregate Savings (AS) of the economy reduces along with falling investment (I) as well. Accordingly, S=I in the economy is shifted to a lower level causing the national income to become equilibrium at a much lower level than earlier.

Thus, as far as interest policy was concerned, the past experience shows that almost all the Governments have manipulated only rates of interest without controlling inflation. For instance, 1970 to 1977 Government maintained a very low level of interest without taking any effective effort to control inflation making real interest rate negative. Then, 1977 Government, in the first few years of its regime, made real interest rate positive only through increasing rate of interest to be consistent with the high inflation which already existed. In this case also, nothing was done to control inflation.

In subsequent years too attempts were not made to lessen inflation and always adjustments were introduced only to interest rates. Thus, particularly from 2007 onwards rates of interest were continuously made lower highlighting the need of increasing investment. Finally, from 2019 onwards with the impact of COVID-19 pandemic, rate of interest was drastically reduced along with reducing deposit rates more speedily. In this phase also, it was not seen paying any attention to control inflation, and as a result, real interest now has become negative discouraging channeling money to the banking system.

Practice of Deductive Methodology

These trends usually show that our policy-makers and Government authorities usually follow a deductive or abstracted kind of approach for solving whatever the problem they encounter. As such, no difference we find in the case of adopting recent reduction of interest rates also. Differing, they should examine and analyze the past experience and trends in similar issues by following more inductive methodology and considering their outcomes for making better decisions to solve current problems. When macroeconomic issues are taken, they are closely related to each other. If one variable is adjusted it can affect many other variables with multiplier effect over time. As discussed in the earlier part in this short discussion, if interest rate is slashed without managing inflation it makes real interest rate negative creating financial market repressed. Further, this reduced interest rates accompany a higher reduction in deposit rates and depositors’ income which badly affects aggregate demand of the economy reducing future economic prospects as well, which in turn, discourages making investment decisions more than earlier.

Plan formulation and implementation

Therefore, what is needed, particularly at a crises situation like the COVID-19 pandemic is making a short run action plan as done in the early 1960s, for carrying out the necessary adjustments in macroeconomic variables. For example, the 1960 Government in its early stage formulated a 3-Year Action programme abandoning the 10-Year plan (1959-1968) to face a crises situation emerged at that time. Nevertheless, plans should be implemented successfully for acquiring better results.

Now critics say that the basic objectives of the recent interest rate reduction have not been achieved showing that more than 70% of funds have been channeled to the Government sector for getting its public debt requirements fulfilled rather than channeling funds to revitalize investors in the economy.

However, the common phenomenon that we can see with regard to planning in Sri Lanka is giving a big publicity at the plan formulation stage and taking ad hoc decisions very often when coming to the implementation phase either by deviating from plans partly or totally, letting plan copies to be resting only in office cupboards. For example, if we consider all the major plans such as the first 6 - Year Plan (1947-53), Six Year Investment Programme (1953-59), the 10 Year Plan (1959-1968), then Five year plan (1972-1977) implementation could not be seen at all and as such they became policy documents rather than real plans, and thus, this situation in Sri Lanka is fully endorsed with Philip Kotler’s adage that plans are nothing if it they are not implementable.

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