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Why are low interest rates a must?
Economists expect that low interest rates will lead to economic growth via efficient functioning of financial markets. This is called the expansionary monetary policy. The expectation is that funds diverted from the interbank market to the public will lead to higher consumption or investments. 
To put it simply, imagine a person who paid Rs. 25,000 as interest, when interest rates were high and now pays Rs. 15,000 due to the decrease in interest rates. The Rs. 10,000 increase in his monthly income is not due an increase in effort or a revolutionary idea by his part but simply due to a change in the environment. Chances are that given the low interest rates he will opt to increase his consumption. A household that did not consume fresh fruit juices can now consume orange and watermelon juice twice a week. This sparks a chain economic reaction in the main economy that leads to growth where the respective increases in the fruit production and the producers’ revenue lead to an increase in our subject’s consumption, etc.
Further, economists also assume that the risk aversion of the mainstream economy will either remain at the same level or decrease with the reduction of rates. As a result, the reduction of rates will encourage investors to invest more. This could be the result of one of two things. Firstly, because of the increase in returns (due to low funding costs) which meets the required rate of return of the investor at his current risk acceptance levels. Secondly, due to the reduction in risk aversion reducing the required rate of return and increase in returns meeting the reduced required rate of return. It is expected that the increase in investments will lead to higher production, which will lead to more employment opportunities and ultimately will result in sustainable economic growth with distribution of income being spread acceptably.
For the above two scenarios take place, i.e. growth in consumption and investment, it is a must that interest rates remain low for a prolonged period of time.
Do real interest rates play a part?
To reiterate, for all of above to take place, interest rates need to be at low levels for a prolonged period. More importantly, they need to be low at a level that stimulates higher consumption and investment. To ascertain this, the movement in real interest rates or better known as the difference between nominal interest rates and inflation rates of the economy can be looked at. 
In Economics, it is said that high inflation diverts income from lenders to borrowers. The inverse could be said of scenarios where inflation is low and nominal interest rates are high. In such a scenario, where the real interest rates are high, lenders would not want to lend at all. This is due to the lenders required rate of return being lower than the real interest rate of the economy. The same could be said of investors, if the investor has a required rate of return lower than the real interest rate, he would be more inclined to place funds in risk free bill/bond than invest them in a risky project. Along the same line, a company may not be motivated to invest in a new plant when the current ROE is 5.5% and the real interest rate is 5%, as the incentive to do so is quite marginal.
Looking at 2014 July data, the real interest rate spread is at 3.37%, which, in Sri Lankan context is a healthy real interest rate.
Data from January 2012 show that the real interest rates for Sri Lankan Rupee have been on a gradual decline. However, even though it was on a declining trend 22 months out of the total 31 months recorded, the real rate is above 3.5%. While for 15 months almost 50% of the observations recorded, real interest rates are above 4%. As could be seen now, the challenge is for the Central Bank to maintain the real interest rates within a range of 3% - 4%. If this feat could be achieved in the next five to 10 years, we will reap the real benefits of the expansionary monetary policy.
Pensioners’ problem
The issue of reduced income for pensioners has always been an issue in the forefront of discussions whenever rates decreased. Here the decision we have to make is whether we are going to entertain pensioners at the expense of economic growth for our future generations. Unfortunately, even though it is the main point; this discussion must spill over to the efficiency and liquidity of other financial markets as well.
It is undisputed that a decrease in interest rates will reduce the interest income of pensioners and threaten their livelihoods. However, as explained earlier, if our economy is to grow, it is not an option but a must that rates are maintained at acceptable levels. There will be no economic growth if the overnight rate reaches 10% and if the one-year rate reaches 15%.
In any economy, a significant portion of the wealth is accumulated in pension funds, pensioners’ savings and excess liquidity in corporates. This is due to the young workforce rarely having the means to accumulate large savings, and even if they do, those savings would be spent on consumption in vehicles and housing. As such, it is important that the savings of the pensioners/corporates be directed to investments that generate higher economic value. This will provide much needed to liquidity to financial markets, when the liquidity dry up and a higher return for these passive savers.
These investments come in the form of investments in corporate bond market, mutual fund market and the stock market.
Liquidity, transparency and accountability of capital markets
Now we come to the real business end of an expansionary monetary policy regime. The funds of pensioners that are yielding low returns in banks need to be wooed for investments in capital markets as they offer higher returns that they seek. This will inject much needed liquidity to capital markets of Sri Lanka.
One main such market is the corporate bond market in Sri Lanka. That has been illiquid and stagnant for a long period now. If we are to reap the full benefits of a low interest rate regime, it is important that we create our selves a liquid bond market. It should also be noted that both the Rupert Murdoch empire and Google once issued high yield securities (junk bonds) to start up as banks declined to fund them. We also hear many similar stories in Sri Lanka, where now large and successful companies were once turned down by banks. A liquid bond market will allow our companies to raise capital by issuing bonds in the market, which will utilise idle funds to carry out investments.
Low rates will also make mutual funds more attractive to investors. Fund managers should actively attempt to increase their base of “funds under management” by attracting new investors. This is an excellent opportunity for fund managers to generate returns higher than interest rates and win customers. Given that, there are no hedge fund operations in Sri Lanka. The active role played by fund managers will crowd out the pricing errors created by irrational individual investors, as fund managers will have access to analyses to spot any arbitrage opportunities in mispricing.
However, for all this to take place, there need to be accountability and transparency in the equity market. Lack of criminal punishments to securities fraudsters will hold back the investors and hence the performance of fund managers, which will result in an illiquid equity market, where chance will lead to higher returns than the ability to spot arbitrage opportunities.
Bubbles and risk for banks
When rates decreased, we experienced bubbles in housing, vehicle, and equity markets in the decade of 2000 – 2010. Such bubbles come into play partly due to the fault of the investor and partly due to the fault of the banks.
We saw a rapid increase in housing, vehicle and equity prices as rates declined. This increase after its correct fundamental price is the bubble. Such a bubble exists partly due to the belief by investors that prices will keep on increasing. Such belief is not backed up by economic fundamentals but in most cases by rumours as seen in Sri Lanka. In such a scenario, it is the investors’ own fault that they will suffer losses when the bubble bursts.
However, it is a different story when it comes to banks. Especially in Sri Lanka since almost 50% of our banks are systematically important to the economy. Alternatively, are the “too big to fail banks.” This makes it very important that banks value their balance sheet accurately.
It is of utmost importance that banks in Sri Lanka have an accurate transfer pricing policy that accurately transfers not only the cost of funding but also the interest rate risk and the liquidity risk to customer. An accurate transfer pricing will decrease lending to sub prime customers, which will eventually ease off the burden on credit risk and provisioning costs. Further, banks should also measure their economic value of capital and stress test it against capital adequacy ratios to ensure they are sufficiently capitalised in the event a sudden raise in rates.
A gradual and rational rate reduction as has happened in LKR is always a sign of economic recovery. However, the ultimate objective of economic growth can be achieved only if we manage to avoid bubbles and the resulting crash, as we experienced previously. In order to avoid such bubbles we need ensure that the breaks and checks are in place and applied at the right time.
These checks and breaks need to be in both capital and money markets. Both the Securities and Exchange Commission and the Central Bank have an active and an important role to play. The SEC needs to encourage retail investors to invest in mutual funds/hedge funds (if any) and not take direct equity positions until our stock market and investors mature. Further, SEC also needs to question irrational price gains and losses that are far from fundamentals. There need to be active investigations and punishments to securities fraudsters who should not be allowed to walk away.
Transfer pricing policies of banks need to be checked by CBSL and ensured of their effectiveness in transferring risk. Further, CBSL also should ensure that banks have sufficient capital to withstand a shock in interest rates.
If these do not happen, what we will see is another set of bubbles. In addition, when they crash we will be back at square one. People will be complaining of stock market fraudsters and the stagnation of housing and vehicle markets. Corporates will be complaining of high interest rates and the Central Bank will be busy with restructuring another bank.
Most importantly, you and I will be paying for all that with taxes and interest.
(The writer is former banker and a member of CIMA. He holds a bachelors degree in International Business and Management, Master of Arts degree in Financial Economics and a Master of Science degree in Finance.)
