Krishna Bhardwaj

Reduction of Interest Rates: What’s the real objective? 

— Krishna Bhardwaj 

The Monetary Policy Committee (MPC) of the Bank of Mauritius (BoM) took the decision on Monday 27th September to bring down the key Repo Rate of the BoM by 1% from 5.75% to 4.75%. This sharp reduction of the key market-signalling rate of the BoM is coming after a lapse of 18 months during which the Repo Rate was kept unchanged at 5.75% by the MPC. In sharp contrast, it will be recalled that the MPC had reduced successively the key Repo Rate in the relatively shorter period of 5 months from October 2008 to March 2009 by as much as 2.5% when Rama Sithanen was Minister of Finance, bringing it down from 8.25% to 5.75% by March 2009. This reduction in the key Repo Rate is expected to signal a reduction in the interest rates paid by commercial banks to depositors as well as in the interest rates they charge on their loans to borrowers.

Although the September 2010 reduction of the key BoM rate by 1% appears to be a substantial concession in the prevailing circumstances, it has some merits. It has silenced at one stroke all the lobbies, including some in part of the media, which had been clamouring for it. It has by the same token removed the wedge that was sought to be driven by the same parties between the incumbent Minister of Finance and the BoM alleging that the two sides would be adopting contradictory positions as regards giving a further fillip to the economy. The decision also has had the merit of leaving no ammunition in the hands of those who were looking for a scapegoat to blame were the economic situation to worsen due to expected deteriorating external market demand conditions in which neither the BoM nor the Ministry has a say. This move constitutes therefore a masterstroke to turn the tables on those who were keen to identify a peg on which to hang their recriminations if things did not finally work out well for the economy. It has dealt a blow to those who manage to put themselves on the “right” side by blaming it on the “others”.

It cannot now be said that the BoM did not give more than what the private sector was asking for, as a pre-condition for it to bring tangible outcomes from the export market. While the private sector could have been happy with a quarter per cent reduction in the key Repo Rate or half a percentage point at best, it got a 1% reduction instead, which is more than enough. In line with the case it had been making out before the MPC’s recent decision, the private sector’s effective lower cost of borrowing as from now should give it the leeway it said it needed to forge ahead on external markets. The ball is now in the court of the private sector. We will be happy to see it fulfil its part of the contract by raising the real volume of its exports, by increasing employment and by raising its productivity sufficiently well to achieve sustainable growth. It cannot claim that the domestic policy framework has not been supportive of its demands. If, however, we do not see export levels rise and employment sustained despite the favourable policy environment, we should be asking ourselves the real reasons behind the din raised by it in the media before the recent MPC meeting. 

Gainers and losers 

In policy decisions, there are gainers and losers. If borrowers from banks, including the tourism and textile sectors, stand to gain by way of lower debt servicing costs due to this interest rate reduction, savers at banks and other financial institutions will immediately be made to bear the brunt of this downward adjustment. Excluding foreign currency deposits, savers have kept a total of Rs 215 billion of deposits with commercial banks. A 1% reduction in the interest rate banks pay on such deposits will mean that commercial banks will pay Rs 2.15 billion less by way of interest to their depositor customers in a year. It is an enormous sacrifice on the part of the saving public in favour of exporters who will see the interest bill on their borrowings reduced.

This substantial loss by depositors due to the recent MPC decision will also benefit the banks by as much. Inasmuch as banks reduce their lending rate to a certain extent to reflect the reduction in the key BoM rate, this benefit to them will be partly offset due to lower earnings by banks on their loans. But the banks will nevertheless remain net gainers as most of their significant contracted lending rates are not to fall below a floor rate as set out in the lending contract, irrespective of what happens to the key Repo Rate of the BoM. At the time borrowers engage to borrow, banks make them agree that the interest rate will fluctuate with reference to some other key rate e.g their prime lending rate or the BoM Repo rate but will not, in any event, drop below a pre-established floor rate. Their effective lending rate will therefore not suffer to the same extent, the more so as banks’ total loans to the private sector are some Rs 20 billion less than their deposits. This can clearly be seen in the huge difference banks get between the interest income they pay to depositors and the interest they earn in turn from placing the same deposits in loans and investments. For example, in the accounts for the year ended 30 June 2010 published by the MCB yesterday, this bank has declared that in all it paid depositors interest amounting to Rs 4.2 billion on their total deposits; however, it earned interest income by employing the same deposits in the granting of loans and making financial investments amounting to Rs 9.3 billion, a difference of Rs 5.1 billion in its favour, which is higher than all the interest it paid to depositors during the year.

The objective of the private sector to fight for a reduction of the key Repo Rate of the BoM conceals the real objective, which is to work up a depreciation of the rupee. The work to get the rupee depreciated by intimidating the BoM has already begun in the media even as the MPC announced its decision. In the ordinary course of business, the recent fall in rupee interest rates will make rupee assets (e.g. low-yielding Treasury Bills) unattractive to investors. It will also impact negatively on the incentive for people to save and hence it will trigger higher levels of consumption. It is foreseeable that the low level to which interest rates will fall as a result of the recent reduction in the key BoM rate will put savers in a sort of a trap. They will become increasingly indifferent to saving more money. Income earners will accordingly be tempted to squander away more of their money on consumption, especially through imports. Banks however will gain in the process because running down of deposits by savers will help them curtail any liquidity surplus they would be holding currently. They will also gain by way of additional incomes from accelerated foreign exchange transactions due to increasing imports. Accelerating imports and the low yields on rupee assets acting to cut down inflows of foreign exchange will have the effect of curtailing the supply of foreign exchange on the local foreign currency market. 

Conflictual bi-polarisation of interests 

Once certain exporters and their specific banks get a controlling grip on the local foreign exchange market by this means, as they have done in the past from time to time, they will push the rupee into a depreciating range, by manoeuvring scarcity on the local foreign exchange market. This situation will materialise the more so if the prevailing economic slack in our external markets were to accentuate. Rupee depreciation will, in such circumstances, enable the exporters of goods and services to pocket more rupees per unit of foreign currency (Euro, USD, GBP, etc) they will deliver to the local market. This will improve the exporters’ profit and loss account but it will, by the same token, produce higher prices for consumers and push them further against the wall. Savers and consumers will lose doubly due to the fall in the interest income they were previously earning on their savings and also because they will have to pay up more rupees for the same amount of imported goods and services on account of the depreciation of the rupee.

This kind of conflictual bi-polarisation of interests has proved harmful to the country as successive rounds of inflation and wage compensation over the years have proved. Uneven distribution of gains and losses across the different counterparties has aroused suspicions about each other’s hidden motives. Now that the BoM has crossed the Rubicon by deciding to cut the interest rate and bring it to such a low level, it is time to reconcile and set out to achieve higher national objectives. What are they? Producing a more confident overall future economic outlook; a sustainable balance of payments; an inflation that does not keep eating away into people’s purchasing power; a larger and higher value-added space on external markets; improving the country’s capacity to employ larger numbers and diversify into a wider range of skilled activities with a more inclusive entrepreneurial class and an across-the-board reputation for the highest standard of professionalism in all we undertake.

There is a need to use the occasion to “re-stabilise” relations in the economic and social fields or as President Obama would have said “to reset the button”. We cannot make sustainable progress if we keep bulldozing certain categories of citizens constantly to the bottom as eternal souffre-douleurs whenever adjustments in policy have to be made.

Krishna Bhardwaj

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