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With the continuous rise in cost of living, the people in low-income categories who depend heavily on interest income for their living, particularly in their old age, are the most severely affected by the fall in interest rates. They find that their interest income is hardly adequate to meet fast-rising day-to-day expenses, including rising medical costs – Pic by Shehan Gunasekara
In line with the Government’s policy to revive the economy hit by the COVID-19 pandemic, the Central Bank of Sri Lanka (CBSL) has implemented a policy package containing a variety of monetary stimulus measures since last year to ease the financial difficulties faced by private sector entrepreneurs. Reduction of market interest rates is a key policy initiative in this policy package.
Following the drastic reduction of CBSL’s policy interest rates and Statutory Reserve Requirements (SRR) in several rounds, interest rates have come down to historically low levels by now.
Market interest rates down
The CBSL has reduced its policy interest rates continuously since last year with a view to reduce market interest rates so as to facilitate private sector activities. The present Standing Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR) are only 4.50% and 5.5% respectively, compared with 8.00% and 9.00% two years ago.
Consequently, market interest rates have declined rapidly to single-digit level. For instance, the 364-day Treasury bill rate is down to 5.10% from 11% two years ago. The Average Weighted Fixed Deposit Rate (AWFDR) of commercial banks declined from 11% to 6.53% during the last two years. One-year fixed deposit rate of the National Savings Bank (NSB) is halved to around 5% from 11% two years ago.
Poor savers penalised
While, the present low interest rate regime has not yet contributed to any significant increase in bank credit to the private sector as envisaged, it has punished savers by offering low yields for their life-time savings.
With the continuous rise in cost of living, the people in low-income categories who depend heavily on interest income for their living, particularly in their old age, are the most severely affected by the fall in interest rates. They find that their interest income is hardly adequate to meet fast-rising day-to-day expenses, including rising medical costs.
The country’s majority of the workers are in the informal sector, and they are not covered by any pension or social security scheme, so their meagre savings are the only source of income after retirement.
Instead of boosting bank credit to the private sector, the low interest rate regime has helped the Government and public corporations to cover up their weak finances at low cost, as I explained in a recent Daily FT column (http://www.ft.lk/columns/Bank-credit-to-private-sector-picking-up-at-slow-pace-in-response-to-monetary-easing/4-712502).
Fast-ageing population
The socioeconomic consequences of low interest rates need to be analysed in the context of population dynamics.
Sri Lanka has achieved an advanced stage of demographic transition much earlier than the peers which have similar socioeconomic conditions. Sri Lanka is one of the fastest population-aging countries in the world.
The rapid decline in the fertility rate since the 1970s is the main factor that contributed to population aging. The country’s total fertility rate (the average number of children a woman would have during her child-bearing years), is estimated to be the lowest in the South Asian region.
The next most important reason for population ageing has been the increasing life expectancy due to the country’s improved medical facilities.
Since the mid-1970s the share of the younger cohorts of the population has continued to fall while the share of population in the age range above 15 years showed an increase.
The situation changed since the late 1990s when the share of the working age population (15–64 years) began to decline. Concurrently, the share of the elderly population (above 65 years) has gradually risen during the last two decades reflecting population ageing.
Old-age dependency ratio rising
As a result of the above demographic dynamics, the share of the population aged below 14 years declined from around 33% in the late 1980s to 23% by now while the share of population above 64 years doubled from 5% to more than 10% during this period.
Consequently, the share of the working age population has declined over the years resulting in a doubling of the old dependency ratio (the number of people aged above 65 years as a ratio of number of people aged 15-64 years) from around 8% in the late 1980s to 16% by today. The old-age dependency ratio is projected to rise to around 25% by the end of the next decade.
The population ageing adversely affects the economy in two ways. First, the decline in the share of working age population has a downward effect on labour supply, and consequently on economic growth. Second, population ageing results in an increase in the dependency ratio calling for support systems at the household level and old-age social security schemes at the national level pressurising the government budget.
In the absence of adequate social security facilities, declining bank deposit rates have manifold implications for the elderly people who depend heavily on interest income for their living.
Most workers lack retirement benefits
Only the public sector employees accounting for around 15% are eligible for regular monthly pension benefits.
The country’s majority of workers are in the private sector accounting for around 45% of total employment. They do not enjoy any pension facilities except the Employees’ Provident Fund (ETF) and Employees’ Trust Fund (ETF) schemes and limited gratuity payments at the time of retirement.
Hence, they deposit such once and for all proceeds received at retirement in bank deposits and other financial institutions. Given their limited income sources, they usually avert risks in investing in alternative interment avenues such as stock trading, real estate businesses or speculative dealings.
The informal sector employment consisting of own-account workers and family workers accounts for around 40% of total employment. These workers do not have regular income flows, and their access to formal financial institutions is rather limited. Among them, those who have deposited their limited funds in banks and other financial institutions suffer due to low interest rates.
Tax on savings income
Low interest rates can be considered as a tax on interest earnings. For example, a one-year fixed deposit now earns only 5% per annum, compared with 11% two years ago, as mentioned earlier. Thus, the saver has lost 6% that she would have received if interest rate was not administratively forced down by the authorities.
This income loss is just like a tax, as it has the same effect on after-tax income by paying income tax at the rate of 6% per annum.
Low interest rates also have negative effects on interest earnings of the EPF and ETF accruing low returns to the outstanding balances of member employees.
Inflation tax
Considering the inflationary effects on purchasing power of money, savers also incur inflation tax losses. For instance, adjusting for annual inflation rate of 4.2% as reflected in the latest National Consumer Price Index, a one-year fixed deposit with NSB carrying a nominal interest rate of 5% per annum now yields only 0.8% in real terms (nominal interest minus inflation rate).
If a more realistic price index such as the Producer Price Index is applied, the real rate of interest would be negative.
Interest rate ceilings hurt small savers
Interest rate ceilings imposed on microcredit are detrimental to livelihood of the poor households who save in Microfinance Institutions (MFIs), as articulated by Dr. Nimal Fernando, former Practice Leader for Microfinance at the Asian Development Bank in his incisive monograph “Understanding and dealing with high interest rates on microcredit” (ADB, 2006).
Dr. Fernando states, “If lenders mobilise deposits, microcredit interest rate ceilings may compel them to lower their deposit rates, adversely affecting savers. Because ceilings depress the profitability and viability of MFIs, savers may be reluctant to place deposits in them. This aggravates the institutions' funding problems while curtailing a valuable service in demand from poor clients and source of domestic investment.”
Financial repression
Low interest rates have given rise to financial repression in the country. Such repression occurs when monetary policy forces funds to be channelled to the Government that would otherwise go to private sector borrowers. Financial repression policies include caps on interest rates, direct government borrowings from captive sources (e.g. Employees’ Provident Fund) and closer connection between the government and banks.
Sri Lanka’s recent experience shows how financial repression can be used to finance the Government’s domestic debt by increasingly borrowing from the banking sector at low cost ignoring inflationary consequences.
Thus, low interest rates have helped the Government to reduce its debt servicing costs while penalising savers.
Lower rates of returns maintained in financial repression environment discourage both saving and investment, as pointed out by Ronald McKinnon and Edward Shaw in their celebrated financial repression hypothesis introduced in 1973.
“Impossible trinity” at work
The CBSL is beginning to lose its grip on both the exchange rate and interest rates in recent weeks amidst capital outflows, reflecting unquestionable validity of the mainstream economic theorem of “impossible trinity” or “policy trilemma”, as I explained in a previous Daily FT article (http://www.ft.lk/columns/Policy-trilemma-poses-formidable-challenges-to-interest-and-exchange-rate-management%20/4-71322).
As revealed at the recent Monetary Policy Review meeting, the CBSL is determined to sustain current low market interest rates and to keep the exchange rate around Rs. 185 per US dollar.
However, reflecting upward movement of market interest rates, the yield rates of recent Treasury bill auctions have gone up marginally, and the CBSL experiences considerable undersubscription due to market resistance to low yields on Government securities.
As regards the exchange rate, the rupee is hovering around Rs. 200 per dollar deviating widely from the CBSL’s “desirable” range.
Meanwhile, the CBSL took a 360-degree turn from its recently issued directive to exporters and banks demanding to sell a portion of foreign exchange proceeds to the monetary authority in a bid to avoid rupee depreciation.
Such policy reversal is proof of the impossible trinity theorem which says that no central bank can simultaneously fix both the exchange rate and interest rate without experiencing capital outflows.
CBSL unfairly at receiving end for economic ills
To be fair by the CBSL headed by Prof. W.D. Lakshman, my senior at Peradeniya University, I would like to mention here that the roots of most economic ills faced by the country are beyond the control of CBSL, as I reiterated in earlier columns.
In the backdrop of the failure to contain the budget deficit, successive governments have resorted to foreign and domestic borrowings over the years to fill the fiscal gap resulting in unsustainable debt accumulation.
Given the tightened global financial markets and the country’s weak sovereign debt ratings amidst the pandemic, the Government is now compelled to resort to domestic bank borrowings exerting immense pressures on the money market.
This tends to push up interest rates including Treasury bill yields, despite CBSL’s effort to lower them. This is the formidable challenge faced by CBSL at present.
I came across a recent newspaper article written by my university batchmate Prof. Sumanasiri Liyanage, who studied Money and Banking along with me at Peradeniya under the brilliant teacher, Prof. H.A. de S. Gunasekera. He argues that the orthodox recipe has failed to work in Sri Lanka during the last three decades.
Prof. Liyanage states, “These elements include fiscal discipline maintaining the fiscal deficit around 5 per cent of the GDP, the independence of the central bank that follows inflation oriented monetary policy, liberalisation of trade and capital transfer, and going back to the IMF for meeting ‘temporary’ imbalances of the balance of payment. In short, orthodoxy proposes to follow strictly the dictum of the ‘Washington consensus’ as a long-term corrective measure.”
My understanding is that successive governments have faced multiple challenges in adopting the much-needed macroeconomic corrective measures such as containing the budget deficit and maintaining flexible interest and exchange rates over decades. The inability of the authorities to tackle such challenges has resulted in the failure to reap the benefits of economic liberalisation.
Hence, the main reason for the failure to achieve economic success seems to be the authorities’ inability to tackle the policy constraints, rather than the weaknesses of the orthodox recipe per se.
Prudent fiscal-monetary policy coordination essential
Misalignment of fiscal and monetary policies is the root cause of current macroeconomic imbalances which compel the CBSL to fix interest rates and the exchange rate simultaneously, going against the mainstream economic principles.
Low interest rates have enabled the Government and public corporations to borrow heavily from the banking sector, penalising savers to a large extent. Such a policy stance has detrimental effects not only on the living conditions of savers but also on domestic savings, which show a declining trend in recent times due to the negative effects of low interest rates. In particular, interest rate ceilings on microcredit discourage small savers.
When interest rates are too low, the CBSL has limited space to manage market liquidity by using its policy interest rates.
Considering the country’s growing old-age population and unsecured employment in the large informal sector, a review of the controlled interest rate policy seems necessary.
Fiscal and monetary policies need to be reformulated within a cohesive macroeconomic framework aiming at sustained economic stability without resorting to fixed interest and exchange rates.
(Prof. Sirimevan Colombage is Emeritus Professor in Economics at the Open University of Sri Lanka and Senior Visiting Fellow of the Advocata Institute. He is a former Director of Statistics of the Central Bank of Sri Lanka, and reachable through [email protected])
