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Interest rates cut will have costs to businesses

THE marathon in lending rates cut is gaining momentum signalled by latest decision by CRDB bank to cut down its interest rate from 22 per cent to 16 per cent that goes hand in hand in a fresh bid to reduce borrower’s payback burden.

Will low lending interest rates have benefits or cost? NMB had also announced lending rate cut from 19 per cent to 17 per cent and for smaller and medium enterprises down to 21 per cent from 23 per cent.

BOA Tanzania also reduced interest rates to 11 per cent, and Tanzania Mortgage Refinancing Company (TMRC) trading along these dynamics last week launched their 12bn/- T-bond a 1st tranche of 120bil following rates reduction in history.

Tanzania has more than 40 commercial banks not including community banks and other strategic policy banks.

The bank of Tanzania forthcoming policy rate could prompt other banks to follow interest cut suit. Why banks and their regulator are acting to lower lending rates now and not three years ago continue to be an area of interest to economists eager to know what this reduction would mean to our market context.

Is discount due to high levels of NPL? Is lessening due to return of capital? Is drop due to liquidity scarcity? Is lessening due to default rate? Or is it a bargain due to cost of borrowing for salary workers in public and private sector from 22 per cent to 16 per cent?

The notion that interest rate may boost economy or have negative effect starts from a principle, that banks make money on the difference-the marginbetween how much they must pay to attract deposits and how much they can earn by lending them out.

Changes of the interest rate unsystematically and clumsy due to competition would not spare bank’s operation in one piece.

What various individuals do not recognize, when interest rates are truncated, banks’ profit margins on loans will also be small.

As a result banks will have no real incentive to take on the risks of lending. This is critical because in a market economy, resources tend to flow to activities that provide the greatest returns for the risks the lender bears.

Interest rate adjusted for expected inflation and other risks serve as market signals of these rates on return.

Although returns will differ across industries, the economy natural rate of interest further depend on factors such as the nation’s saving and investment rate.

There are costs associated with lowering interest rates. Principally, low interest rates provide a powerful incentive to spend rather than save.

In the short-term, this may not matter much, but over a longer period, interest rates cut penalize savers and those who rely heavily on interest income.

When economic resources finance more-speculative activities, the risk of a financial crisis increases particularly if excess amounts of leverage will be used in the process.

Some economists believe that banks and other financial institutions tend to take greater risks when rates are maintained at low levels for a lengthy period.

If short-term interest rates are low relative to long-term rates, banks and other financial institutions may over-invest in long-term assets, such as Treasury securities.

If it happen interest rates rise without warning, the value of those assets will fall whereby bond prices and yields will move in opposite directions. In the past, banking was very

unexciting, but relatively steady. Businesses put their money in savings accounts, on which banks paid them interest. Banks would then use those sums to offer loans to other businesses, who they charged a higher interest rate.

The variance between these two interest rates would cover any losses such as NPLs, etc.on those loans. Whatever was left over would be the bank’s profit.

Currently, even if a bank wants to operate that way, it’s much tougher. With little in savings accounts, and current accounts kept as small as possible, banks will often be left with no enough sums to support their lending endeavours.

This will either forces banks to borrow more.

This will creates additional leverage or sell their loans through instruments like securitization. While both of these deeds can be perfectly safe from business point of view, these sorts of transactions can also lead to complications if not conducted industriously. While interest rates cut will drive down bank deposits, on one hand, will increase the demand for loans on the other.

This aspect is what most people consider will drive the economy.What many don’t reckon interest rates cut inspire firms and consumers to take on more debt.

Much as market is said to be reacting to Bank of Tanzania interest rate wavering measures arguably set to pave the way for introduction of interest rate based monetary policy, some economists argues that low rates can discourage banks from making loans and cost of low interest rate could surpass benefit of rates cut.

How rate drop can dishearten banks from making loans can be disputed, although interest rates cuts are hypothetical aimed at accelerating economic growth, if central bank cut rates excessively without putting into context the same thinking that created this problem, then there will be future problems (read Albert Einstein on problem solving view point).

As an alternative, banks might put their money into safe assets such as Treasury bills or T-bonds that are free from risk yield nearly as much as loans would.

This would overturn the volume of loans, particularly the ones that banks retain on their books such as commercial and industrial loans. Constituents and drivers that boost economic growth are not exclusively dependent on rate of interest.

What is imperative is for the regulator especially at this point in time for Tanzania to come up with package that would help banks operations go expeditiously because commercial banks and strategic banks generally borrow on short-term and lend long-term.

Is debt a bad thing? In my view it is not, if it is taken on prudently and in moderation.

But, if not, debt can be particularly dangerous if a loan obtained without considering consequences caused by rate of interest alteration.

THREE days ago, a group ...

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Author: Dr Hilderbrand Shayo

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