Inflation, interest rates and bank lending
The Central Bank of Sri Lanka has officially declared that the
prevailing inflation rate in the country is 26.6% which is slightly
below the previous declaration of 28.2% just a few weeks back.
Despite the fact that there are diverse opinions with regard to the
actual rate of inflation in the country, it has to be accepted that Sri
Lanka is among the very few countries experiencing an abnormally high
inflation rate in South East Asia at present.
Although there had been an unprecedented increase in the prices of
oil and increased consumption levels attributed to mass markets such as
India and China with a resultant escalation of food prices leading to
inflationary tendencies throughout the world, Sri Lanka’s position as
being one of the highest in terms of inflationary rates in South Asia
needs serious attention of all citizens since further escalation of such
a situation will be really detrimental to everybody.
Rapid increases of prices of essential items in a very short
timeframe without any control can lead to a situation called ‘hyper
inflation’ and when we look at the history of several countries
including Russia, Germany, Israel, Bolivia and Turkey it shows that
these countries too have gone through a period of “Hyper inflation’ in
the past and currently Zimbabwe is a country facing such a serious
inflationary situation in the world.
The term ‘Inflation’ simply means the rapid increases in prices of
goods and services of a country within a short period. A rapid increase
in the rate of inflation is definitely a serious problem of any country
since the value of hard currency erodes rapidly discouraging savings and
encouraging borrowings which further contributes to high inflation.
It also affects the balance of payments of a country widening the
trade gap with exports discouraged paving way for more imports as
importing becomes cheaper than domestic purchases and also exporting.
Furthermore when there is a rapid increase in inflation people would
not go for long-term well planned investments but will concentrate only
on day- to-day living which in itself in highly detrimental for the
long-term growth of an economy.
Bank interest rates have a very close relationship with the
inflationary rates of a country and very often interest rates act as
indicators of the inflationary rate.
Quite apart from the constant attempts made by Central Banks to
curtail inflation using the interest rate adjustment mechanism as a
monetary policy to curb inflation, the average depositor too decides on
his investment options based on the inflationary trends and the interest
rates offered by Banks.
When the inflation is high the prices of commodities increases and
the purchasing power of ‘hard currency’ declines rapidly thus forcing
people to invest their money in seemingly speculative ‘high yielding’
investments on a long-term basis without a proper planning on return on
investment rather than investing in average Bank savings accounts.
Basically when there is a tendency for high inflation people opt to
go for borrowing for day-to-day consumption and those who have surplus
savings will go for long-term investments such as in gold and land etc.
without any preplanned returns depriving the much needed cash inflow to
the Banking system and the required liquidity levels in the Money
Since the Banking system of a country acts as a human body’s blood
circulation system in mobilising financial resources for needy sections
of the country/ economy, slow down in Bank savings means a definite slow
down in the economy due to lack of adequate funding for development
activities thus resulting in long-term adverse consequences.
When one looks at the changes taking place in the Bank interest rates
in the recent past almost all commercial banks in the country have
increased their rates of interest on average one year fixed deposits up
to around 18-19% p a which is about a 2-3% increase compared to the
rates offered just six months back.
Correspondingly the average lending rates of the commercial banks too
have been increased to about 25-26% p a which is an upward revision of
about 5-6% from the rates applied a few months back.
Whilst the average savings interest rate offered by the commercial
banks remains static around 4-5%p.a with various incentives being
offered such as lottery schemes with valuable prizes etc. to attract and
retain such depositors, some of the commercial banks in the recent past
in an unprecedented move have commenced introducing ‘special savings
accounts’ under various brand names offering high interest rates ranging
between 12 to 14%p.a. in order to retain the existing deposits as well
as to attract specific market segments whilst being competitive in the
High interest rates
There are numerous other non-banking financial institutions too
operating with or without licences from the Central Bank of Sri Lanka
which offer exceptionally high interest rates in order to attract
depositors who are desperately looking for a ‘better return’ on their
hard earned money in the face of the high inflationary situation
prevailing in the country at present.
According to the official figures declared by the Central Bank of Sri
Lanka the rate of inflation which stood at 16.4% in December 2007 has
increased up to 28.2% (71% increase) during June 2008 which could be
considered as an unprecedented increase that has taken place in the
As we have witnessed in the past few months this high inflationary
trend has led to a higher rate of interest on bank deposits which in
turn has effected an upward shift in ‘lending rates’ of commercial
This is due to the fact that banks are trying to maintain an
appropriate ‘mark up’ to cover their operational costs, risk premiums
and profit margins etc.
In addition to the interest rate offered to the depositors when
deciding on the interest rates on lending. The final outcome in a highly
inflationary scenario would be the exceptionally high interest rates
that will be applied on bank lending and ultimately the average borrower
will have to bear the burden in terms of an unbearable interest cost.
The burden on the average borrower is quite evident from the high
incidence of delays in repayment of bank borrowing experienced in the
recent past with almost all the commercial banks in the country pressed
for tedious money recovery action to recover their dues. This scenario
applies to other non-banking financial institutions as well.
The Central Bank of Sri Lanka recently issued new guidelines with
regard to classification of overdue loans in a move to closely monitor
loans of Licenced commercial banks. According to these new guidelines
the commercial banks are required to classify credit facilities as
‘overdue’ when the due date of payment of the monthly instalment of a
loan exceeds by 61 days as against the previous limit of 91 days.
This new regulation despite the good intentions behind has made a
severe impact on the ‘Non Performing Advances’ (NPA’s) of commercial
banks requiring very close monitoring of credit facilities and
expeditious recovery action.
Due to this latest method of classification of NPA’s the overdue loan
portfolios of most of the Commercial Banks have increased by several
billions in some cases severely affecting their financial performance
since Commercial Banks are required to set side appropriate portions of
their profits as provision for bad and doubtful debts.
Due to such strict guidelines prudent bankers become more stringent
in their lending decisions, credit approvals and granting new loans
which may result in an indirect ceiling on Bank lending although there
may not be a very visible impact of this on the short run.
Both the increases in the lending rates as well as any curtailment of
granting of loans by the commercial Banks on the pretext of more
stringent pre lending analysis would finally affect the ultimate
borrower which in turn will have a direct impact on the economy in terms
of lowering of production and employment generation.
When Bank borrowing becomes too costly entrepreneurs will naturally
be discouraged from borrowing for investment purposes in new projects/
ventures etc. which will directly have an adverse impact on the overall
economy on the long term.
Since inflation is a result of more money in circulation than the
goods and services available for consumption, one of the important
measures in curbing inflation would be to increase production of goods
and services in a country whilst curtailment of which would further
aggravate the situation.
Hence increasing of interest rates only as a means of curtailing
money supply in an economy can lead to many other negative side effects
in the long run including lowering of production in a country unless
effected in a well balanced manner.
One of the main sectors which have been severely affected by the
recent increased lending rates is the ‘personal borrower’ who is the
monthly wage earner wanting to obtain a housing loan or a personal loan
to repair his vehicle.
Although the monthly commitment of the repayment on such credit
facilities keep on increasing along with the increases in the interest
rates coupled with the increases in the personal expenses for day to day
living due to the high inflationary trend, the repayment of such
personal loans become an acute problem since the average wages have not
been increased to meet such an upward movement in interest rates and
cost of living.
This situation has resulted in most of the personal borrowers of
commercial Banks facing real difficulties in meeting their financial
obligations in time leading even to legal prosecution by Banks.
The use of ‘credit cards’ in Sri Lanka increased tremendously during
the past decade due to the active promotional campaigns carried out by
most of the commercial banks in the country with certain foreign banks
taking the lead.
However the present inflationary trends have tempted most of the
credit card users for increased borrowing as a means of instant and an
easy provider of ‘purchasing power’ and finally ending up being unable
to repay such borrowing with huge interest burdens since rates applied
are comparatively higher than normal bank borrowing.
The recent Central Bank guidelines on provisioning for Non performing
Loans has introduced stringent provisioning requirements on credit card
outstnadings as well, making it mandatory to categorise as ‘Sub
Standard’ when the ‘minimum payment’ of a credit card outstanding is
delayed by 120 days as against the previous time frame of 180 days.
unable to repay debts
When such borrowers due to genuine reasons are unable to repay their
debts are compelled to repay their overdue borrowing by the Banks the
only option available to most of them would be to hurriedly dispose of
an immovable/movable property belonging to them to supplement the funds
required to repay their loans and disposing off of such properties in a
short time frame at reasonable prices has become a real problem
specially in a depressed economic situation similar to the one we are
experiencing at present.
Although Licensed Commercial Banks under money recovery action are
legally authorised to auction and/ or acquire mortgaged properties to
recover the overdue debts under ‘Parate Action’ (Recovery of Loans by
Banks special provision-Act No: 04 of 1990) they too find it difficult
to find suitable buyers who are readily willing to purchase such
acquired properties in a highly inflationary economic satiation of this
nature thus Banks end up becoming owners of many prime properties
without realising the much needed liquidity.
This situation once again affects Bank’s lending channels since the
money lent (bank’s assets) are locked up in unproductive illiquid assets
such as immovable property/vehicles etc. for indefinite periods of time
without bringing in any productive cash inflows to the banks or the
Unless this rapid inflationary trend is arrested in the near future
despite the fact that the interest rates offered by Commercial Banks to
their depositors could be further increased to suit the inflation trend
there is a definite limit up to which the ‘lending rates’ could be
increased since after a certain point there will be no borrowers for
borrowing at such exorbitant interest rates.
Hence if the average borrower stops borrowing on the face of
unbearable interest costs eventually the banking industry will be the
first casualty and thereafter the whole economy since it will create a
chain reaction on almost all sectors of the economy in vicious cycle.
In a situation of this nature Commercial Banks will have to act in a
very responsible and prudent manner in continuing with selective lending
as much as possible whilst maintaining ‘reasonable profit margins’
without over burdening the borrowers.
Narrowing down of interest spreads, reducing non preforming loans and
curtailing operational costs whilst maintaining reasonable profit
margins etc will have to be the key strategies that Commercial Banks
will have to strive at present.
Furthermore borrowers who are faced with genuine cash flow problems
will have to be assisted by way of rescheduling their repayment
programmes providing longer repayment periods with appropriate interest
rate reductions etc. in order to create a win-win situation looking at a
more long term strategy of survival.
Whilst the partial opening up of the Treasury Bill market recently
for foreign investors is a positive move towards easing out the current
liquidity problems in the economy at least as a temporary measure from a
fiscal point of view, the Government as well as the Central Bank of Sri
Lanka will have to play a major role in trying to curtail high
inflationary trends in the country with fundamentally sound economic/
monetary policies with encouragement for improved production of goods
and services in the country with suitable Foreign Direct Investments and
making our local rupee stronger as against foreign currencies rather
than trying to artificially control the inflation solely by manipulating
the interest rates in order to have a proper balance of such economic
forces to prevent any major economic calamity.
(The writer is an Attorney-at-Law and is employed as a Manager
attached to a leading Bank in Sri Lanka.)