In an economy, the interest rate plays a major role, as it can have an impact on every part of the economy in different ways. The Central Bank, as the sole monetary regulator, is expected to control the interest rate, so that it can decide on the money supply leading to inflation. It is with broader money supply that people demand for more goods and services. Once people have money, they tend to buy more, resulting in demand-pull inflation, which means too much money chasing too few goods. This is when we just take a glance at the rate hike, but there are many more to be discussed in the Sri Lankan context.
Having considered the prevailing economic situation in the country, the Central Bank of Sri Lanka, through its monetary policy review, decided recently to increase the key policy interest rates that hopefully influence the investors’ sentiments, business expansions, stock market, people’s spending and the money supply in the country at large.
The Colombo Consumers’ Price Index (CCPI) rose to 6.8 percent in February 2017 from 5.5 percent in January 2017. Further, an increase by 1.3 percent within a month could be seen. Credit to the private sector is expected to be minimized through the rate hike in order that inflation is in control, although mainly caused by prevailing drought and tax revisions.
To create a healthy economy and a better living standard for citizens, the inflation has to be in control, which is somewhat difficult for a country like ours, which largely depends on imports, recording continuous balance of payment issues, which rose from US $ 8.4 billion in 2015 to US $ 9.1 billion in 2016. It is in such a backdrop that we have to discuss the economic impact of increasing the interest rate, a hot topic among the business community.
It is needless to say that the private sector-led economic growth is the way forward for a country like Sri Lanka, where the government or public sector is no longer capable of creating employment and other welfare activities, many of which are financed by imposing taxes on people. Hence, the private sector must take the leadership for economic growth. That is why the Central Bank governor also stated recently that the private sector had to open wallets, take risks and invest locally. However, there is a problem arising in opening wallets in an economic situation where things such as the tax regime are highly uncertain and unfavourable.
Interest is the cost of borrowing by definition. Borrowing or lending is a key business activity for business organisations to expand their operations and try out new ventures, which ultimately create employment, broadening the production possibility curve of the economy. It is with the recent interest rate hike that the business organisations are further hit in an economy jeopardized by political uncertainties and a negatively impacted tax regime.
The companies that are in need to take loans will have to pay a higher interest rate as the borrowing cost, which spontaneously makes their expense column up. Many business organisations, which are discouraged by the prevailing interest rate, have chosen alternative ways of financing such as making a rights issue for the existing shareholders rather than going for debentures, the income of which is taxed since recently.
The level at which the private sector entities are sluggishly engaged in economic activities, can always result in a stagnant economy. Once it is difficult for business to finance for their expansions, all they try to do is to survive instead of expanding. Less investment means less job opportunities, poor living standard and in the end, less tax income for the government.
Even if the interest rate hike is not so favourable for the businesses that borrow, it is good for the lending institutions like banks and financial institutions. Therefore, the banks might make profits under the prevailing circumstances but can be prevented from making further investments because the statutory reserve ratio has gone up to 7.50 percent. A robust economy cannot be expected, whenever the private sector is restricted from exercising its full capacity.
In a country, where financial literacy is considerably at a low position, the majority is not so aware of the logic behind the rate hike and its repercussions. Nevertheless, they are positively as well as negatively affected by the rate hike. A rate hike is always good news for savers, as they are offered a high interest rate for their savings. People might deposit their hard-earned money in banks, expecting risk-free good returns for them and paving the way not to choose risky and lucrative investments like stock market.
In a highly commercialized environment, the people are compelled to spend the future-earned money, which is now taken as loans. Almost everyone takes loans and uses credit cards and leases, etc. These costs make people’s disposable income less. As a result, their demand for goods and services goes down. This goes from bad to worse, being highly detrimental for loans taken with a floating interest rate, when people are dependent on a fixed income like the salary.
In addition to the rate hike, the recently imposed new taxes also have narrowed the disposable income to a greater extent. When people deposit their money in banks and become less capable of spending on things, money circulating in the country remains narrow.
The new entrepreneurs cannot bear a huge borrowing cost, as they are struggling to blossom. The small-scale entrepreneurs and self-employed people could be discouraged to start new ventures. Furthermore, this means less employment opportunities, resulting in a situation where people have to struggle in finding jobs. However, people stand to benefit from these changes, when inflation can be controlled.
The stock market is considered an indicator of a healthy economy because it quickly reacts to whatever the changes taking place in politics and economy. The stock market becomes a victim, whenever the interest rate is announced to have increased. When explained in simple words, people tend to withdraw their investments made in the stock market and deposit them in banks, once the rate is high. Due to this kind of investors’ sentiments, the retail investors have refrained from trading in the market.
Even though the local investors motivated by higher interest are not so keen on the market, foreign investors have been buying shares continuously regardless of the current state of affairs. Shares of many companies have been undervalued paving the way for foreign investors to pick at cheap rates. However, this might be detrimental for local retail investors in the long run. Even if we could see a few acquisitions this year, no major foreign direct investments to the stock market could be seen. This may rely on factors most of which are still hidden and unexplored.
The era of plantation companies seems to have disappeared in the market. Furthermore, high expectations cannot be kept on the fast-moving consumer goods (FMCG) sector companies also, as people will not spend hugely with a less disposable income. The shares in the finance industry are frequently traded, as they are expected to make profits.
When the timely changes are taken into account, the interest rate should be increased, so that the aggressive inflation can be controlled and mitigated. Then, we can look forward to better economic opportunities in the future.
(Amila Muthukutti, a business executive with capital market experience, is currently employed by a leading company in Sri Lanka. He holds a BA in economics from the University of Colombo)