Why you can’t cap downward interest rates
Dr Ernest Addison, Governor, BoG
Two weeks ago, a policy think tank, the Institute of Economic Affairs (IEA), proposed that the Bank of Ghana (BoG) consider regulating lending rates to help cope with the persistently high cost of interest rates. of interest in the country.
He said market dynamics and moral suasion had failed over the years to drive rates down, resulting in a large gap between the policy rate and lending rates.
He went further by proposing that a cap of five percentage points be imposed on the spread between a bank’s lending rate and the central bank’s key rate.
With the policy rate now 13.5 percent, this means that no bank would be allowed to charge more than 18.5 percent interest on a loan, when this proposal is accepted and implemented. Interest rates currently average 21 percent, although some customers pay as much as 25 percent, depending on their risk profile.
While the proposal sounds compelling, especially given the controversial and seemingly intractable nature of the lending rate issue in the country, it is unpopular over time.
The era of regulating or capping interest rates is over with all the lessons it brought. The most recent example is in Kenya, where a rare attempt by the state to regulate interest rates in a free market economy has been quashed in four years and a comprehensive plan is now underway to right the wrongs.
Just as the case is presented in Ghana, Kenya viewed the September 2016 action as its perfect response to the pernicious high interest rate regime. But in November 2019, the Kenyan government repealed the law after a series of backlash and pockets of praise.
Elephant in the room
Lessons from Kenya aside, regulating interest rates strikes me as a short-term, artificial, easy, and unsustainable approach by an authority that does not admit that it is part of the problem.
Lending rates, which measure the cost of funds to borrowers, are the result of actions by the government, central bank, lender, and borrower. Any attempt to find a solution to the problem must include all the players proportionately.
As far as the government is concerned, the budget deficit and the debt situation are the biggest concerns. Large deficits fuel high debt and increased borrowing deprives the private sector of productive funds.
Known as crowding-out, increased government borrowing is a productive counterpart because it robs productive enterprises of funds, fuels further debt through repeated deficits, and raises interest rates, inflation and debt. currency depreciation.
Zero deficit financing
It is interesting to note that large deficits and the accumulation of arrears have taken root; which meant that the government had to borrow more from domestic and foreign sources on an annual basis. But as the government needs more funds, coincidentally from the same financial institutions that lend to private borrowers, it is forced to offer attractive rates on its risk-free bills.
These yields – and not the central bank’s key rate – then become banks’ benchmark rates for fund pricing. The reason is simple: if the government, which will literally never default, is willing to pay, say 19% for three years, why should a bank lend to a business or individual, who can easily default, to the same or lower rate?
The impact on rates aside, increased government borrowing from domestic sources is forcing banks to treat private sector borrowers as a second option, especially in times of uncertainty. As a result, private borrowers wishing to borrow are often forced to pay more in order to access credit.
This is currently being played out in the country. Banks have had to respond to the government’s increased appetite for funds with a corresponding increase in their holdings of government securities. Meanwhile, the private sector was the loser, receiving just 5.5 percent of new loans in June, compared to a 28.8 percent growth in investment in government securities.
While the pressure to cap rates is understandable, it will be hard to resonate even with the BoG, which has found the root of the problem.
In my mind, such a proposal would not have garnered huge support from the BoG about 20 to 30 years ago, when state controls were the order of the day; not in this 21st century, when liberal economics took root even in once state-dominated economies.
In this current dispensation, market forces, supported by targeted state interventions, are the most favored, popular and productive options.
When implemented effectively and efficiently, market forces bring out the best in economies and their players by fueling competition and rewarding the most diligent efforts.
In this regard, the first and broadest solution is to iron out macroeconomic imbalances to avoid the need for crowding out.
Once this is done, banks would be forced to lend primarily to the private sector at rates that offset the risks.
The long-term finance market needs to be developed and deepened to help ease the cost of funds for banks. To this end, efforts to create a development bank are timely.
Again, BoG needs to pay more attention to bank operations. More often than not, inefficiencies, managerial largesse and lack of innovation are passed on to unsuspecting clients as costs, resulting in higher loan prices.
The legal regime for defaulting borrowers also needs to be improved. Late business resolutions and foreclosures increase the default rate, which is passed on to borrowers.
Overall, regulating interest rates is not an option, given the unintended impact on credit to SMEs and the economy in general.
The solution lies in fiscal discipline, effective oversight, and a more responsive system that also records and keeps all borrowers and their history.