Domestic Economy

Cuts in Interest Rates and Macroeconomic Implications

Cuts in Interest Rates and Macroeconomic  ImplicationsCuts in Interest Rates and Macroeconomic  Implications

All commercial banks and credit institutions have been compelled by the Money and Credit Council (MCC) to lower the cap on deposit interest rates from the current 22 percent to 20 percent as of May 5, a move that authorities are hoping would help dissipate the credit crunch and boost business lending.

Calls for cutting interest rates have recently been heard from every side. Proponents of a rate cut cite the need for cheaper money to revive Iran’s ailing industries. They argue that rates should be cut in line with the decline in inflation to boost business investment. There are, however, opposing views, contending that a cut in interest rates could stoke inflation – which is already high – by increasing money supply.

The Financial Tribune asked economist Pouya Jabal Ameli’s view on the MCC’s new move and the effects, particularly on macroeconomic indicators.

  How will macroeconomic indicators be affected by the cut in interest rates?

First of all, I do not believe the 20% deposit interest-rate could actually materialize, particularly in view of the existing credit crunch and fierce competition among banks to absorb more liquidity. Moreover, there are credit institutions, some of which are not fully supervised by the Central Bank of Iran (CBI). This gives them the upper hand in offering higher interest rates and luring customers, which would in turn give way to increased competition among banks.

Furthermore, even if authorities succeed in maintaining the low deposit interest rates, it would give rise to business lendings. The borrowing businesses and companies will in turn use the money to purchase raw material or pay overdue wages to workers, thus increasing the amount of available liquidity and the consumers’ purchasing power. This would lead to increased inflation in the short run.

The effects of interest rate cuts on economic growth and unemployment will remain marginal, as the manufacturing sector’s problems go beyond shortage of fund.

 What will be the impact on the manufacturing sector?

For an extended period over the past decades, the real interest rates were negative, meaning nominal interest rates were below inflation. But even in such times no significant growth was observed in the production sector. This is because factors other than money supply, such as cumbersome and harmful regulations, taxes, insurance policies as well as the sanctions [imposed on Iran by the West over Iran’s nuclear program] pose barriers to growth of the manufacturing sector.

Therefore, I do not think increasing the money supply can resolve the problems facing the manufacturing sector, nor can it give a new momentum to production.

 What then would be a better policy for the CBI?

The CBI, like any other central bank, should be able to directly influence interest rates through appropriate measures, such as the so-called ‘overnight interest rates’, which enables it to regulate the interbank interest rate; currently standing at about 29%. This would in turn influence deposit interest rates. Of course, regulating the overnight rate is only possible by increasing the commercial banks’ reserves in the central bank since the CBI does not intend to print more money.

But given that the commercial banks are currently faced with shortage of liquidity and deterred commitments, the CBI must focus its efforts primarily on realigning the commercial banks to perform their responsibilities, which is accepting deposits, giving business loans and basic investment products like savings accounts. This calls for a strong supervision by the CBI to prevent the commercial banks from entering risky investments which pushes them into borrowing huge amounts at high interbank rates. Only in a healthy banking system and in accordance with international banking standards are inflation and deposit interest rates interlinked, as authorities have assumed.

  How will lower deposit rates influence other markets?

Quite naturally, as the banks lose their galore, people turn to more profitable markets for investment. This is partly because people and private institutions have a more rational anticipation about the future of inflation than the policymakers. The lawmakers have predicted a single-digit inflation rate for the current Iranian year (started March 21). This is while no mechanism has been put in place to find out the people’s anticipated inflation.

Therefore, I believe liquidity will flow towards other markets such as the housing market. The currency market is also generally a lucrative market, but in light of the recent progress in nuclear negotiations and prospect of a boost in foreign trade, I think the currency market will be less alluring than other markets such as housing.

  Do you think this could help the housing market step out of recession?

It increases the chances of such outcome.

  The MCC decision is to be reviewed every three months. What do you presume the council’s decision will be in three months?

The decision to review the monetary policy every three months is a right move as it allows the lawmakers to review the macroeconomic indices and make policies accordingly. But I do not think the interest rates will increase after the three-month period, since the MCC’s main focus is on extending support for the manufacturing sector rather than the banking system. Therefore, I think they will either maintain the current interest rates or reduce it further.