Economy, Business And Markets

Tale of Interest Rates

Post-Doc and Teaching Fellow at Alzahra University
Tale of Interest RatesTale of Interest Rates

As far as the money market is concerned, interest rate higher than the equilibrium rate means the real money supply exceeds real money demand. In other words, the amount of money people and businesses hold as liquid is greater than the amount they should be holding. The behavioral response then is that they convert money into interest-bearing deposits, which now is the case in Iran.

Consequently, there should be an increase in the amount of funds available for lending. The increase in loanable funds, in the face of constant demand for loans, will inspire banks to reduce interest rates and thus stimulate the demand for borrowing. However, as demand for loans is not constant and is increasing due to liquidity crises banks are facing, we see even higher real interest rates demanded by a variety of banks and lending institutions of different stripes, mostly including the several thousand uncertified financial institutions headed by vested interests.

This means demand for loanable funds is always exceeding supply. In this case as the real interest rate moves up further, as a consequence investment and consumption decline. This is another feature of the struggling Iranian economy over the past few years.

Hence, as long as the demand for loanable funds increases over and above the increase in supply of such funds, real interest rates will not decrease. To the contrary, as banks require more loanable funds, on the heels of increasing demand come higher interest rates. One way to cut real interest rates should be increasing the supply of loanable funds.

Since the supply of loanable funds comes from both the private and public sector and the government is unable to achieve 41% of its projected revenues and has been piling up unusually high debts, the supply of loanable funds can be increased by either private savings or increasing banks lending power.

Over the past three years as the economy continues to take some relief with the decline in the rising rate of inflation, from a galloping 40% in 2013 to 15% in mid-2015, a debate has been going on whether or not to adjust nominal interest rates with the rate of inflation. This has translated to demands for government intervention to cut interest rates. Last week’s top press headlines were about an agreement by the major banks to cut interest rates by 2 pp, which was implicitly denied three days later.

While it is usually the central bank that is responsible for determining the money supply and nominal interest rate through tools like the discount rate and open market operations, in Iran the nominal interest rate depends on the Money and Credit Council. The MCC decides on the interest rate ceiling and back in April reduced the ceiling from 22% to 20%. Now the central bank officials say they don’t believe in rates by decree. As such, it seems there is a determination to change course and let the banks influence the rates.

At the same time that the government is issuing treasury bills that have high yields to maturity of 26%, with lower interest rate funds will be channeled into the bond market where it is secure and earns relatively high interest. This might justify why treasury bills are facing a thin market, if it was well publicized and welcomed it would put further pressure on real interest rates.

As the government is aware that the pressure on demand for loans is not going to diminish anytime soon, it is facing a hard time reducing the cost of money without inflationary pressure. Imposing lower interest rates will lower the cost of borrowing for banks and might help them to survive their ‘ponzi’ behavior only in the short run.

This path is preferred to other means of lowering interest rate, like the promised lower reserve requirements in the recent government stimulus package, because it will entail less inflationary pressure. While this affects the return on saving, the depositors can avoid the loss by purchasing government bonds and securities.

Another policy that the Central Bank of Iran should consider is the so-called quantitative easing, which is used when the target of the CBI is not the interest rate, but the amount of reserves.  The CBI can do this by buying financial assets of banks in exchange for reserves and increase the supply of funds. By doing so, the value of assets increases and later the central bank can resell the purchased assets and reduce the quantity of money in circulation.