Businesses need loans, but they are too expensive. Investment in new ventures is low because it is hard to find a business plan that can return more than a bank offers to its customers.
In fact, banks are spending most of their resources renewing loans to the biggest debtor of them all, the government. Why has the circulation of money ground to a halt in Iran?
Despite inflation falling from 40% highs two years ago to around 12%, interest rates have remained high. Currently, bank deposits earn real returns of over 10% per year.
Why do banks offer such high deposit rates? Simply, because they are short of cash. They need deposits to stay in business, because most of their assets are locked up as bad debt.
Our sister publication Donya-e-Eqtesad recently looked into the subject, in a long article titled “The Economy’s Master Key in Year 1395 (the new Iranian year starting March 20, 2016).”
In the author’s opinion and in our own, the buck stops with the government. Although there are many reasons for the blockage of money circulation, low business investment and so on, fiscal spending and more importantly, how it is funded seems to be the root of all the evil.
Most governments around the world spend more than they earn in their fiscal budget. Cutting spending is hard and, in cases, borders on political suicide for an administration. And when taxes, or in Iran’s case the sale of natural resources, is not enough to foot the bills, the government turns to borrowing.
Modes of Borrowing
A government can raise foreign debt by borrowing from international institutions like the International Monetary Fund or other governments or sell bonds to international investors. However, foreign creditos are strict.
The IMF always asks for changes in government policy or regulations before endowing money from its coffers. Other governments and international investors are also less understanding of government hiccups.
In Iran’s case, there is no access to such modes of borrowing.
Another option is borrowing from the central bank. It’s a lot like borrowing from your family or friends. There is no repayment schedule or collateral. This sort of money borrowed is scarcely repaid. Instead, it causes hikes in money supply and pushes the inflation trigger.
Alternately, the government could opt for selling bonds to the public. Most of Japan’s government debt is owned by Japanese households. This form of debt is more stable than foreign debt and has little inflationary impact. No collateral needed either. Just the government’s word that it will redeem the bonds in due course is enough.
Everybody’s Fine!
However, some disdain timed obligations. So instead of selling bonds, they borrow from banks by asking them to lend to state companies and ministries. In a state-dominated economy, banks are left with little choice. They lend and they lend without acquiring proper collateral or guarantees for repayment. They sometimes have to finance uneconomical projects.
But when the time comes to collect payments, lenders are usually left cap in hand. So the bankers invite the state borrowers to sit down and negotiate a new loan to cover the principal and interest of the previous loan.
That way both sides are happy. Borrowers just go back to their business and leave the debt unpaid, and the bank can claim a profit on its books from lending, bringing the bank’s managers a good yearend bonus! Such is the state of banking in a state-run economy.
Wrong Kind of Competition
Is there any oversight? Yes, the central bank is monitoring banks and their lending, albeit half-heartedly.
The Central Bank of Iran has been in the government’s pocket in much of Iran’s history. And commercial bank chief executives have a habit of taking the CBI governor’s seat.
The banks can keep the cycle running, as long as they can attract enough money. They can quench their thirst for cash by offering higher deposit rates or borrowing from the central bank.
The competition between lenders over deposits and their shortage of liquid funds are the main reasons behind the gap between inflation and interest rates. Ultimately, the high rates shift money from business investment to banks, keeping non-state borrowers in want of cheap financing.
The private sector suffers while state corporations do not mind the higher interest rates because they neither have the intention, nor the capacity to repay their debt.
Back to the Coffers
Whenever banks fall short, they turn to the central bank for assistance. Pressured by the government, the central bank is made to lend. This is actually the government borrowing from the central bank indirectly.
It is one of the main structural reasons behind high inflation in Iran.
For lack of monetary tools and consistent policy, the central bank’s main route for curbing inflation, as it has now been tasked by the new administration, is to slow down its lending to banks.
An unavoidable result of that in Iran’s economic system is a slowdown in economic output.
A Way Out
To break the cycle, government debt to banks should be securitized and sold to buyers on a debt market. Some loans will have to be written off as losses, so banks will come under financial pressure.
The securitization of government debt will add to transparency and force the government to think twice before borrowing.
Then and only then the central bank can buy government debt, in turn bringing down borrowing rates and stimulating the economy.
Furthermore, the liquidity released to banks as a result will help revive business lending.
The government has already started on this path. The administration is introducing new debt securities and surveying its finances to find assets that can back bonds.
The central bank is tightening its oversight on banks, courtesy of newfound independence given by the government. There is a long way to go. However, this may be the greatest economic overhaul in Iranian history.
