Frontier Research
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Why high interest rates can be part of the solution for Sri Lanka’s economic crisis

Photo by Towfiqu barbhuiya on Unsplash

Let’s refer to why increased interest rates, especially in the middle of a crisis, can be good news. I will try to answer this through a Q&A format.

When you think about “interest rates” or “rates” what rate does it refer to ?

Firstly, when we think about ‘rates’ itself, you’ll hear a lot of different types of rates (e.g., policy rates, bank loan rates, bank deposit rates, treasury bill/bond yields etc.). These rates generally move together and for the purpose of illustrating the points in this blog post with simplicity, let’s assume the economy has one interest rate. This can be thought of as the rate at which someone gets money from a bank if they save or the rate at which they’ll have to pay loan interest back.

How do low rates drive higher consumption and imports?

Interest rates were kept low from mid-2020 onwards, and started to move up late last year. Low interest rates lead to cheap loans for people and companies, more money in the economy, and more consumption.

When people have cheap housing loans, they buy more imported cement, steel and other materials for construction. Similarly, consumption means buying more raw materials, machinery, and yes, even consumer goods. This leads to additional imports to fulfill this demand and therefore, we have more money flowing out from the country.

How do higher rates help in reducing imports and consumption?

Increasing interest rates are able to counter this to an extent, by reducing consumers, businesses and the government’s ability and incentive to import and finance additional imports.

So, slowing down import growth in non-essentials or even contracting it, means less money going out, meaning more money available to finance essentials like food and fuel.

But that’s only one implication of it.

What are the other implications of raising interest rates for an economy?

Rising rates also mean that companies who have dollar earnings but are keeping this money outside the country in hopes of the LKR depreciating further to get a better return once converted to local currency, are now unable to borrow as easily to finance business operations. This means that businesses are more inclined to bring those dollars back into the country.

The next way this helps, is by giving a good interest rate locally for people to invest in. Anyone who has dollars will now be given a better return if they save in Sri Lanka (by investing these in treasury bills, treasury bonds or holding it in a bank deposit). So, it’s possible that they bring dollars into the country this way, though maybe not a lot of dollars.

Higher interest rates also means that money gets pulled out of circulation, as people tend to save a greater fraction of their income with higher bank rates.

The final way this can help, is by showing confidence. Before early April, Sri Lanka had been plodding along, not doing anything much in terms of taking corrective policy actions, and then finally started taking strong action. This sends a powerful signal and starts builds confidence that Sri Lanka is finally starting to take tough policy choices to set its economy on the road to recovery, instead of shying away from tough policy actions.

How do these factors help the economy as a whole and how long does it take?

The combination of these factors helps support the currency by reducing the rate of depreciation and encouraging more people to remit dollars within the local banking system. As such, banks have more dollars to finance the importation of urgent essential items. It also helps in reducing imported inflation, which would be price increments caused by the cost of imported products going up, given a depreciation of the currency.

However, this doesn’t mean that all these factors immediately improve. It can take a few weeks for these aspects to translate into these positive effects and if there are separate events that weaken the foreign liquidity situation, that can still lead to a worse situation for depreciation and availability of essentials. However, even in such a negative situation, higher interest rates can make the situation “less worse” than it otherwise would have been.

What about every other loan given at interest rates lower than current ones?

Given rising interest rates, fixed bank deposits would also offer better returns — And this would be positive for those who depend on interest income.

Well, why don’t we just keep interest rates high the entire time?

Since many loans are on fixed rates, loans given out prior to the Central Bank undertaking strong policy rate hikes should be unchanged and only loans which have floating interest rates (i.e., have interest rates which are linked to existing interest rates) would have a higher interest component to pay back. That is definitely a bad outcome for consumers and businesses that depended on these low interest rates.

However, low interest rates can help “expand” the economy. There is no growth with high rates. In fact, if there are firms needing to refinance their debt, they’ll suffer, since the refinanced debt would now be at much higher interest rates. As such, many companies would have trouble repaying interest back on their loans, and may have to “restructure” or negotiate different payment terms on these loans with their creditors. This could mean businesses cut back on recurrent expenditure in the form of wages and salaries to refinance their debt, leading to higher levels of unemployment and lower growth.

As such, raising interest rates is not without a catch. Policy actions moving forward are likely to be tough as well, and the more we wait, the tougher the policy stance we’d have to take on later down the line.

So, what is my take on all this and what does the road ahead look like?

At the point the interest rate hikes happened, there was huge strain on the economy in terms of prolonged power cuts and a lack of essentials including food items, gas and medicine. We aren’t able to focus on economic growth because we first need to deal with being able to sort out these shortages.

If interest rates are kept low, then more money goes into imports directly or indirectly. That causes more and sharper depreciation continuing for far longer, resulting in much higher costs across the board than otherwise. Far more companies would suffer in the form of higher business costs given prolonged power cuts and higher fuel costs. As a result, far more people are going to be unemployed when businesses fail on the back of 15-hour power cuts and a complete collapse of the economy.

My view is that raising rates are the better policy action for Sri Lanka at the moment. Going for “growth” by keeping interest rates low when all this is happening on the ground is ludicrous.

That doesn’t mean those negative impacts can be forgotten. In my view, immediately strengthening and expanding coverage to a social safety net is vital to make sure the most vulnerable in our community is protected. Thankfully, there is some expansion of this through a World Bank project that is now happening, though it is still not enough and a lot more is definitely needed.

Since we’ve taken policy action in terms of hiking interest rates to a large extent, what remains to be seen is reforms on the fiscal side, where the government would need to take measures in its upcoming Budget to ensure it’s able to bring in sufficient revenue to its coffers, reducing the need to borrow excessively alongside other measure to rationalize expenditure in the form of reforms to State Owned Enterprises.

Because the situation was so bad, we would have eventually needed to hike rates or risk the country going into a hyperinflationary spiral. The earlier we could have raised rates, the smaller we would have needed to do it by. If we had moved fast last year, smaller hikes, better results. When we did it, delayed, it’s harder. If we had waited, even a few weeks, much much harder.

Thankfully, we acted — even if it was late. There is still a lot more action to be done on varied fronts to make sure this works out fully, but the fact that we ARE acting now brings some confidence. The hope is that good action continues.

Written by : Chayu Damsinghe (original post on Twitter)
Compilation support : Malitha Goonaratne

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