Cheap credit boosts growth, so why aren’t low rates the norm?

In a global macroeconomic context of slow and cautious growth, Sri Lanka is unusually fortunate in that it is – if you will – serendipitously continuing to post strong GDP growth. But Sri Lanka is even more special on another front as well: By hiking interest rates, the country’s central bank is pursuing other policy aims that may result in this strong economic growth being rather unceremoniously strangled.

The theory behind interest rate dynamics is simple enough. The cheaper it is for people and companies to borrow money, the more money they’ll borrow. When people and companies borrow money, they buy things and/or invest in their businesses, thus increasing consumption and generating economic growth. When interest rates decline – all else equal – growth will tend to increase.

On the flip side, raising interest rates – part of the purview of the central bank, in most countries – means that there are fewer potential borrowers than before who can afford the new, higher price of borrowing money. With less additional money borrowed that is allocated to buy and invest, all else equal, economic growth tends to moderate.

Lower growth rates tend to be bad for everybody: The electorate, businesses, and the job tenure of central bankers and politicians, for starters. There are a few worse things, though, as we’ll see shortly.

Simple enough, right? Of course, in economics (and economics is hardly alone in this sense, unfortunately), nothing is ever simple, and all is never equal. Indeed, by this logic, no central bank in its right mind would ever raise interest rates, for fear of choking off growth. This, clearly, is not the case.

Recently, though, most major economies have either been cutting interest rates, or maintaining them at levels that are at or close to historical lows (see Figure 1). The recent launch of QE3 – the third round of so-called quantitative easing – in the United States guarantees a flood of monetary liquidity for months to come. The reeling Euro zone is trying to throw money out the door with a prime rate of just 0.75%, with Britain coming in even lower. In Asia, rates are generally higher, but still closer to historical lows. And then there’s Sri Lanka, at around 14%, following on from a hike in February.

A word of caution: the prime rate isn’t the interest rate you’ll get if you drop in to your local Abans to buy a fancy sterling steel LG refrigerator. The keeper of the U.S. prime rate, the Wall Street Journal, defines the prime rate as “the base rate on corporate loans posted by at least 75% of the nation’s 30 largest banks”. Banks view you and me as far riskier borrowers than corporate borrowers. In February, Sri Lanka’s central bank hiked its key benchmark lending rate to 9%. The average weighted prime lending rate (see Figure 2), though, was 11.4% then. And if you or your neighbor wanted to borrow money for a fancy new Mahindra Scorpio, you’d have paid somewhere closer to – brace for it – 20-25%, if you were lucky.)

There are a number of reasons for a country’s central bank to increase interest rates. Periods of excessively rapid economic expansion or credit growth can seriously derail an economy and banking system. If a country’s currency is appreciating too much or too quickly – if, say, interest rates are high, triggering inflows of currency from foreign investors searching for yield – the central bank may reduce interest rates to make the local currency a bit less attractive to speculators (or, less politely, “hot money”) from abroad.

Sri Lanka is boosting interest rates for a few reasons. Bank lending was growing far too fast, the central bank said, leading to concerns that banks were getting sloppy as they lent to marginal borrowers who would be smarter to stay away from the punch bowl. Make the cost of capital higher, and lending growth will decline. In fact, the central bank went a step further, imposing a credit growth ceiling of 18% (23% for banks that have accessed foreign capital) – which might sound high, but isn’t at all compared to recent loan growth of around 40%.

On a related front, if it costs more to borrow money, fewer people and companies will borrow money to buy imported products. Sri Lanka’s trade deficit – that is, the difference between what it imports and what it exports – is exploding, as the country imports a lot more (oil, cars, Blue-Ray players, Australian cheddar cheese) than it sells abroad (tea, spices, apparel, bras). If this keeps up for too long, the rupee will come under even greater pressure, resulting in continued and perhaps faster depreciation of the currency. On top of that, inflation is rising, and the government deficit is also increasing far too fast.

There are three things worse than making capital more expensive, and the possible consequence of choking off economic growth: A banking sector meltdown, a currency crisis and inflation. Given this platter of lousy options, Sri Lanka’s central bank is arguably choosing the least-bad one.

Will it work? The rupee’s descent seems to have slowed, although it’s too early to say that it’s stabilized. The banking sector has not imploded, although it will take time to understand how many bad eggs there are in the basket.

Perhaps worst of all, though, economic growth forecasts have been steadily scaled back in recent months – and if the central bank has its way, there is more of this to come. Credit growth that is capped by the central bank ensures that banks will be able to charge what they please – and it will be the desperate borrower who suffers. In this environment, everyone loses.