Low interest rates yet to stimulate private investment

By Dr. S.S. Colombage
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The Central Bank (CB) in its recent Monetary Policy Review – September 2014 has announced a continuation of its low interest rate policy stance. Accordingly, the CB’s Standing Deposit Facility Rate or SDFR (rate applicable for placement of overnight excess funds of commercial banks) will remain unchanged at 6.5 per cent per annum and the Standing Lending Facility Rate or SLFR (rate applicable for lending of overnight funds to commercial banks) will remain at 8 per cent. These low policy rates that were introduced in January this year have remained intact since then.

Going beyond the continuation of low policy rates, the CB has now imposed a limitation to the access of banks to the Standing Deposit Facility (SDF) at the current SDF rate of 6.5 per cent to a maximum of 3 times per calendar month with effect from 23rd September 2014. Deposits beyond this limit are to be offered a reduced interest rate of 5 per cent per annum. This new dual rate structure is aimed at encouraging banks to disburse their excess funds to the private sector rather than conveniently parking them in the CB using SDF.
These desperate monetary policy decisions reflect the frustration of the CB in failing to boost private sector credit irrespective of the continuous interest rate cuts implemented over the last five years. As in the past, the ‘forced’ interest rate reductions are unlikely to make any positive impact on private investment, given the macroeconomic policy inconsistencies, unfriendly investment climate and severe technological drawbacks. Hence, realisation of investment growth by means of low interest rates seems a remote possibility.

Banks making high profits

As rightly pointed out by the veteran banker M.W. Panditha in his letter which appeared in last Sunday’s Business Times, the reduction in deposit rates during the 12 months ending September 19 was more than the reduction in lending rates and therefore, interest spread (margin) of commercial banks has increased enabling them to boost their profit margins. The reported increases in profits of several commercial banks for the first half of this year could be mainly attributed to the high interest spreads, as net interest income accounts as much as 80 per cent of pre-tax profits of the banking sector.

The CB’s standing facility window which offered relatively attractive returns has been a comfortable source of interest income with zero risk for commercial banks. Bank credit to the private sector remained almost stagnant showing only a 0.8 per cent increase in the 12-month period ending July 2014, compared with an 8.9 per cent increase in the preceding 12 months. This reflects the low demand for credit from the private sector as well as the preference of banks to avert market risks in the downward moving interest rate environment.

The impact of the reductions in CB’s policy rates on market activity depends on their effect on the interest rate structure. Although the policy rates may have an immediate impact on short-term money market rates, investment decisions of entrepreneurs are largely based on long-term interest rates and their market expectations. Given the fragmented financial market in a developing country like Sri Lanka, the link between short-term and long-term interest rates is rather weak. It is also questionable whether banks are willing to expand credit although they may have reduced the lending rates in conformity with the CB’s directives. Excessive use of the standing facility window by commercial banks proves this point.

Broken link between interest rates and private investment

Theoretically, there is negative relationship between interest rates and investment meaning that investment should rise as interest rate falls and vice-versa. But that has not happened. This could be partly explained by the recent stagnation of private investments. Following the cessation of the war, private sector investment showed a gradual increase from 17.3 per cent of GDP in 2009 to 22.4 per cent by 2012. Since then, however, it seems to have stagnated at the same level reflecting the resilience of private investment to interest rate cuts. The rise in gross domestic investment from 28.9 per cent of GDP in 2012 to 29.2 per cent of GDP in 2013 was entirely due to an increase in government investment from 6.5 per cent of GDP in 2012 to 6.8 per cent in 2013.

Investor expectations crucial

It is rather unwise to anticipate an increase in private investment merely by means of low interest rates, as there are so many other economic and non-economic factors that influence investment. Investment decisions are usually based on comparisons between the expected rate of return of investment and opportunity cost of investment. The expected rate of return is measured by the term known as Marginal Efficiency of Capital (MEC), which was introduced by the celebrated British economist John Maynard Keynes to emphasise that profit expectations rather than interest rates are crucial in determining investment. The opportunity cost is measured by rate of interest. As long as MEC is higher than interest rates, investments are profitable and therefore, firms will invest more, and vice versa. Increasing optimism among businessmen leads to high expectations among them causing an upward shift in MEC. In contrast, low business confidence causes a downward shift in MEC.

Theoretically, the lower the interest rate, the cheaper the cost of capital, and therefore, investments will be more profitable. However, as pointed out by Keynes, investment could be relatively unresponsive to changes in interest rates, particularly at the extreme ends of business cycles. During a recession, investors are pessimistic about the future outlook, and therefore, they may be reluctant to expand their businesses with increased borrowings even at low interest rates. During a boom, on the other hand, they increase their capital even with high interest rates due to their optimism.

Expectations are influenced by factors such as rate of return on inputs, term structure of interest rates, macroeconomic economic environment, technological changes, exchange rate volatility, capacity utilisation, aggregate demand, fiscal stability, inflation, political stability, business confidence, availability of credit and cost of production.

Slow growth of productivity

Productivity of capital plays a crucial role in determining investment. Textbook economic theory suggests that productivity of an input declines as more units of that inputs are used while keeping the other inputs fixed in the short run, as implied by the law of diminishing returns. Therefore, it is not profitable for firms to increase their capital indefinitely even though interest rates are low.

This could be explained by the notion of Marginal Productivity of Capital (MPC), which means the additional output that could be produced by using one more unit of input. A simple way to ascertain the trends in MPC is to compute the Incremental Capital Output Ratio (ICOR), which is the inverse of MPC. In Sri Lanka ICOR declined marginally from 2.09:1 in 1994-2003 to 2.00:1 in 2004-2013, according to my estimates. Conversely, MPC showed only a marginal increase from 0.48 in 1994-2003 to 0.50 in 2004-2013. This indicates an inadequate productivity growth in Sri Lanka. Hence additional investments are not profitable to firms. This could be a major reason for the insensitiveness of investment to interest rate cuts.

Technological progress lacking

Technological is a key driver in investment in the modern knowledge-based global economy. Innovative high-tech products raise marginal efficiency of capital. Sophisticated machinery and equipment that we witness today are the outcome of technological progress. Technological progress reflects the growth of knowledge from advances in basic sciences such as the discovery of thermodynamics to highly practical ideas like designing an aircraft wing. Competition among countries too has intensified with technological progress and global integration.

Capital and labour inputs were considered as the key determinants of economic growth in the Harrod-Domar type growth models that became popular since the late 1930s. Technological progress, however, enabled economic growth even without any increase in capital or labour inputs. Technological progress as the key long-term growth driver was first introduced by Robert Solow in 1956 in his path-breaking neoclassical model, the one that won him the Noble Prize in 1987. He showed that the rise in capital per person is the major determinant of output growth. As explained by Solow, technological progress is crucial in a country’s economic growth.

The so-called four ‘Asian Tigers’, namely Hong Kong, Singapore, South Korea and Taiwan as well as other East Asian countries such as Malaysia and Thailand were able to sustain high economic growth mainly due to their Science, Technology and Innovation (STI) capabilities. In contrast, Sri Lanka has failed to achieve technological progress even after three and a half decades of economic liberalisation. Sri Lanka is still depending heavily on low-tech manufactured exports mainly garments. High-tech exports account for only 0.9 per cent of total manufactured exports in Sri Lanka in 2012, compared with the corresponding ratios of 43.7 per cent in Malaysia, 26.2 per cent in South Korea, 26.3 per cent in China and 6.6 per cent in India.

Low R&D

A major impediment to technological progress and innovation in Sri Lanka is the inadequate allocations for research and development (R&D). The total expenditure for R&D is as low as 0.2 per cent of GDP in Sri Lanka in comparison with nearly 4 per cent of GDP in South Korea, and over 2 per cent in Singapore. R&D enabled these countries to achieve knowledge-driven growth, and graduate to the high-income country status. In Sri Lanka, the government contributes around 55 per cent of the total R&D expenditure, the private sector around 40 per cent and other agencies including foreign sources around 5 per cent. High priority needs to be given by both the government and the business sector to raise R&D investment in Sri Lanka from its present low levels. In this regard, the path-breaking initiative taken by the Ministry of Technology and Research, in its Five Year R&D Investment Plan (2015-2020), to raise R&D expenditure to 1.0 per cent of GDP is commendable.

The country’s productivity of capital as reflected in MEC could have been raised to substantial levels, had strategic R&D policies been adopted at the right time. This could have paved the way for transforming the country into a knowledge-based economy by now. Currently, Sri Lanka is placed at the 101st position out of 142 countries in the global rankings of a knowledge economy. This reflects the country’s backwardness in knowledge economy features that cover education, innovation, ICT, tariff and non-tariff barriers, regulatory quality and rule of law.

Future policy directions disappointing

Having experienced severe economic setbacks throughout the post-liberalisation period manifested by inadequate technological progress, low business confidence and macroeconomic inconsistencies, no new policy strategies seem to be forthcoming from the authorities to make a significant economic breakthrough in the future. According to the recent policy announcements of the Ministry of Finance and the CB, apparel products, tourism and worker remittances are to be the leading drivers of foreign exchange earnings in chasing a per capita income level of US$7,000 by 2020. The failed import substitution strategy is also often cited as a preferred policy option. In this kind of narrowly-focused policy environment, there is very little scope to induce private sector investment in high-tech, knowledge-based industries which would yield higher rates of return on capital.

In the absence of a favourable investment climate, the low interest rates will only lead to encourage consumption at the expense of savings and to boost property markets. The excess fund holders tend to move to alternative assets such as commodities, real estate and risky financial instruments. The demand for assets results in a surge of asset prices leading to asset bubbles. Meanwhile, entrepreneurs prefer to use cheap credit to generate quick profits by engaging in trading activities rather than investing in risky and complex long-term productive ventures.
In conclusion, it should be noted that the government has become a big gainer in the low interest rate environment by saving enormous amounts of interest cost with cheap borrowings in the Treasury Bill market.

(The writer is a former central bank official and university academic. He could be reached at sscolom@gmail.com)

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