Is high Government borrowing really responsible for high interest rates?

(Please note that the following article was written at the end of 2002, though it has become even more relevant today, a few months later.)

By Dr. Mark Ellyne, IMF Country Representative, Zambia.

Question.

Chanda Chisala (Zambia Online): Why is it that Bank lending rates have not been falling in direct correlation with the falling government borrowing over the years, as indicated by the declining yield rate on Treasury bills? Wouldn’t this show that government borrowing is not necessarily responsible for the high bank interest rates as is conventionally held by economists?

Answer.

Dr. Mark Ellyne (IMF):

While many have made the assertion that high government borrowing is responsible for high bank lending rates, you have noted that the yield rate on the key 91–day government treasury bills has fallen substantially, from 51.1 percent in January 2002 to 29.7 percent in September 2002, whereas bank lending rates have fallen a mere 4 percentage points from 55.3 percent to 51.0 percent over the same period. Thus, many people wonder if government borrowing is really the cause of high interest rates, and why bank-lending rates have remained so much higher than the Treasury bill rate.

Before discussing what causes interest rates to move, it is important to realize that the interest rate is the “ price of money”. Thus, cheap money or easy money simply means being able to borrow at low interest rates.

I have explained on various occasions that interest rates, including bank-lending rates, are determined by three factors. First is the expected inflation rate. This sets the floor for interest rates. Nobody will lend at a rate of interest lower than the expected inflation rate over the same period. Because we do not know the “expected” inflation rate, we typically take the current rate of inflation as the indicator of business or banks’ expectations over the near future. In September 2002, the inflation rate was 23.8 percent, which might be thought of as a measure of the expected inflation over the next 6 to 12 months, even though the government has promised to reduce inflation by year-end. Actual trends however are generally a better predictor than promises. What is clear is that the rate of inflation has been going up over the past months and the banks being cautious will not bring the interest rates down very fast unless they are convinced that inflation rate has come down and will stay low.

The second factor determining interest rates is the level of government borrowing from the public. In this case, GRZ issues treasury bills or bonds and has to pay banks or private individuals a price at least as high as anyone else is willing to pay, which is why domestic borrowing is so expensive. The government can also borrow directly from the BoZ, whereby it does not compete with private commercial market – this typically only impacts the expectations for inflation. When the GRZ borrows a large part of the public's available stock of money, then it "crowds out" the private sector and generally pushes up interest rates. Commercial banks uses interest rates on government securities to form their base rate. If commercial banks can lend to government at say 30 percent risk free, then for them to lend to the private sector they will need to add on a risk premium on top of the 30 percent. The implication is that interest rates on government securities have to come down by a larger percentage for there to be a significant drop in commercial bank rates. When interest rates on government securities remain high, commercial banks will still make high profits even though the private sector might not be able to borrow from banks.

The third factor determining the interest rate levels is the efficiency of the banking sector. Banks that are very inefficient or that have a high amount of bad loans have to charge high interest rates to their customers to cover their inefficiencies or bad debts. We know from recent cross–country comparison studies that Zambian banks have among the highest overhead costs among African countries. And some Zambian banks are carrying non-performing loans on their books.

There is also a fourth factor called the “ risk premium” that is implicitly included in the interest rate charged by commercial banks. This captures the difference in sovereign risk between lending in Zambia versus lending in the USA. That increased risk is frequently associated with the overall quality of economic policies rather than the quality of customers.

Finally, there is something economists call interest rate parity. When one country's currency, like the Kwacha, is depreciating at an annual rate of 23 percent, the interest rate has to be at least as high to prevent people from converting their money into US dollars and investing offshore.

Why then have bank interest rates failed to come down to levels of the treasury bills yield rates? As explained above: the rate of inflation has remained high at about 25 percent reflecting expectations of future inflation; government borrowing through treasury bills and bonds is up by more than 50 percent at the end of September ; and the Kwacha has depreciated by 23 percent over the past year. Given that borrowers in Zambia are risky, is it any wonder that banks demand over 45 percent interest when they can get over 30 percent by investing in government securities.

Dr. Mark Ellyne is IMF Country Representative. He does not necessarily share all the views of Zambia Online or Zambian Capitalism Magazine, but he always generously answers our querries on questions involving the Zambian Economy. – Editor, Zambian Capitalism Magazine.