Dynamics of Interest Rate

By Hom Nath Gaire

In the business of borrowing and lending money, the lender charges and the borrower agrees to pay an amount in excess of the amount lend and borrowed. The excess amount is called interest, in common language. In economic terminology, like rent and wages, interest is a factor payment. It is paid for the use of capital as a factor of production. In other words, interest rate is the cost of capital per unit of time.

Economists define interest as a payment for the sacrifice made by the income holder by deferring consumption for the time being and imparting with liquidity, a reward to the income holder for their savings. Interest rates are indeed very important economic variables. There are many uses of interest rates.

Use of Interest Rates

·       To indicate the liquidity conditions in the financial markets.

·       They are indicators of expectations about inflation. If the long term interest rates are lower than that of short term, it can be inferred that the market participants have lower inflation expectations.

·       Interest rates are indicators of the result of monetary policy actions. Therefore, interest rates can be used to analyze the ex-post monetary policy stance.

·       Interest rates can be used as monetary policy tool as well as targets. Many central banks, in recent years, have moved towards interest rate targeting from monetary targeting.

·       Interest rates can also be used to analyze exchange rate movements.

·       The last but not the least, the interest rate data can be used to macroeconomic analysis of consumption, saving, and investment.

In this context, it must be noted that interest rates play a key role in monetary analysis, as they are a key element in the transmission process of monetary policy.

Interest Rate Determination

As the interest rate is cost of capital, the term capital is used in two senses; (1) money capital, i.e. stock of money that could be loaned out, and (2) physical assets e.g. land, building, plant, machinery etc. Money capital in the form of bank deposit, share and debenture yields different forms of incomes --- interest and dividend. On the other hand, investment in physical capital yields income called return on capital. However, economists believe that money capital finally takes the form of physical capital and interest paid on money capital takes in the form of cost of capital.

Because of this reason, the monetary theory of interest is given more importance than that of real theory of interest. The common peculiarity of monetary theories of interest is that the interest is a monetary phenomenon, which is determined by demand and supply of money. Further, monetary theorists believe that interest rate varies inversely with supply of money and positively with the purchasing power (value) of money. The defenders of the monetary theories of interest argued that when supply of money increases, purchasing power (value) of money falls and, hence the rate of interest also come down.

Real Interest Rate

The "real interest rate" is approximately the nominal interest rate minus the inflation rate. It is the rate of interest an investor expects to receive after subtracting the expected inflation that is going to be experiences in the economy. However, this is not a single number, as different investors have different expectations of future inflation. Since the inflation rate over the course of a loan is not known initially, volatility in inflation represents a risk to both the lender and the borrower.

Real interest rate is considered as one of the major determinants of saving as well as investment in an economy. Theoretically it is assumed that savings can be increased if real deposit rates are positive. Accordingly, the central banks of the respected countries, adopted interest rate policy for maintaining positive deposit rates. The common objectives of such policy are the following:

·       Mobilization of higher level of savings in the form of bank deposits.

·       Prevention of capital flight from the country.

·       Mobilization of financial resources to productive sectors of the economy.

·       Promotion of economic activities particularly industrial and commercial.

For more or less same purposes, Nepal Rastra Bank (NRB) --- the central bank of Nepal--- had regulated interest rates in the pre liberalization era. By doing this, NRB attempted to keep real deposit rates positive making frequent revisions in nominal rates whenever inflation rates were changing. NRB was unable to appropriately monitor the movements and the real interest rate was moving up and down over time.

Economists agree that the real interest rate is determined in the market for investment and savings and thus by the forces of productivity and thrift. Hence, the real interest rate adjusts to equilibrate desired savings (providing the net supply of funds) with desired investment (generating the net demand for funds). In an increasingly integrated world economy with internationally mobile capital, the real rate of interest is determined largely by global forces of saving and investment. For relatively small open economies, the world real rate of interest is somewhat independent of domestic circumstances, especially over the medium to long term.

Factors Affecting Interest Rate

On the basis of monetary theories, a number of factors influence the level of interest rate. Among the factors the size of government borrowing is very important. The higher the size of the budget deficit, the higher is the level of interest rate and vice-versa. This fact has been one of the factors affecting the level of interest rate in Nepal.

It is to be noted that both the government and the private sector borrow from the domestic market. Obviously, funds that can be borrowed from the domestic financial market are given. With the given funds, when the government domestic borrowing increases, it puts pressure on domestic interest rates to go up. With the rise in domestic interest rates, the government borrowing crowds out the private sector investment.

However, the situation of Nepal's financial markets contradicts with the notion of crowding out effect of interest rate. Because the trend of private investment in Nepal is not encouraging in the recent years and whatever the private sector is making investment that is generated from their cash flow and surplus profits. Similarly, private sector bond market (debenture) market is not developed at all in Nepal which indicates the government deficit financing could not crowd out the private investment. On the other hand the budget deficit of the government is almost financed by foreign grants and concessional loans and hence the government should not rely on the domestic borrowing. Therefore, the crowding out effect is not applicable in Nepal since the government has not been able to spend even the grants and concessional loan given by the donors.  Another factor affecting the interest rate relates to business conditions. When economic recovery takes place, economic activities increase, putting an upward pressure on interest rates and vice-versa. In an interest rate deregulated economy, market forces determine the level and the structure of interest rates. Here market forces are automatically guided by business environment prevailing in the economy. In this respect, one of the questions that are very often asked is about the appropriate level of interest rate. As the business environment is affected by various physical as well as psychological issues, especially in least developed countries like Nepal, and almost uncertain to predict an appropriate level of interest rate.

The third factor relates to the role of lobbies and pressure groups. In the society, the different interest groups play their roles in raising or lowering interest rates. Retirees will like to see deposit rates going up. Likewise, households will also prefer higher interest rate on their deposits. On the other hand, industrialists and business community will put pressure for lower interest rates. In the Nepalese context, industrialists and business seems to be found exerting pressure on monetary authority and the political authorities for a lower level of interest rate.

Whether market determined or determined by the monetary authority, there are two aspects of interest rates. The first is the level of interest rate and the second aspect relates to the structure of interest rates.

What is the Optimal Rate of Interest?

One can ask: what is an optimal rate of interest for an economy? Nonetheless, there could be a number of ways of judging the appropriate level of interest rate.

First, real rate of interest, which should be positive to encourage saving. It discourages low yielding investment and thus has positive impact on growth. Again the question remains unanswered, what should be the optimum level of real interest rate. According to monetary policy decision rule of J.B. Taylor, an American monetary economist, the level of real deposit rate should not be less than 2 per cent. Once we agree to this rule and add the inflation rate to the 2 per cent desired real interest rate, optimal nominal interest rate can easily be calculated.

Second, interest rates of neighboring countries should also be taken into account while judging the optimum level of domestic interest rate. It is important to attract foreign capital to accelerate the economic growth of the country. In this case, a common principle is that the domestic interest rate must be higher than international interest rates. In Nepal’s case, Indian interest rates could serve as reference rates.

Third, returns on investment projects are also important factors to judge the appropriate levels of interest rates. Relatively high returns on investment will encourage investors for making additional investment with an aim of making more profit which in turn increases the demand for Loanable fund and interest rate as well. In this case, even the higher interest rate is also considered as appropriate.

Fourth, in a developing country like Nepal, interest rates in unorganized markets can also be used to judge the appropriate level of interest rate. In Nepal it is found that money is being lend and borrowed at extremely high interest rate (up to 36 per cent in normal situation and even in four digits in special cases) in informal market and up to 20 per cent in saving and credit cooperatives. In this context, relatively higher interest rate (up to 12/14 per cent) in the formal banking system may be considered as appropriate.