Interest rate inferno

A cut in interest rates and a reduction of reserve requirements have been touted by experts as the key to overcoming the current economic standstill. Niveen Wahish looks into the proposal
It has been a ripe time to cut interest rates for months now, the government has repeatedly indicated. In September 2001, while still minister of economy, Youssef Boutros Ghali announced a 0.5 per cent cut on National Bank of Egypt investment certificates. Since then, the market has been waiting, anxiously, for a similar decision to be implemented on a larger, national scale. Government indications, however, have held little hope. When it came down to making the anticipated change, the government has been taciturn.
Bankers have been expecting the Central Bank of Egypt (CBE) to cut its discount rate -- that at which it lends to commercial banks -- for almost six months now. Such a move would trigger a reduction of commercial banks' credit lending rates as it would mean a reduction on the costs borne by those banks. The fact that no action has been taken on this front does not mean the government is unaware of the move's necessity for the recovery of the economy.
On the contrary. Last month, addressing the press, Mahmoud Abul-Oyoun, CBE governor, emphasised the financial sector's pivotal role in reviving the economy, saying that banks should work on cutting their interest rates on new loans. Banks cannot do so, however if the CBE fails to cut its discount rate first. The last time the discount rate was reduced was almost a year ago, when it went from 12 to 11.5 to 11 per cent in just two weeks. The discount rate acts as an indicator to banks of whether the trend is for an increase or decrease in interest rates.
While stressing how essential it is to cut interest rates at this point, Mounir Hindi, professor of finance at Alexandria University, warns that these cuts must be gradual. Hindi cited Alan Greenspan, Federal Reserve Bank governor, saying that he cut rates between 0.25 and 0.50 at a time over 10 times in 2001. "And it must be clear to the market where interest rates would be heading next," Hindi said, explaining that the welfare of banks and insurance companies, which have interests to pay to their clients and are counting on receiving certain interests on their own deposits with other banks, must not be jeopardised.
One factor that may explain the reluctance of CBE to cut the discount rate is the unstable value of the Egyptian pound. As Hindi explains, under stable conditions, when an economy is in good shape, a high interest rate on the local currency helps support the currency's value, thus encouraging individuals to keep their savings in the local currency. Moreover, a greater interest rate differential (the difference between the interest rate on the pound and that on the dollar) would hedge against dollarisation. Today, with the economy going through a period of imbalance, said Hindi, the interest rate, no matter how much higher than the dollar, will not support the pound. Individuals opt to keep their savings in dollars because the difference in the exchange rate makes up for any difference in interest rate.
This is the catalyst behind an increased dollarisation process, in which deposits in dollars are growing at a rate faster than deposits in Egyptian pounds. According to CBE figures, while deposits in Egyptian pounds grew from around LE176 million in October 2000 to LE193 million in October 2001, deposits in foreign currencies during that period grew from the equivalent of LE54.5 million to LE67.6 million.
While it is definitely an issue of concern, it is not one the government need worry about at this stage.
"We are at a stage where the pound is stabilising," Faiqa El-Rifai, former deputy CBE governor, told Al-Ahram Weekly. El-Rifai pointed out that tourism is expected to improve, support from donor countries is on the way, and all the efforts to boost exports and ration imports are expected to bear fruit.
Hopes of an improved position of the pound, however, will not find individuals rushing to convert their pound savings when interest rates are lowered, El-Rifai said. She added that this is an opportune time to cut interest rates given that interest rates on the dollar have gone as low as 1.75 -- not an incentive for savers. Even if interest rates were to drop to seven, or six, from their 9.5 rate on three month -- one year deposits, there would still be an interest rate differential of around four or five per cent.
"This is within the range that the CBE has always thought was suitable as a differential between the two currencies," El-Rifai pointed out.
Depositors are not the only ones to be affected by cuts in interest rates, of course. Investors are the other part of the equation. In fact, a cut in interest rates would first and foremost benefit investors. It would enable them to take loans for projects at a lower rate than the current 12 to 16 per cent depending on their credit-worthiness, Ahmed Naim, head of the International Division and Financial Markets Division of Al-Watani Bank of Egypt, told Al-Ahram Weekly.
"This rate should drop to at least 10 per cent," he said.
The consensus seems clear. A drop in interest rates is needed to "get the wheel rolling," as El-Rifai puts it. As investors are encouraged to set up new projects, she said, new jobs will be created and purchasing power will be boosted, ultimately pulling the economy out of recession.
Sounds nice enough. But realistically, it will take quite a bit more than interest rate cuts to reach that target. Part of the effort was mirrored last week, when the CBE announced that it would be lending banks some LE1.8 billion at four per cent interest rate. The banks, in return, are theoretically expected to re-lend it to customers at six per cent interest rate -- the condition being that these loans be channelled to finance locally manufactured goods. While the theory behind the CBE initiative is noble, it has been shunned by critics as impractical. "Lending out CBE's pledged amount is a hassle," said Naim. He added that the customers banks will target with this money are small borrowers who will probably not take out more than LE10,000 each.
"It will be very costly for banks to ensure that those borrowers pay up," Naim said, questioning how banks can guarantee the loan is financing local production.
Amr Bahaa, vice-president of the Arab Banking Corporation(ABC), suggests that instead of burdening banks with the payback interest rate, CBE should have instead decreased reserve requirements (the money banks are required to keep unutilised), from the current 14 per cent to 12 per cent. A one per cent decrease in reserve requirements frees LE2.8 billion of funds, which banks can then lend out. "This will be a natural process without CBE interference in the market," he said.
As always, the controversy over interest rate action remains in the air. As too, does the anticipation and impatience. The country still awaits the government's grand cutting of the interest rates. The fruit, after all, does not remain ripe eternally.
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