No point dropping interest rates

  • Business
  • Saturday, 25 Apr 2009

Cutting interest rates further is unlikely to achieve much but will further damage returns to savers and the value of the ringgit

COMMON economic wisdom often does not tally at all with what actually needs to be done and has to be tempered with a clear assessment of what’s on the ground. When that is done, common sense should take precedence.

Let’s look at a couple of economic clichés. The first one is that if inflation is low, then there is room to cut rates further, the converse of the logic that if inflation is high, then higher interest rates will bring it down. The other is that bringing down interest rates will help stimulate the economy.

Those two clichés, as with all clichés, are not always right. With respect to Malaysia, it has been argued that lower inflation rates indicate that interest rates can be lowered further while bringing down interest rates further will be good for the economy.

The question to ask is whether lowering interest rates at this stage will actually be desirable and whether it will have its intended effect. While it may be possible to lower interest rates without raising inflation, what will it achieve?

If Bank Negara decides to lower interest rates next week, as many people expect, there is little that it is likely to achieve but it will further erode returns to savers already, very low at around 2%.

And the lower interest rates will weaken the already weak ringgit in the short term as those holding ringgit will get lower returns and, therefore, might opt to move into other currencies.

Will there be any benefit from such a rate reduction? Not likely. Recent evidence is that interest rate reductions do not do anymore to stimulate the economy beyond a certain point. An example is Japan where interest rates have been around zero for many years with little effect on the economy.

What is more important is the availability of credit at reasonable rates to borrowers, especially during difficult times when banks shy away from making loans because of the likelihood of higher loan losses.

That is a real issue in the Malaysian context. And sometimes, the lower interest rates are not even fully reflected in the lending rates customers pay. Witness for instance the recent hike in car hire purchase interest rates by up to one percentage point at a time when Bank Negara has cut the overnight policy rate (OPR) by 1.5 percentage points from November to now.

What is the point of cutting interest rates if the savings banks make in terms of reduced costs of funds are not even passed to the borrowers? It might be better to just let depositors earn a fairer interest rate.

Currently, at around 2% a year, that does not even equate to the inflation rate, which was 5.4% last year, although it is expected to come down to around 2% this year. That means, after adjusting for inflation, depositors won’t get anything from keeping their money with banks.

About the only reason for cutting interest rates now that we can think of is if there is an influx of money into the country because of higher relative interest rates. The weakening ringgit is clear indication that is not happening right now.

That means Bank Negara has a clear window ahead and there is no pressing reason why it should cut interest rates next week. It can afford the luxury of waiting and seeing.

We don’t have to cut rates just because everybody else is doing it.

· Managing editor P. Gunasegaram believes that interest rates – lowering them that is – can only do so much. The bigger issue right now is confidence.

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