The Mongolian government and people are trapped in debt, living from one loan to another. The authorities have adopted the view that economic development would not be achieved without borrowing money. There is a Mongolian saying that goes ‘People with debt do not progress, and livestock with worms do not get fat’. However, almost every Mongolian has a loan today. Despite repetitive economic declines and extremely high interest rates of business loans, the government is still increasing taxes. It has led to the shrinking of private businesses and an exodus of unemployed people to foreign countries. Mongolia’s experience is a clear example of the increase in budget deficit triggering the government debt to grow larger and further hike in the interest rates offered by banks.
The reason why loan interest rates increase
A financial market is where parties with surplus capital supplies money to those who need it. Commercial banks have the responsibility to act as an intermediary between these parties, and package the capital based on the needs related to the amount, term, and cost of capital. Having taken their own operational cost and estimated profits into account, the commercial banks set the interest rate of loans.
Currently, Mongolia’s deposit rate is 14-16 percent, while the lending rate is 22-28 percent. It has taken the interest rate spread (lending rate minus deposit rate) to 8-12 percent. In Japan, term deposits have an annual interest rate of 0.1 percent, whereas the interest rate is at 0.02 percent for demand deposits. Their loans have an interest rate of 1.5 percent, and housing mortgage has 2.5 percent interest. The interest rate offered by bank reflects the level of risk around whether the bank will be where it is next year, and if it will be able to return your savings.
Savings accounts are profitable only when the interest rate of their savings deposit is higher than the inflation rate in the country. Financial markets in developing countries do not have a lot of surplus capital because the private sector has a relatively low level of capital accumulation, and income levels vary greatly. In this case, the surplus capital is drawn by banks who compete with their interest rates.
In an open economy, the interest rate of savings also depends on the exchange rate of the national currency. For example, the savings interest rate in Mongolia was 16 percent for MNT and 6 percent for foreign currency, including USD, in 2016. The difference of 10 percent reflects the risk of weakening currency. For instance, the tugrug exchange rate went down by 25 percent in 2016, which means the tugrug savings had a loss of value.
How do Mongolian banks make profit?
Given it is very rare to be able to keep your business profitable after acquiring a loan with an annual interest rate of 25 percent, Mongolia’s private sector has always been deprived of money. Despite granting fewer loans, Mongolia’s commercial banks made a total profit of 176 billion MNT in 2016. Loans comprise half of their assets.
In 2016, the government spent 25 percent of its budget revenue on making interest payments of the loans they had acquired. When the government was unable to fund the salaries of public servants (administrators, teachers, police…etc), they issued bonds domestically and have been selling them to commercial banks at a rate higher than their interest rates. At the end of 2016, the government bonds made up 14 percent of total assets of commercial banks.
It meant that the commercial banks could make huge profits without actually doing anything. On top of that, Mongol Bank invented the housing mortgage initiative, printed 3.8 trillion MNT, and provided the money to commercial banks at a 3-5-percent interest rate. It was then distributed to people as an 8-percent housing mortgage. For the banks, it was another source of income that came without risks. This housing initiative drove up the prices that had started to come down naturally. This bubble is still in the housing market today. Mongol Bank has now transferred these funds to the public budget, which has increased the budget deficit. And, it is the people who end up paying for the budget deficit through taxes and loans.
Another reason why there is a big difference between the lending and deposit rates in commercial banks is that bad loans have been increasing (8.4 percent). Also, commercial banks have increased their funds designated to protect from loan risks. The banks have started accepting as loan collateral items such as unregistered livestock and mining licences of deposits that have not been validated by independent parties. As this fund increases, the banks see more shortages of cash and draw savings offering high interest rates.
Mongolia is currently unable to fund its development because commercial banks are offering extremely high interest rates for their loans. As the banks reduce their provision of household and business loans, non-banking financial institutions have expanded and are offering expensive loans with interest rates nearly 10 percent higher than the bank loans. Subsequently, there are now more pawn shops that lend money to people in return for their mobile phones and cars at extremely high interest rates calculated on daily basis. If you calculate the annual interest rate, it would reach 40 percent. Our economy is trapped in debts.
What needs to be done to bring the interest rate down?
Our economy is projected to grow by 2 percent this year. However, it is not a feat the government has achieved, but rather is largely connected to China increasing their imports, which helped increase our coal mining and exports. Also, the International Monetary Fund (IMF) program has allowed us to use cheaper loans to pay expensive loans back, and started making up for the budget deficits. In this favorable condition, what we need to do is to refrain from increasing budget expenditures, reduce budget deficits using export revenues, and stop issuing bonds in the domestic market or at least keep its interest rates significantly lower than savings rates.
The bubble in our construction industry will continue growing unless the government stops the current housing scheme, halts controlling prices, and restricts subsidies. All bubbles look good until they pop, and we know that we will be left with nothing when it happens.
It is a step in the right direction that Mongolbank is starting the work to verify the quality of loans in banks. After the completion of audits on commercial banks by reputable organizations such as PwC and KPMG, the banks will need to increase its assets significantly, and smaller ones might need merging. Following the 1998 financial crisis, the IMF did the same thing in South Korea and dramatically reduced the number of commercial banks. When foreign banks entered the market, the lending rates decreased as there was an increase in healthy competition.
If our banks have less bad loans, the interest rate spread will decrease, which will reduce the interest rates for loans (as long as they do not buy bonds from the government) and lead to reductions in the budget deficit. Restrictions on populist programs and initiatives would help decrease corruption and revive fair competition in the private sector. This will allow the risk levels and savings interest rates at banks to go down, which will reduce the lending rates. Only then there will be opportunities to find funding for businesses and diversify the economy.
2017.08.09