The Mongolian parliament is currently discussing draft legislation to introduce a cap on interest rates of bank loans. Because of high interest rates, the cost of goods and services are rising, businesses are being forced into bankruptcy, and there are fewer incentives to do business.
Therefore, the Defacto Debate this time was organized on this important topic and was broadcasted on MNB (Mongolian National Broadcaster) television channel last week. Financial analyst D. Angar proposed arguments for setting an interest rate ceiling by law while economist S. Bold argued against it. Here is the summary of their arguments, research, and conclusions.
A legal cap on interest rates should be introduced
A key function of the financial market is brokering between two parties – connecting the economic population which has financial accumulations with businesses who need the capital. It was only the commercial banks who carried out this brokering for the last 27 years, and the price they charged has been too expensive. Therefore, we should introduce a cap on interest rates and put it into law, so that this brokering is conducted in a more cost effective, efficient manner for businesses.
Mongolia has copied all of her legislation on banks, non-bank financial institutions, credit unions, and stock exchange from foreign countries. However, the ceiling on interest rates (set by the law), which has been implemented in over 80 highly developed countries, has been overlooked by us so far. As a result, our banks have become a means to take money from businesses, instead of supporting them.
Our government policy has been conducted by bank lobbies and has served the banks well. This is one of the reasons why our capital market is undeveloped today. Due to the absence of a well-developed stock exchange and an insurance sector, financial brokering is conducted only through 14 banks. According to Mongolbank, Mongolia currently has 9,900 people who have savings of over 100 million MNT (~40,000 USD). As the banks compete for people who have accumulated capital, they are putting the savings rates through the roof. Its consequences are being borne by businesses, who have no choice but to obtain a loan with high interest rates. Such expensive loans are the reason why manufacturing is not developing and why there is no economic development.
Mongolia has now become one of the ten countries in the world that has the highest loan interest rates. If the ceiling is set by the law and the interest rates go below 18-20 per cent, banks will be decreasing their savings rate. For example, the banks will decrease the savings interest from 14 per cent to 9 per cent, because they would no longer have to issue loans with an interest rate of 18 per cent. Even 9 per cent is a high interest rate if you look at other countries.
A legal cap on interest rates shouldn’t be introduced
Restricting the interest rate of loans is an obsolete concept. All the countries who made this change have seen outcomes that were completely opposite to what they had expected. Interest rates reflect how the economy is doing. If we want to reduce interest rates, we need to look at the underlying reasons. When the economy has a degree of accumulation somewhere, the capital tends to go to the most reliable and stable sector. We cannot blame the banks for the fact that our banking system has developed more rapidly than other systems as a financial broker.
Mongolia’s credit ratings fluctuated between CAA1 and B1 for the last twenty years, which means we have been scored 20-40 points out of 100. During this time, our economy received an injection of 15 billion USD as foreign direct investment. The general indicator of whether this capital has stayed in-country or not is the balance of payments. So if we look at the balance of payments in the last twenty years, our balance is only at positive 1.1 billion USD. This suggests that our economic model did not allow foreign investment to seep into our economy.
In addition, the average rate of inflation stood at 10 per cent annually in those years. Also, our economy grew from half a trillion MNT to 27 trillion MNT. The outstanding debt of loans granted by banks increased from one trillion to 16 trillion MNT. The interest rate of loans was 48 per cent twenty years ago, 28 per cent ten years ago, and 19 per cent today. All these numbers tell us that the 14 banks have been fulfilling their role of financial brokering somewhat effectively over the years.
If interest rates are capped by law, the banks tend to grant loans more to those who have less risks and stronger collateral, and less to those who have slightly higher risk profiles. This results in fewer loans obtained by small and medium sized enterprises. In turn, it negatively affects the loan supply, and leads to deterioration in indicators such as financial brokering and penetration. As evidenced by many case studies from Latin America, Africa, and Asia, the interest rate caps create an illusion of lowering interest rates in the short term, but actually increases them in the long run. This can also be seen from studies by international organizations such as the Asian Development Bank and the World Bank.
Rebuttals
For: Mongolbank says that the average loan interest rate offered by banks is 18-20 per cent. However, SMEs are paying an interest rate of 2-2.5 per cent monthly and 30-36 per cent annually. It is impossible to conduct business when the loan is so expensive. This is why our economy does not have manufacturing, but now is based on consumerism.
What Mongolia’s financial market lacked in the last 27 years is competition. Currently there are only two countries in the world that have not allowed foreign banks to come in – Mongolia and North Korea. When foreign banks are players in the market, there will be competition, which would result in reduced interest rates and better quality of services offered.
When you look at the more than 80 countries who capped interest rates, their positive outcomes have outweighed the negative ones. The United States has a law that the interest rate of a loan does not exceed 8 per cent annually. The percentage stands at 20 in Germany, and 28 in France. Japan is the country that has the lowest interest rates with business loans having an interest rate of one per cent annually. Their housing mortgage has an interest rate of 0.5 per cent. But Japan was one of the countries with the highest interest rates during the 1950-60s.
The Japanese parliament made a law against loan-sharking in 1956. Over time they brought the interest rate down from 30 per cent to 20 per cent today in all arrangements including legal and civil. Otherwise, the banks would never reduce their interest rates because it would decrease their profits.
Against: As a person who worked in Mongolbank before, I don’t think they produce false reports. If they did, all numbers concerning our economy would be false. No bank is issuing loans with an interest rate of 36 per cent today. This number might be from 20 years ago. Across the entire banking system, the weighted average interest rate is at 19-19.5 per cent. It may be a different case if we include micro loans. Some banks have capped their annual interest rates at 24 per cent, which translates into 2 per cent a month, as part of their internal policy.
There isn’t going to be any positive outcome when a ceiling is set by the law. On the contrary, it would be a step backwards for Mongolia. Such legislation and business environment will negate foreign investment. How are we going to look to the outside world if we grapple with the consequences of a problem and not its causes?
It is true that we are lacking in financial sources, cash in the economy, and loan availability. This is because our economy was in some form of crisis in 13 out of the last 20 years, and we are still experiencing impacts from those events.
The United States, Japan, France, and Germany have tried this law. The United States had high interest rates on salary loans. Even though they saw a decrease in interest rates in the short term, it quickly reached the cap in the long term. Both the United States and Japan saw an increased amount of illegal loans, and more arrangements between individuals, encouraging a hidden system.
To be continued
Trans. by B.Amar
2018.02.14