A looming cash crisis

A looming cash crisis
Dr Mahendra Reddy
www.fijitimes.com - Saturday, February 21, 2009

THE continuous increase in interest rates over the past six months does not augur well for Fiji's economy.

The raise in interest rates will affect the economy via two channels - the construction and consumption channels.

As interest rates rise, home values fall and consumers feel they are losing on their value of total stock of assets.

They will cut their consumption.

That is, they will cut down general spending as well as avoid borrowing against their homes.

Thus new construction will be less forthcoming.

If this situation is prolonged and simultaneously, real income declines either as a result of inflation or pay cuts or layoffs, we may trigger a crisis in the sub-prime mortgage market where borrowers are just making theirs ends meet with multiple payment demands.

The banks are behaving this way (raising interest rates) because due to shrinking liquidity, retail and wholesale deposit rates have been increasing and no bank would want their interest rate spread to continue to worsen.

Hence, they have rushed into raising lending rates to maintain the interest spread.

The Reserve Band of Fiji is also a contributory institution to this rise in interest rates.

It must now immediately examine its two main tools - the RBF funds rate and the discount rate.

The RBF funds rate is the bank to bank borrowing rate.

At any given time, some banks have extra reserves and some have a shortage of reserves. In the funds market, banks with excess reserves lend to those that are short handed.

The RBF can intervene in this bank-to-bank transaction by buying and selling bonds to the banks thus restricting the liquidity at the level.

When RBF sells bonds, it pulls funds out of the bank, thus reducing liquidity.

Secondly, the RBF also uses a discount rate which it employs when it lends directly to a bank.

Thus raising this discount rate will also cause the banks to raise their lending rates.

Therefore, it is not the banks only which are trying to protect their interest spread by responding to the retail and wholesale market, but rather, they are also responding to RBF's use of the two key tools at its disposal.

We must also note that prolonged use of government expenditure without raising the productive capacity of the economy also raises inflation rates and thus the interest rates.

It is for this reason that we must be prudent in use of government expenditure particularly when it comes to debate of whether established international benchmarks should be compromised.

* Dr Reddy is the Dean of the Faculty of Commerce, Hospitality and Tourism Studies at the Fiji Institute of Technology. The views expressed in this article are his and do not necessarily reflect that of his employer.