Last Updated on October 1, 2023 at 9:23 pm
Every time the RBI lowers interest rates, we see many investors complain. In this article, Harshini explains why a high-interest rate is not healthy for our finances by taking Turkey’s example, where interest rates were recently increased to 17%!
Older readers may recall when EPF and PPF rates were as high as 12% in the 90s. Many investors wish to go back to that time, not realising the rate was high because the Indian govt was battling bankruptcy. Stock market followers may recall that the sharpest drop in interest rates triggered the bull run in the 2000s.
About the author: Harshini Gopu works in a global financial institution as a senior associate. She is experienced in credit risk and capital management. Her financial blog is Learnfineasy. She is also a budding artist. Also by Harshini: Factors that determine your CIBIL score and how to improve it and Interest Rate Swaps: A way for MFs to reduce interest rate risk and Now everyone can get an income-tax exemption for payment of deemed LTC fare.
Recently we may have noticed that Turkeys central bank recently hike interest rate to 17% They have also hinted towards a tighter monetary policy to control the rising double-digit inflation. Another thing to be noted is Turkey’s Currency Lira has lost 50% of the value since 2018.
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Let us understand Turkey’s problems to understand the interest rate hike by the central bank and why the Lira value is lost drastically.
When did Turkey’s problem first start to appear? Turkey had a rapid growth (Average rate 7-8%) from 2002 to 2012, making it one of the fastest-growing economies in the G20 countries. But this rapid growth resulted in the unbalanced growth driven mainly due to Capital accumulation. Rapid foreign capital inflows were used to finance the construction activities in the country. Majority of the capital accumulation was financed through foreign Debt as the country had access to the cheap credit in the world of cheap interest rate during that period.
In all developed nations, we can find that the Central Bank of the Country will have independence from the Government policy to protect the country’s economic interest.
The Turkish government had access to the Central bank policy and decisions and pressured them to keep the interest rate low, increasing credit. Keeping the interest rate low, the Government thought it might help the local economy borrow more money at a lower interest, but it also led to higher inflation. This is the main reason for the economic crisis of Turkey today.
High inflation is the most important problem in Turkey. It eroded the value of Turkey’s Lira 60% from 2018. The inflation rate is above 15% from 2018, and Turkey’s Central Bank target was around 7 %, whereas other countries’ target is around 2%-4%.
The problem with high inflation is it can erode the value of the currency. To control inflation, an important key is to increase the rates. If the rates are increased, then the borrowing will come down to that extent, inflation can also be kept in control. But as said earlier, Turkey’s Government favoured keeping the interest rate lower, which kept the inflation increasing in turn, the value of Lira kept on losing its value.
Turkey’s real return after considering any interest and high inflation rates is negative. The negative real return was a huge problem to Turkey as it was dependent on the Foreign inflows. Turkey also continuously spent more import than receiving from the export, which led to the large Current Account Deficit. The problem became worse due to the complete collapse of Tourism due to the Covid pandemic. Tourism was one of the major revenue to the Turkey economy.
Since the real return of investment is negative, foreign investment will be low, and the two major countries that get affected here are Spain and France, who are the large debt holders of Turkey. They will not invest more when their return on their investment is meagre, and when they are scared, they will not be getting the investment back.
Due to low foreign investments and the inflow of money reduces, the government started spending from its reserve for the different government programs like subsidies etc. Because of this, the central bank had to increase the money supply in the economy. This will lead to a depreciation of the Lira currency against other currencies in the world. The households of Turkey lost confidence in Lira. They started to exchange with the more stable currency, i.e. Dollars, which made the Lira lose more value rapidly (sold more lira for fewer dollars). The Central Bank and the government steps to improve the situation didn’t come out well since the Household held very less Lira to have any effect.
As a major step to keeping the Lira stable, the Central Bank has bought a major quantity of the Lira in the open market using all its foreign reserves. It has also banned 6 large Currency trading banks temporarily for trading the Lira in the hope of stopping the speculation on its weakening value. Despite all these things, they are not in favour of Lira.
To keep the high inflation in control, economists worldwide suggest that Turkey has substantially increased its interest rate. Finally, the Central bank has raised the rates by 2%, which may be too little too late but we have to wait and watch the further development regarding the valuation of Lira and High inflation rates.
The next time RBI decreases interest rates, we must be thankful for having more money to spare, thanks to lower inflation and vice-versa!