Tuesday, 31 July 2012

Interest Rates and Growth

In early July 2012, the ECB decided to cut the interest rate by 25 basis points (for those who are not familiar with the expression one basis point is 0.01%. So 25 basis points is essentially 0.25%. Don't ask me why the just cannot say 0.25% I have wondered about it many times before!). This was considered as an attempt to boost investment in the Eurozone, by making both lending and deposit banking rates fall. The following graphs represent the effect this policy had in Germany for deposits and loans with maturity up to 1 year (all the data for the following graphs were collected from the ECB website):
Deposit Rates

Lending Rates
As you may see deposit rates have been steadily falling over the last year, reaching a level below 0.5% in July. The lending rates had reached a top of 4% in late 2011 and have roughly stabilized at about 3.30-3.40% during the last months. Obviously the EU policy change had some effects in reducing the deposit rate whilst it had insignificant ones in the lending rate.

Now, compare this with the lending rates in Greece, Italy, Spain and Cyprus:


Notice anything different? Yes, indeed. For each one of these countries the interest rate has been higher than Germany's by about 1.2% in the case of Italy and an astonishing 4.1% in the case of Cyprus. Greece, with all the apparent problems in their economic system has a lending rate of approximately 7%! Although the EU policy of reducing interest rates from 1% to 0.75% has obviously had some effects in these countries. the fact is still that with lending rates this high there cannot be a significant increase in investment. Without an increase in investment the above countries cannot have the growth they need to raise from the depths of the banking and sovereign crisis they have entered about a year ago.

Rates this high did not even occur in 2008 in Germany where at its maximum, the rate was about 6%. While the common approach for central bankers and policymakers is to manipulate the interest rate when the circumstances require it, this is not always the optimal solution. In order for the banks to be able to lend, they themselves have to have an abundance of money and not worry whether they can achieve Core Tier 1 requirements which have increased in the midst of a banking crisis! (In the realm of bad decisions, this has to be one that deserves to be appointed king).

Thus, having no resources to lend, banking institutions in the South have to be extremely selective of whom they will lend. Having less than enough deposits, makes the deposit rates soar, making lending rates follow. More on deposit rates on the following article.

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