Non-curious Statist Model 'Killed' the Financial System to Reward Borrowers

Aug 28 , 2021
By Abdulmenan M. Hamza

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In the face of persistently high inflation, real saving and lending rates have remained negative for most of the past decade and a half. The main beneficiary from this state of affairs is the government, the state-owned enterprises (SOEs) and private-sector borrowers, while the main culprit is a distorted financial market, writes Abdulmenan Mohammed (abham2010@yahoo.co.uk), a financial analyst with over two decades of experience.

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The philosophical basis under which the Ethiopian developmental state model rests has a significant contribution to many of today's economic woes. The implementation of this paradigm, although in a flawed form, has caused classic government failures while trying to correct market failures prevalent in developing countries. To address market failures in credit markets, several instruments have been used, including directed credit schemes, the increasing dominance of the state banks, expanding borrowing from the central bank, a range of administered interest rates, and repressive financial policies.

These instruments have caused considerable market distortion in banking. Ironically, they remain intact despite the promises of reform encompassed in various documents.

The developmental state model embeds the state-directed financial system in which resources are allocated according to the government’s priority. The distortions currently playing out can be traced to an era when the country fell under the spell of socialism, in which the state controlled economic activities. But the reversal of the liberal reforms of the 1990s and early 2000s following the adoption of the developmental state in the mid-2000s is the main culprit.

The new economic paradigm increased the breadth and width of state intervention in the financial system. The presence of market imperfections, including capital constraints, information asymmetry and uncertainty about risks and returns, have encouraged the government to intervene in the banking industry extensively to bolster long-term investments.

One of the methods applied is keeping lending interest rates to state-owned enterprises (SOEs) and priority sectors down, which is much lower than what would be in a competitive market. When this is combined with a direct credit scheme to SOEs, the result is a massive build up of debts, which would be unthinkable in a competitive banking market.

Below-market lending rates have had a severe ramification of distorting many of the interest rates. Here is how the logic plays out. The Commercial Bank of Ethiopia (CBE) sets its lending rates much lower than what they should be in a competitive market as it is the main policy arm of the government. To sustain its cheap lending, it sources significant deposits at generous terms from the SOEs and other government agencies. In such a situation, the private banks are price takers in the lending market due to the constraint set by the pricing conduct of the CBE and its market power, service homogeneity and meagre switching costs for customers.

Coupled with the floor saving rate set by the National Bank of Ethiopia (NBE) and the strategy of the private banks to earn constant interest margin, the result is savings rates remaining close to the minimum threshold even though there is a significant surge in inflation. For instance, the difference between the maximum and minimum savings rate has been two percent between 2001 and 2019, according to the NBE. This saving rate setting strategy is sometimes supported by the collusive behaviour of private banks.

This is telling about how the banking market is distorted. In the presence of a competitive financial system, lending interest rates respond to the inflation rate, in addition to the prices of inputs such as saving rates and other operating costs. However, it is striking that in the face of persistently high inflation, real saving and lending rates have remained negative for most of the past decade and a half, causing a significant transfer of wealth from savers to borrowers. The main beneficiary from this state of affairs is the government, the state-owned enterprises (SOEs) and private sector borrowers.

Apart from facilitating a significant transfer of wealth from savers to borrowers, distorted interest rates have reduced the effectiveness of monetary policy, caused a significant accumulation of bad loans and advances, distorted resource allocation and discouraged saving.

If we go by previous experience, changing to the minimum savings rate is the most effective instrument affecting all interest rates. The trouble is that it will squeeze the interest margin of mainly the CBE, which has given a significant amount of long-term loans to SOEs at a very low fixed interest rate. If the minimum saving rate is pushed up, the interest margin gets thinner as the CBE cannot easily pass the increment to its mega borrowers. This would probably cause financial distress to the bank.

Sadly, enacting a significant interest rate increase on the existing borrowers would burden the mega borrowers, mainly SOEs and other government bodies that are already highly indebted with massive interest costs. This is not practical.

The financial sector is in a quagmire. Untangling the banking industry from the scourges of distortion requires a well-considered policy and time. The policy should consider a gradual increase of the savings rate, scaling down the privileges afforded to the CBE so that it would set a competitive price for its lending and subjecting borrowing to the SOEs to the normal credit assessment procedures.

There should also be monitoring of any collusive behaviour among the private banks and fastening the development of the treasury bills market to push all interest rates up.

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PUBLISHED ON Aug 28,2021 [ VOL 22 , NO 1113]

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