Interest rates are amounts charged by lenders to borrowers as fees on borrowed assets. The interest rate is the price an individual pays for the use of money they have borrowed; it can be thought of as an economic rent. When a person deposits money in a bank, they receive interest as a percentage of the total amount deposited. Similarly, when an individual borrows money, they pay interest to the lender as a percentage of the total money they owe the lender. The percentage of the principal amount paid as a fee over a given period is the interest rate. Interest rates are macroeconomic variables that bear significant implications on a country’s economy; interest rate movements are regularly reported because they have direct effects on borrowers and a nation’s overall economy. Modern economic thinking acknowledges the fundamental role of interest rate policies, as they facilitate the achievement of internal and external balance of an economy and ensure efficient allocation of financial resources in an economy. It, therefore, is necessary to understand the topic on interest rates by describing its determinants, what causes changes, and its effects on non-performing loans.
Interest Rate Determinants
Several factors determine interest rate levels. These include differentials in inflation, levels of investments, differentials in interest rates, public debts, political stability, economic performance and terms of trade. Differentials in inflation refer to the levels of inflation when comparing economies. Nations with consistent low inflation levels represent an appreciation of their currency values accompanied by increased purchasing power. Examples of nations who have maintained low level inflation over the years are Japan, Switzerland, and Germany. The levels of interest rates in such countries are usually low, hence high investment levels (Fender 21). This is because the fee at which financial institutions and other lenders charge for money and assets borrowed is favorable. Countries with high inflation levels, in contrast, experience persistent increases in the levels of interest rates. This implies that inflation differential is a significant determinant for interest rates.
The levels of investments also affect the levels of interest rates. When the national income increases, people are induced to save and invest. They seek to acquire loans and other investment assets from financial institutions to facilitate their ventures. Financial institutions, in turn, seek to maximize their profits from lending through increments in interest rate levels. Similarly, when national income is low, people do not save and the levels of investment decline (Fender 26). Financial institutions, during such times, attract their customers by lowering interest rates to foster investments. This indicates that investment levels are imperative in the determination of interest rates.
Differentials in interest rates refer to variations in interest rate levels in a given economy. Interest rates, exchange rates and levels of inflation are correlated. When interest rates are manipulated, for example, using fiscal policy, they exert pressure over both exchange rates and inflation levels. When the levels of interest are high in an economy, lenders receive high returns. Interest rates, therefore, attract foreign capital and investments and push up the exchange rates. The effect of higher interest rates is lessened, however, if the level of inflation in a given nation is higher compared to others. When the levels of interest are low, they discourage foreign investments and cause a decline in the exchange rate. The impacts of interest rates increase if the inflation levels or additional factors drive down its currency. Differentials in interest rates, therefore, are determinants of the level of interest in any economy.
Public debts are those accumulated by the government to finance public sector projects. Developing countries, for example, engage in large-scale deficit financing to foster developments such as infrastructure and health care. Such activities stimulate economic growth and development; however, nations with large public debts are less attractive to foreign direct investments (Feld, Lars, and Jost 39). This is because large debts result in inflation; high inflation level implies that such a debt is to be serviced with depreciated currency in the future. When a government, for example, opts to settle a public debt through printing currency, it consequently increases the money supply and affects the interest rates. Additionally, if a government cannot settle the debt through domestic means such as the use of monetary policy, it must increase securities supply and sell them to foreigners at low prices. This lowers the exchange rate levels, consequently affecting interest rates.
Political instability and economic performance are imperative in attracting foreign investments. These factors affect interest rates through the exchange rates. A politically stable country attracts foreign investors because it instills confidence about its currency into them. Political turmoil, in contrast, causes a loss in investor confidence and results, in a movement of capital to stable economies. Additionally, countries that perform well economically attract foreign investments and improve their exchange rates. Given the correlation between exchange rates, inflation, and interest rates, stable exchange rates translate to stabilize interest rates that encourage investments and price stability through controlled inflation levels.
Causes of Interest Rate Changes
There are several causes of interest rate variations. These include deferred consumption, political short-term gain, inflationary expectations, liquidity preference, taxation, investment risks, and alternative investments. Deferred consumption means a delay in using the money or asset acquired through borrowing. When lenders loan money to borrowers, they delay spending the money they remain with on consumption of goods and services. This is according to the time preference theory that examines the perceived value of present and future earnings using the interest rates charged on current earnings (Coibion, Olivier, and Yuriy 96). This theory implies that individuals prefer present goods to future ones; therefore, in a free market, interest rates will be positive. This shows that deferred consumption causes variations in interest rates.
Nations achieve political short-term gains especially during economic booms or during periods of low interest rates. When interest rates are lowered, the economy of a given nation gains a short-run boost. Interest rates for financial institutions and markets are altered during such gains; however, too much political influence can affect interest rates negatively. When political figures, for example, affect the interest rates for their own gains, it might result into low investment rates, stagnant economic growth, low exchange rates, and high inflation levels. The central banks, therefore, bear an obligation to limit political interference in regards to interest rates.
Inflationary expectations are opportunities that consumers have in regards to future inflation. When consumers will expect lower inflation levels in the future, they decrease their present expenditures. Similarly, if consumers expect the levels of inflation to increase in the future, they increase their present expenditures. Lenders, in turn, expect borrowers to compensate them during these times; for example, when consumers decrease present consumption due to inflationary expectations, lenders increase interest rates in order to gain present returns (Coibion, Olivier, and Yuriy 88). This shows that the interest rate changes are dependent on inflationary expectations.
Liquidity preference refers to the inclination of consumers towards portfolios that are easily changed into cash. Liquidity preference causes interest rates to change; consumers view highly liquid portfolios as easy to sell (Bibow 56). Interest rates are volatile in the short-term, and this implies that consumers prefer holding short-term portfolios with high returns on the interests of long-term investments. This is because short-term portfolios are highly liquid as compared to the long-term. A three-year Treasury bond, for example, that pays 1% is more preferable to a thirty-year bond earning 4%. Interest rates, therefore, change according to the liquidity preferences exhibited by consumers (Below 61).
Taxation affects interest rates; taxes are tools used by the government to implement fiscal policy alongside government spending. The government may sometimes impose taxes on interest rates such that lenders pay revenue to the government when offering their services. When this happens, a lender may pass the tax burden to a borrower, through increments in interest rates (Bradford 19). Similarly, when tax exemptions or incentives are accorded to lenders, they may minimize the interest rates imposed on their borrowers to attract them towards their services. Taxation, therefore, plays a significant role in altering interest rates.
Investment risks such as absconding loan repayments alter interest rates. When a lender realizes they face a high risk in lending the borrower money or an asset, they tend to increase the interest rate to compensate for the anticipated losses. Examples of investment risks include bankruptcy, loan defaults, and death of a borrower. Low investment risks, in contrast, result in decreased interest rates because lenders prefer loaning creditworthy customers who have minimal chances of defaulting repayments. Additionally, when a lender has a choice between using his assets or money in alternative ways, they have to forego returns from others. This implies that if the alternative investment has high returns the lenders alter interest rates to favor their returns.
Effects of Interest Rates on Nonperforming Loans
The relationship between interest rates and nonperforming loans suggests that nonperforming loans are caused by high interest rates. An increase in interest rates, results in an increased interest burden on borrowed assets and loans, which causes borrowers to default (Bloem, Adriaan, and Gorter 36). This increases nonperforming loans in a bank’s portfolio, hence limiting the funds available for lending to future borrowers. Interest income reduces gradually and ultimately may cause the failure of a financial institution if unaddressed. The occurrence of crises in financial institutions has often been associated, with an accumulation of nonperforming loans, which do not account for a sizeable portion of portfolios of insolvent institutions.
Nonperforming loans may result in systematic bank crises. A systematic bank crisis refers to a situation whereby a significant portion of a country’s banking capital is wiped out. This type of crisis stems from lack of depositor confidence in the financial system. When such crises occur, the affected financial institutions experience erosion in their capital and equity. A majority of developing countries has a form of control over capital movement; however, such controls have limited effectiveness especially during banking crises. Additionally, countries have limited control over domestic interest rates. This implies that they have a limited capacity in controlling the negative impacts of nonperforming loans.
A persistent increase in interest rate gaps may result in disregard of the need for changes in the structure and institutional behavior of financial institutions. The transaction costs associated with processing savings, payment services, and monitoring borrowers, for example, may drive a wedge between the interest rate returns received by depositors and rates charged to borrowers. Additionally, high reserve requirements set by central banks may widen the interest rate gaps and contribute to nonperforming loans because it acts as an implicit financial tax (Bloem, Adriaan, and Gorter 46). The financial tax may allow for financing of high fiscal deficits, thereby creating an environment that fosters an increase in inflation levels due to widened interest rate gaps.
Nonperforming loans generate significant financial and economic costs to a given economy. Nonperforming loans have a negative effect on private and foreign investments; they discourage investors because of the gap between interest rates to a depositor and borrow they generate. Additionally, they increase deposit liabilities and restrain the scope of a financial institution to the private sector due to a reduction in banking equity and capital. Nonperforming loans also pose a threat on private consumption consequently discouraging savings. These loans, in the absence of mechanisms to protect depositors, may lead to economic contraction and widen interest rate gaps further. An additional consequence of nonperforming loans is that they lead to financial crises especially when they exceed banking capital in a majority of financial and banking institutions.
Some determinants of the accumulation of nonperforming loans are attributed to high interest rates, business volatility, deterioration of terms of trade, and economic downturns. High interest rates encourage defaulting of loan repayment. This is because high interest rates discourage saving and investments, hence borrowers do not accumulate enough funds to repay their loans. Business volatility refers to uncertainties associated with entity activities. According to liquidity preference theory, when the level of uncertainty for a given venture is high, consumers prefer holding investment portfolios in forms, which are easily changed into cash. Such a situation represents s periods of high borrowing in which lenders take advantage to maximize their returns through the imposition of high interest rates on borrowers.
Deterioration in terms of trade may be caused by an absence of diversification or low rates of capital formation. This reduces foreign investor confidence, which results in a decrease in exchange rates and increases inflation. Increased inflation may cause increases in interest rates, consequently leading to the accumulation of nonperforming loans (Bloem, Adriaan, and Gorter 51). Similarly, during economic downturns, the money supply in an economy reduces. Individuals with investment interests, therefore, result in borrowing; due to increased rate of borrowing, lenders use this opportunity to maximize their gains through increasing the interest rates on loans and assets. Additionally, the level of investment and capital formation during economic downturns decreases significantly, hence borrowers have trouble in fulfilling their repayment obligations to a borrower. This contributes to the accumulation of nonperforming loans and deficits in banking capital.
The impact of interest rates on nonperforming loans is significant and affects the economic growth of a country. Financial institution managers, therefore, should be cautions when making lending decisions because they affect the future of their organizations and the economy as a whole. Managerial decisions in financial institutions often rely on competing opinions of rivals and the prevailing interest rates. A wider comprehension of interest rates and nonperforming loans and their implications on the economy facilitates informed decision-making. The understanding of these factors is imperative to the governing authorities of a country, who implement and control monetary policies through the central bank. Increasing the interest rates, for example, has a direct effect on nonperforming loans. Interest liberalization reduces the level of savings and investments because it widens the interest spread gap (Fender 83). An understanding of the impacts of interest rates on nonperforming loans, therefore, enables the governments assess and balance the effects of monetary policies such as the determination of the level at which to liberalize interest rates.
Conclusion
Interest rates are an imperative factor in the determination of the economic development and growth of a country. Countries have different policies of maintaining and controlling interest rates; some follow traditional policies while others formulate and implement monetary policies to control interest rates. Such policies are formulated when there is a need to increase investments, promote investments, or promote efficient allocation of resources. Interest rate levels are determined by factors such as differentials in inflation, levels of investments, differentials in interest rates, public debts, political stability, economic performance, and terms of trade. Additionally, changes in interest rates are caused by factors such as deferred consumption, political short-term gain, inflationary expectations, liquidity preference, taxation, investment risks, and alternative investments. When determining the interest rate levels, central banks assess these factors and weigh their effects on the economy.
The levels of interest rates have significant effects on nonperforming loans. They cause an accumulation of these loans which results in economic contractions, low foreign and private investments, and decreased saving. Additionally, the rate at which borrowers default payments on loans increases with increases in interest rates hence causes an increase in investment risks. Given these implications, financial institution managers should be cautions when making lending decisions because they affect the future of their organizations and the economy as a whole. Governments should also assess and balance the effects of monetary policies such as the determination of the level at which to liberalize interest rates to minimize the accumulation of nonperforming loans.
Works Cited
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Bradford, David F. Taxation, Wealth, and Saving. Cambridge, Mass: MIT Press, 2000. Print.
Coibion, Olivier, and Yuriy Gorodnichenko. Why Are Target Interest Rate Changes so Persistent? Cambridge, Mass: National Bureau of Economic Research, 2011. Internet resource.
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