B.Tumentsengel: Interest rates are major indicator of economy

B.Tumentsengel, director of economic analysis and policy at the Monetary Policy Department of Mongol Bank recently gave an interview regarding interest rates, which has become a hot topic in recent years...

B.Tumentsengel, director of economic analysis and policy at the Monetary Policy Department of Mongol Bank recently gave an interview regarding interest rates, which has become a hot topic in recent years.

Interest rates are an issue that the public has a vested interest in, as a result, high interest rates has been a target of criticism. There aren’t a lot of people without loans but there are few that really understand what interest rates are. How would you explain interest rates in the most logical way?

Looking at it from a bank’s perspective, interest rates are something that determines the price of a financial product. In simpler terms, whether a person or company took out a consumer loan or business loan, interest rates are essentially payment for using that money for a certain period of time.

In the bigger picture, macro sense, average interest rates are a reflection of the risk in the economy of that country. Therefore, looking at interest rates both from the microeconomic and macroeconomic sense is important in understanding interest rates.

You said that in the macro sense, interest rates are a product of the risk that an economy has. Then why are interest rates lower in some countries and higher in others?

Let’s look at the example of one of the countries with the lowest interest rates in the world, Japan. Why does Japan have an average interest rate of only one to two percent? This has mainly to do with the excellent competitiveness of the Japanese economy.

It lies in the fact that Japan can produce Lexus or Prius vehicles and ship them around the world.

A company like Toyota can find cheap funding from anywhere in the world. Financial organizations approach the companies themselves, ask their needs, and propose favorable conditions. It can raise capital freely on any stock exchange such as the Tokyo, London, or New York stock exchanges.

In order to have a company that has such good competitiveness globally, a country has to have a few characteristics that are essential to this. Politicians must be ethical and not only implement the correct policies but do it sustainably, the business environment must be favorable, and the education system must be preparing top professionals. This allows global competitiveness, a trade surplus, high national reserves, economic stability, low risk, and, as a result of low risk, low interest rates.

In the case of Japan, even though the deflation caused by having an aging population affects interest rates, the manufacturing capabilities, economic competitiveness, the institutional environment, and education are the main foundational factors for interest rates. What has been said about Japan can be said about other countries that have a low interest rate. As such, you can say that interest rates are a major indicator of the state of the economy.

How do banks determine their interest rates?

If you look at loans from the perspective of it being a financial product, the price of this product or the interest rate depends on how much it cost the bank to raise that money, how it covers those costs, and what it’s intended profit margin is.

The most important factors from a cost perspective of the banks include interest rate costs, operational costs, and loan loss provisions. Interest rate payments from banks to its customers make up around 60 percent of total costs, the biggest expenditure.

Operational costs for a bank include office rent, employee salaries, costs to operate ATM, etc. These costs vary from bank to bank depending on the business model, number of branches, and structure. Loan loss provisions are there to ensure there is some protection from the loan becoming non-performing or bad, therefore some of that cost has to be included in the interest rates. This allows the bank to provide 100 percent of a customer’s savings money even if 10 MNT of a 100 MNT loan is not repaid. Since a bank is a business organization, it covers these costs and sets out a financial plan for a profit margin. This plan determines how the bank will use the capital it has raised from customers, whether it be to purchase securities, provide loans, or store it in a foreign currency. Benchmark interest rate, the interest rate of government bonds, and the minimum amount of reserves will all be factored in. The service fees of a bank and forex profits and losses are also included. So you can say funding demand, competition,

performance, business strategy and financial plan of a bank will determine what type of loans the bank will provide, how much it will provide, and its interest rate.

The high interest rates have been linked to the profitability of banks, in which many people say that the profit margin needs to be decreased. Are banks really profiting that much? How profitable is banking in Mongolia compared to other countries?

The argument that the profitability of banks is too high is mainly made by those who do not work in the banking sector. Analysts make conclusions on how much money the bank expended for every one MNT in profit.

For example, you might say that 249 billion MNT in gross profit for the banking sector in 2017 sounds like a lot. But your viewpoint might change if I tell you that 249 billion MNT in profit is earned through activation of 28 trillion MNT in assets and capital. This is the result of savings accumulation of all customers, loan providence to one million debtors, and the financial service to all business sectors in the country. It essentially is a main indicator of the capability of Mongolia’s economy. If you look at it this way, 249 billion MNT is a small number and in the future, as the economy improves and growth continues, this number should increase even further, not decrease. If you divide the banking sector’s total assets of 2.7 trillion MNT by the gross profit of 249 billion MNT in 2017, the return on equity (ROE) for the whole sector is roughly nine percent. What this means is that if you are an investor, it is better to save your money in a savings account for a year with an interest rate of 14 percent than it is to invest in a bank. The same can be said in terms of comparative profits in Mongolia and abroad. Between 2006 and 2015, the ROE of the banking sector in Mongolia was on average 14.1 percent. Other countries that are classified as lower middle income countries have a rate of 14.6 percent.

It is said that interest rates in Mongolia are high compared to other countries. What is the main reason for this?

In the last 10 years, in terms of average interest rate, Mongolia ranks in the top 15 globally. Even though Mongolia had an average interest rate of 300 percent in 1990, 40 percent in 2000, the current rate of 18 to 19 percent is still relatively high. This is evident in the costs of raising capital, operational costs, loan loss provisions, and profit margins. The most prominent of these costs is the interest rate payments to the customers and the loan loss provisions.

In the last 10 years, the average savings interest rate was 12 percent, which ranks in the top nine globally. Savings interest is a major factor of loan interest rate. In the last few years, the situation has been worse as the number of non-performing loans reached 15 percent. This has caused loan loss provisions to be higher, raising interest rates. However, the cost/ income ratio of the banking system being at around 50 percent is not bad compared to other countries. This allows us to conclude that even though some banks have high operational costs and have room to improve their efficiencies, operational costs are not the main cause of high interest rates.

The cost/income ratio is also not a viable explanation for high interest rates as it is comparable to many other countries.

What action needs to be taken to reduce the loan loss provisions that are a big factor in high interest rates?

Obviously, loan repayment has to be good. It is difficult to decrease interest rates significantly at a time when overdue loans are seven percent and non-performing loans are at eight percent. We can look at three main factors in finding a solution to this. Firstly, economic stability in itself is the biggest factor. The business environment will be good, setting the basis for good repayment.

Second, the governance of the banks and its loan providence must be more comprehensive, its financial plan must be good, and its risk management must be effective. In addition, a loan database is important in knowing correct information about the risk of potential debtors. On the customer’s side, they must make better judgments when choosing financial products, learn better revenue and cost management, and must maintain financial discipline in paying their loans on time. Corporate customers of banks must be able to plan their business and sales correctly. This will build up a good history of credit, allowing the loan loss provisions to be reduced.

Third, if a loan is not going to be paid back, the time and costs to take it to court must be faster and cheaper. At a time when it seems like non-performing loans have become a systemic problem, there needs to be an appropriate mechanism and institutional basis to address this issue. Every bank has an internal process in which it retains the ability to cover non-performing assets. However, we need a systemic mechanism in which nonperforming assets are economized, the balance sheets of banks are improved, and financial products can continue to be offered by banks. Internationally, there is a lot of experience with asset management companies in this regard.

Savings interest is the main determining factor of interest rates. Why is this? Is there a reason that savings interest is so high and is there a possibility to decrease it?

One of the reasons that savings interest is so high in Mongolia is that overall savings in the country is relatively small, sources of funding are limited, and also due to a volatile economy. For example, the loan/deposit ratio in the banking sector has surpassed 100 percent and the savings being overconcentrated means that the source of capital is limited. Demand for capital is high and competition is fierce, which leads to high savings interest rates. If the rates are so high in Mongolia, why aren’t foreign investors racing in to save their money in Mongolian banks? This is mainly due to the instability in the economy. If you subtract inflation from the named interest rates, the real interest rate since 2006 is 1.9 percent, or 44th globally, which is not a particularly high number. There are few people that are willing to risk the exchange rate fluctuations for this kind of return. The fact that supply of capital is low, demand is high, the macro economy is rather unstable, and the tugrug has been highly volatile have all contributed to maintaining high savings interest rates.

In terms of monetary policy, the central bank is seeking to maintain inflation at ideal levels in the short to mid-term. In order to accomplish this, Mongol Bank is working to maximize policy results to influence the money markets. But since monetary policy mainly affects the economy from a demand perspective, Cabinet must shoulder the responsibility of determining the supply policy, diversify the economy, and undertake reform to increase exports. This will allow the economy to have a better immune system and for inflation to be more stable. If the economy is stable, it is easier to raise capital through investment, making it easier for exports, which helps further strengthen savings, ultimately leading to supply of capital increasing and costs to decrease.

If the interest rate of government bonds is decreased along with the policy interest rate, it is said that interest rates will be significantly reduced. How accurate is this assessment?

The securities of the central bank and the government become the benchmark in the market. Therefore, everything depends on how much these rates are reduced. If risk is reduced in the economy and stability is maintained, these rates will fall, leading to a decrease in interest rates. However if these rates are decreased with no consideration for economic risks, it will have adverse effects such as increasing savings interest rates. This is why saying that the policy interest rate being high is the reason that the interest rates are high is wrong. For example, if the securities of the central bank were made five percent right now, where will the money in the existing securities go? It probably will not become a cheap loan all of a sudden. The solvency of banks being at around 40 percent means that there are few companies able to meet the loan standards of banks. At a time like this, we have to ask whether pumping a large amount of money into the market with loans will keep the tugrug stable, how it will affect repayment of loans in foreign currency, how it will affect financial stability, and lastly what its effects will be on normal financial operations of banks and economic stability in the bigger picture.

...Cabinet must shoulder the responsibility of determining the supply

policy, diversify the economy, and undertake reform to increase exports. This will allow the economy to have a better immune system and for inflation to be more

stable...