The Mongolian Parliament is currently discussing the introduction of interest rate caps on lending rates by financial institutions. An interest rate cap is a ceiling on lending rates with the purported aim of lowering the cost of borrowing and protecting borrowers from predatory lending practices. The appeal of such controls on lending rates is understandable. However, international experience suggests that interest rate caps often do more harm than good.
A key concern is that when interest rate ceilings are set below “market rates” – e.g. the rate required to cover banks’ own borrowing costs and the risk of default – the result can be a shortage of credit, particularly for the least established segments of the society. This means that those without a long credit history or significant collateral – such as young borrowers, rural households, female entrepreneurs, new firms, or low-income households – are cut off from the formal credit market, leaving large segments of the society ‘unbanked’.
Another concern is that when such borrowers are excluded from the formal banking system, some will seek financing in informal credit markets. Such markets are not regulated and, as a result, supervisors are unable protect borrowers from the very type of predatory practices the interest rate cap aims to fight. Indeed, higher borrowing in informal credit markets will increase the chances of predatory lending.
It is true that a form of interest rate ceilings – known as ‘usury laws’ – are used in many countries. However, the ceilings in such laws are set at very high levels because they are only aimed at preventing predatory lending, not changing the average interest rate that most banks charge. For example, in the United States, the median ceiling for a 5-year loan is currently 10 times the level of the policy rate. The equivalent ceiling in Mongolia would be over 100 percent.
Nonetheless, average bank lending rates are indeed high in Mongolia. Adjusting for inflation, lending rates in local currency have averaged 10 percent over the last 5 years. Thus, it is reasonable for policymakers to want to find ways to reduce interest rates. But instead of using interest rate caps which can come with costly side effects, it is vital to address three underlying drivers of high interest rates.
- Firstly, Mongolia has high country risk which puts upward pressure on the amount depositors or investors require to hold local currency assets rather than US dollar or foreign assets. The risk premium can be reduced by lowering public and external debt, improving banking sector supervision, and creating a reliable and stable climate for foreign investment.
- Secondly, frequent bouts of high inflation in Mongolia mean that depositors insist on high nominal rates to protect against an erosion of their savings in local currency. In turn, banks then need to charge high lending rates to cover these costs. Bringing about low and stable inflation will lower bank funding costs which can be passed on to Mongolian households and businesses.
- And third, it is difficult for banks to collect payments on defaulted loans given the current legal framework for resolving non-performing loans and constraints in the judicial system more broadly. Thus, banks charge higher interest rates to be compensated for the risk of default and their inability collect collateral.
It is worth noting that, even at the currently high interest rates, credit growth has been excessive in the last year, rising by 25 percent. This has created important financial stability and consumer protection risks. Households have taken loans with double-digit real interest rates to finance consumption and now one out of every two households pays over 50 percent of the monthly income in debt service. Households will need sustained increases in wages, without any employment or health surprises, to repay these loans.
But, again, the solution to this is not to artificially lower lending rates with a new law. The only way to have safe and sustainable credit going forward is to have interest rates that both cover bank costs and are consistent with borrowers’ ability to pay. Thus, the focus should be the underlying reforms identified above which get at the root of these issues. And for the near-term, the recent steps by the Bank of Mongolia to introduce tighter regulations on borrowers’ ability to qualify for such loans will help limit the increase in risks.
Addressing these challenges is central to the agenda of both the government’s Economic Recovery Program and the IMF-supported Extended Fund Facility. And because of the authority’s efforts thus far, there has been progress, particularly with respect to lowering public debt. Financial markets have recognized this progress, allowing Mongolia’s country risk to fall by more than half since 2016 and real local currency lending rates have fallen by 5 percentage points over the same period.
Nonetheless, many of the core drivers of high borrowing costs remain in place and more needs to be done in reducing macro-economic vulnerabilities, strengthening banking sector supervision, and reforming the NPL resolution framework. Such actions will ensure that the financial sector not only supports overall economic growth but also ensures that such growth is shared by broad segments of the population.
Neil Saker, IMF Resident Representative in Mongolia
May 2, 2019