PKF study on high interest rates on SMEs

By Jaromir Sant

It has been five years since works started on removing the debris and rubble left over by the 2008 financial crisis. Most economies have just about found their feet and continued building where they had left off prior to the 2008 crash. Others, the less fortunate, are still struggling with the aftermath of what happened, still unable to breathe properly with the cloud of financial instability hanging over their heads.

Malta can be considered to be one of the luckier survivors of this situation. Of course, it did not escape unscathed, but compared to many other countries, it managed to limit the damage. However, as with many other European countries, it is now facing a looming problem of low inflation and fears the prospects of a potential deflation. The way out of the economic wreckage has already been largely planned out and paved.

What still needs to be addressed to ensure that economies can return to their former activity is the issue of low inflation and interest rates. But how can one do this without thoroughly considering the relationship between interest rates and inflation rates themselves when it is well-known that the two are inter-related?

It is with these considerations kept in mind that PKF Malta will seek to collect statistical evidence from local retail banks, NSO, CBM, GRTU, Chamber of Commerce, among others to try find an answer as to why interest rates charged to SMEs in Malta carry a higher interest rate.

Why is the risk margin charged on interest paid to depositors when compared to the interest charged by banks on loans and overdraft higher than average ECB experience (see graph)? Are banks lording it over the SME market due to their prominence and is this pegged to an unbridled race to earn more return on capital to public listed shareholders?

Certainly banks are tightly regulated in Malta and are not to be considered as a holy cow yet. Since the start of the recession in 2007/8 the two main banks have surprised many analysts, how even when GDP was shrinking, they bucked the trend with superior rates of profit. Hopefully the study will reveal the truth behind perceptions and PKF hopes that it will garner support from stakeholders to finish the study ahead of 2015 budget discussions.

Reports from the Central Bank of Malta seem to be slightly positive. Albeit being below the ideal 2% level, inflation rates are expected to accelerate. These projections, however, are also expected to be subject to a number of factors including the reduction in the price of oil in dollars, the strength of the euro as well as the reduction in utility tariffs for consumers, which is expected to dampen inflation rates.

Moreover it is also being predicted that the announced commercial tariff reduction to be implemented in 2015, mainly through its pass through to consumer prices, will, to a smaller degree, affect inflation rates. All this seems to point towards an expected slight increase in HICP, from 1% in 2013 to 1.1% in 2014.

This slight change can be mostly attributed to the developments in the respective HICP components, namely the reduction of utility tariffs, the increase in services inflation together with the moderate increases expected for non-energy industrial goods as well as food. The increases reported for non-energy Industrial goods as well as for the services are being considered as the main drivers behind the expected increase in the rate of inflation for 2015, reaching 1.7%.

However, being a small open economy, Malta also needs to consider the European economic outlook. Not only is Malta heavily dependent on Europe in terms of its own economy, but it is also a member state in the Eurozone and a negative development in even one member state in the Eurozone might have a negative impact on Malta itself. Besides, being in such a monetary union, provides further constraints on Malta in terms of inflation rates.

If Malta has a higher inflation rate than its trading partners, Malta’s external price competitiveness will suffer a considerable blow. It is hence imperative that Malta sticks to an inflation rate that is homogeneous to that present in its main trading partners to ensure that Maltese price competitiveness is safeguarded.

On the European theatre, we are facing a new economic situation wherein loose monetary policy measures are being used to try and help jumpstart the economy. Following the recession of 2008, termed by some “the Great Recession”, investors naturally became wary of investing and sought only assets they considered to be “safe”.

The returns garnered by these investments were and still are relatively low, so much so that they might possibly be negative if one accounts for inflation. Furthermore, these loose monetary policies decreased interest rates to an unprecedentedly low level. In an effort to try and push the economy further, the ECB announced in June 2014 that it would be offering negative interest rates. This was the first time that the ECB imposed negative interest rates. Such a measure was undertaken to try and dissuade banks from keeping their money at the ECB and instead lend it to potential investors, hopefully expanding the economy.

To add insult to injury in the current sluggish economy, low inflation rates are further slowing the recovery process. According to Eurostat estimates, the inflation rate in June 2014 stood at 0.5% and was projected to grow to 1.5% only by the fourth quarter of 2016. Despite this increase, such figures are still rather worrying.

This negative perspective is not as much fuelled by the negative consequences of having low inflation rates per se, but rather due to the fear of further potential drops in the inflation rate. The risk is entirely based on what consumers and producers believe will happen in the future. If the forces at play in the market forecast stagnant if not declining inflation rates, then they will be prone to adjust their inflation expectations to an expected decrease.

This would then lead to unsettling consequences such as lower wages, leading to a fall in prices and subsequently consumers waiting to make a purchase in the eventuality of a drop in prices in the near future.

Not only would this halt the economy but it might also ultimately lead to the spiraling problem of deflation. In such an economic climate, not only would one be fighting a losing battle against inflation, but the problem of an increase in real debt is also a major consideration that must be taken into account. Under a deflation, the Euro would face a devaluation leading to the reduction in purchasing power not only of locals but also all member states in the Eurozone.

This is the main reason behind the urge for many financial authorities such as the ECB in Europe, to boost the economy and implement as many measures to stabilize prices as possible. After all, the main aim of the ECB, as stated in the Treaty on the Functioning of the European Union, is to “maintain price stability” (where price stability is further defined as keeping the increase in prices in the euro area around 2%).

The ECB aims to transition the economy out of the risky low inflation rate zone into a healthy one while at the same time trying to promote higher lending levels to bolster the frail economy and bring it back to its feet. Indeed the ECB itself has noted that there is a disparity between the actual lending levels and those lending levels suggested by model-based estimates.

One of the consequences of a recession is that most companies make use of internally generated funds to finance any activity they might undergo in the immediate period following collapse. It is hence natural to expect lending to start picking up only in the later stages of recovery.

However there has been a reported decline in credit growth in the second half of 2012 overshadowing the indications obtained from a recent survey conducted by the ECB stating that credit conditions in countries affected majorly by the crisis have regained a large amount of stability.

This same survey on the other hand revealed how banks found the current terms and conditions imposed to be much more restricting than those imposed previously. This, together with the prospect of firms paying back loans through a sum larger than what they pay for their credit standing, would naturally dishearten such enterprises from even asking for such credit.

To conclude, it is with these considerations in mind that the ECB has concocted refinancing operations catering for such problems. The ECB will be initially offering banks up to 7% of bank’s euro area non-financial private sector loans outstanding.

This sum, made available starting from September and December 2014 and loaned for 4 years, will be made available solely for business and not for home loans. However the strategy is further well planned out, since these funds will have a direct relationship with the bank’s current net landing, in an effort to ensure that the aforementioned funds actually end up where intended. One can only hope that such measures have the desired effect.

Jaromir Sant is a Trainee Statistician with PKF Malta