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Lower Interest Rates: Watch Out For Backfire

Friday 13, 12 2019
The decision of the State Bank of Vietnam (SBV) to lower the deposit interest rate ceiling with term deposits of less than six months is not outside the objective of creating conditions to lower the lending interest rate level. However, this decision caused small banks to raise deposit rates for long terms to make up for short-term deposits that are attracted by reputable banks.
Lower Interest Rates: Watch Out For Backfire

Favorable conditions for reducing deposit rates

The State Bank of Vietnam has just decided to lower the deposit rate cap for term deposits from one month to less than six months, from 5.5% to 5% / year, terms of less than one month and demand deposits from 1% to 0.8% / year from November 19, 2019. This is the first time deposit rates have been adjusted downward after maintaining stability from March 2014 until now.

The lowering of the deposit interest rate ceiling is expected to be one of the solutions for commercial banks to lower the lending interest rates. This is also considered a move to ease the monetary policy of the State Bank. This decision is considered consistent with the general trend that central banks around the world are making to keep the economy maintained growth momentum.

Pioneering in the trend of reversing monetary policy is the US. In 2018, the US Federal Reserve (Fed) had raised interest rates four times to narrow the money supply to prevent the economy from overheating which could lead to a bubble of asset values like real estate or stock. However, less than a year later, in July 2019, the Fed had the first interest rate cut since the global financial crisis in 2008-2009. And most recently, the Fed made its third cut in 2019.

The Fed's move is considered a "torch" that stimulates global monetary easing to increase the money supply and lower the value of the domestic currency to stimulate exports. Therefore, the decision of the SBV is entirely consistent with the general movements of the global financial market.

However, this is only considered a necessary condition. Sufficient conditions are intrinsic factors of the domestic economy. Accordingly, the average inflation in the 10 months of 2019 is currently at only 2.48% and is expected to be only about 3% for the whole of 2019, much lower than the 4% target assigned by the National Assembly to the Government. In 2020, the National Assembly continues to set the target of controlling the annual average inflation at 4%, equivalent to the figure of 2019. Therefore, the deposit interest cap ceiling being reduced to 5% is still enough to ensure a positive real interest rate of savings depositors. Therefore, the decision of lowering the ceiling interest rate of the central bank is completely consistent with both domestic and international movements.

But it makes small banks worry

Immediately after the decision of the SBV, banks must immediately adjust their deposit rates. However, this decision of the SBV forced banks to make strategic adjustments in raising capital.

In addition to term deposits of less than six months, the maximum interest rate is only 5% per annum as per regulations, for terms of six months and above, interest rates are significantly different among banking groups.

For the group of excess liquidity, including state-owned banks and some large commercial banks, deposit rates fell for deposits over 6 months, although the reduction was uneven between terms.

Banks with moderate liquidity, including medium-sized banks, kept deposit rates for terms above six months as before the SBV's decision.

Meanwhile, small banks with total assets of less than VND 100,000 billion and currently accounting for the majority of 35 commercial banks have suddenly raised deposit rates for deposits over six months, although the increase between terms and between banks is different.

Why is there such a difference? The fact that interest rates are the same between banks for deposits of less than six months will cause depositors to tend to choose more reputable banks. Therefore, the mobilization of small and reputable banks may decline. This shift is entirely understandable because deposits of less than six months still account for 30-40% of the deposit structure of banks. Therefore, to compensate for this decline, small banks have to raise interest rates for terms of more than six months to attract depositors from bigger banks.

Watch out for the backfire

If this happens to a sufficiently large level and over a long period, even larger banks, in spite of excess liquidity, will have to adjust deposit rates to increase their market share.

Thus, while interest rates for short terms decreased, interest rates for long terms may tend to rise. This process, if maintained for a long time, will cause the total cost of mobilization of banks to increase. The reason is that customers' demand for deposits is increasingly moving from short-term to longer-term. Previously, deposits of less than six months usually accounted for 60-70%, but now it is estimated at only 30-40%.

​To keep the interest rate level from rising back as analyzed above, the SBV must have more measures to keep the liquidity of the whole system in excess. Only then, the interest rate level in the interbank market will remain low to avoid putting pressure on the interest rate level on market 1 (the market between banks and residents, economic organizations).

interest rate level

The SBV's extension of the application time of Basel 2 from 2020 to 2023, as recently stipulated in Circular No. 22/2019 replaces Circular No. 36/2014, is also considered a solution to avoid small banks racing to raise Tier 2 capital as they did in 2019. Also, the State Bank may consider lowering the current key interest rates such as the OMO rate, Treasury bill interest rate ... Only then will new businesses have the opportunity to access cheaper capital.

Keed Reading: How Will Reducing The Compulsory Reserve Interest Rate Affect Banks?

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