San José, Costa Rica, since 1956

‘Jawboning’ on interest rates

In developed economies, banks are being squeezed by ultra-low interest rates. Due to either the U.S. Fed’s attempt to stimulate employment by holding that institution’s interest rates near zero, or to European economies in recession or de-pression, bank lending rates in dollars are at historically low levels. 

This year’s LIBOR scandal, in which several big multinational banks have paid fines for manipulating the benchmark international lending rate, in part reflects the fact that banks can make more money when interest rates are high, due to broader interest-rate spreads (the difference between the average deposit rate that they pay and the average lending rate that they charge borrowers).

In Costa Rica’s dual colón-U.S. dollar economy, dollar rates for both deposits and loans are also at record lows. But an odd situation persists with colones. For 30 years before 2007, the colón devalued against the dollar, first violently in the early 1980s, then at a steady 11 percent annual rate starting in 1987. And prior to 2011, the Central Bank was never able to hold colón inflation below double digits. 

Given this past steady devaluation and high inflation, it was natural that colón interest rates had to be much higher than dollar interest rates, to get people to hold and invest in colones instead of dollars. But since 2007, annual devaluation slowed and reversed, with the colón actually gaining value against the dollar in the last few years, settling at its current exchange rate near ₡500 to the dollar. And in 2011, based on this exchange stability, the Central Bank finally tamed colón inflation, bringing it down to 5 percent. 

If you look at this week’s Tico Times Economic Activity Report of local bank dollar and colón interest rates, you will see dollar 6-month CD rates at 2.15 percent, against a colón rate of 8.54 percent. On the bank loan side, the average dollar loan rate is 10.87 percent, versus a whopping 20.31 percent for colón loans. These huge differences between colón and dollar rates are in line with the long-term historical norm. 

But why do they continue, given that the historical pattern has changed? The colón has stopped devaluing against the dollar, and colón inflation is down to a projected 5 percent or lower for this year. The Central Bank is now having to support the ₡500 exchange rate to keep it from falling lower, and expected pressures on the exchange rate for the next couple of years are anticipated to be downwards instead of upwards.

In a speech last Sunday, Costa Rican President Laura Chinchilla took the Costa Rican state banks to task for high colón interest rates, in view of the damage done by these rates to the pocketbooks of average citizens with home, car and credit card debt. 

Costa Rican banking, especially on the popular consumer level, is dominated by three state-owned banks, which were nationalized in 1948 under the justification that banks should serve national development and not line the pockets of private owners. Over the years, the state banks became bureaucratic and economic black holes, and piggybanks for corrupt politicians. 

They got so bad that in the ’80s Costa Rica was forced to bring back private banking to force the state banks to reform through competition. This resulted in the mixed public-private banking system Costa Rica now has, which, thanks to first-class supervision by the Banking Superintendency, serves Costa Rica well.

But against all financial logic, the state banks, which are backed by the full faith and credit of the government of Costa Rica, pay higher deposit interest rates than the private banks, which have no government guarantees beyond supervision. The state banks, which dominate Costa Rica’s financial market by volume, have increased the “Basic Passive Rate” (BPR), the Costa Rican equivalent of the U.S. Fed’s benchmark prime rate, up from 8.5 percent a year ago to 10.25 percent today (down from 10.50 percent in September). 

The government of Costa Rica is bringing its bond sales under control, and has ceased its upward pressure on local interest rates. With the recently approved Eurobonds Law, the government will begin going to international markets for an important portion of its financing, further reducing colón interest rate pressure. In view of this, the persistently high BPR is looking more and more like the Costa Rican state banks’ own mini-LIBOR scandal: a benchmark rate kept artificially high to increase bank margins, at the expense of the loan-paying public.

Fernando Naranjo, general manager of Banco Nacional – the 800-pound gorilla of the state banks – criticized Chinchilla’s complaints about high colón interest rates as coming from a non-economist. But it so happens that the government names the board of directors of state banks. And, given exchange stability and low colón inflation, state banks don’t have any economic argument to justify paying higher interest rates than private banks. 

Chinchilla is fully capable of moving beyond “jawboning” to force state banks to curb their self-serving high colón interest rates. Expect colón interest rates to drop in the coming months. 

Apart from the negative effect on the loan-paying public, there is an even darker side to consider. Current low dollar interest rates and high colón interest rates, coupled with exchange stability and pressure for revaluation of the colón, are a magnet for speculators. The bet, right now, is simple and low risk: exchange dollars into colones, collect the high interest rates, and then convert back into dollars. If the colón revalues, you get a revaluation kicker on top of the high interest rate. 

Many small, aggressive investors are probably already doing this, contributing to the downward pressure on the colón-dollar exchange rate. Suppose a rogue international hedge fund, with capacity to move money in hundreds of millions of dollars, looked at Costa Rica’s financial market situation and decided to place this same bet in massive amounts. Such money flows could wreak havoc with Costa Rica’s foreign exchange and money markets. Costa Rica would be in big economic trouble.

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