As the rial fails to regain lost ground and Iran's markets are imperiled by a high volume of liquidity, the country's monetary regulator may be left with no choice but to raise interest rates. The recent actions of the Central Bank of Iran (CBI) have reinforced months of speculation that an about-face on bank deposit rates may be in store.
At present, bank deposits with terms of at least one year pay annual interest legally capped at 15% per a 2016 ruling by the Money and Credit Council, Iran's highest financial decision-making entity, which also set lending rates at 18%. But banks failed to adhere to those rates, partly because they were unable to compete with higher yields offered by Islamic treasury bonds that at times offered annual returns to the tune of 28%, and partly due to a myriad of other major challenges such as a choking credit crunch that encouraged them to offer higher interest to attract deposits. This gradually became public knowledge, but as there was a consensus to bring the rates down to foster domestic production, the CBI doubled down on enforcing the rate caps on Aug. 22, 2017. However, the regulator considered a short implementation lag, effectively giving the banks 11 days to absorb as many high-interest deposits as they could.
The move meant that the ailing banking system could function for another year under the previous conditions while at the same time allowing the regulator to maintain the appearance that it is enforcing its forcibly lowered rates. Perhaps the plan was to await the finalization of long-stalled banking reforms to expand the scope of corrective measures. But fast forward to the present, and a currency crisis formed on back of worsening outlooks due to re-imposed sanctions in the aftermath of the US withdrawal from the nuclear deal has meant that annual returns of 15% are simply not going to be attractive enough when compared to massive profits yielded by purchasing hard currency and gold coins.
"There are clear signs that any changes to bank interest rates would only take them higher," a financial source with a seat on the board of a major Iranian bank told Al-Monitor on condition of anonymity. "When the government participation bonds in the capital market have yields going much higher than 20%, bank interest rates can only move toward that direction."
Reports of a possible interest rate hike as a serious prospect first emerged in late June at the same time as the government announced the formation of a secondary foreign exchange market to ease pressures on a sharply fluctuating rial. Then, from early August, the CBI allowed two major banks, the state-run Bank Melli and the privatized Bank Tejarat, to offer bank deposit certificates with 18% annual interest. Reports also suggest that in the run-up to another expected interest rate hike, the banking system has once more mobilized to offer even higher rates — well above 20% — to customers who make bigger deposits. This is while the CBI gave the green light to the banking system to offer bank deposits with 20% annual interest in February to redirect liquidity toward banks at the onset of the currency volatility.
Many officials and pundits, including head of the Association of Private Banks and Credit Institutions and CEO of Bank Parsian Kourosh Parvizian, have referred to what is unfolding as falling into old habits and turning to "faulty cycles." They have pointed out that businesses and the economy as a whole will feel the sting.
"We're trying to make them see the direct effect of an interest rate increase on lending rates because the industries will have to pay higher interests on their loans and they cannot afford that," the Iranian source told Al-Monitor, adding that it will run counter to the country's larger goal of supporting local enterprises. He further noted, "Our opinion is that interest rate hikes have the capacity to work out in certain cases, but are not the answer at present."
The source, who is also a senior member of the Iran Chamber of Commerce, pointed out that true lending rates are already much higher than 20%, making everyone at the chamber, the main official representative of the private sector, anxious about how businesses are to return the loans. Many of them will surely struggle to repay the banks, leading to added pressure on the banking system in the form of a high ratio of non-performing loans.
There are other potential dangers to consider. If the CBI chooses to tweak bank interest rates without paying attention to other macroeconomic indicators — as it did when disastrously dealing with the unfolding currency crisis back in April — it will only hurt the economy. Among the possible ways in which the latter may backfire is the prospect of higher inflation, which will further pressure an already embattled general public that has endured severe price hikes in recent months. Many experts and observers, including the local Institute for Trade Studies and Research, are predicting that the inflation rate, which was brought down to single digits in 2016 for the first time in 26 years and remained there until earlier this year, may jump above 20%. Such a prospect would likely put further pressure on banks to continue the spiral of raising interest rates to match inflation, greatly damaging local industry and enterprises that are already struggling to deal with a plethora of challenges.
For now, the CBI has adopted a wait-and-see approach. On Aug. 21, it allowed banks that had issued high-interest bank deposit certificates last year to extend the terms of such vehicles for one more month. It will allow new CBI Governor Abdolnasser Hemmati to better see the effects of his foreign exchange policy package — which was received more positively than that of his predecessor by traders and experts due to its embrace of a free market — and analyze the long-term effects of a contested interest rate hike.
While the long-term effects of a reversal on interest rates are clear and potentially dangerous, the short-term benefits are in some ways compelling. Being able to offer customers higher yields could allow banks to further absorb rampant liquidity reported at 15.827 quadrillion rials ($376.83 billion), which is higher than Iran's gross domestic product. Nonetheless, the CBI would do well to refrain from making hasty and reactionary decisions and rather focus on tackling root issues by pursuing wider banking reforms in collaboration with the parliament.