The interest on a deposit
Inflation is at its highest level ever because of a global commodity super cycle, a never-ending series of bad policy decisions, and the inability to make any decisions.
Inflation is the worst kind of tax, and it usually happens when a country’s expenses are higher than its income and it keeps borrowing money to make up the difference. Since inflation has always been in the double digits over the last five years, real interest rates have been negative for the last three years.
The difference between the interest rate in an economy and the rate of inflation is the real interest rate. As long as inflation is higher than the interest rate, the real interest rate is negative. This means that your money will keep losing value in the future. When people and businesses think their money is going to keep losing value, they spend it and drive up consumption. This creates a vicious cycle in which growth drives consumption, which in turn drives growth, which further hurts an already weak economy.
So that this doesn’t happen, central banks try to keep the real interest rate in the positive area. The State Bank of Pakistan, which is our country’s central bank, doesn’t seem to care much about real interest rates, so it always reacts instead of being proactive. Eventually, the central bank has to raise interest rates, which is what is happening in Pakistan, where we are close to having the highest interest rates ever. The IMF also says that interest rates should go up even more, which our central bank is strongly against.
The theory is that when interest rates go up, people save more because they get a better return and spend less. Something different is going on this time. Banks are calling people who have traditional savings accounts to ask them to switch to Islamic savings accounts. On the surface, this seems like a good cause, but if you look deeper, you can see that this is a business decision to get more money from depositors who don’t know what’s going on.
The State Bank of Pakistan, which is the country’s central bank, says that the return on savings accounts can’t be less than the floor rate, which is less than 0.5%. At the moment, the floor rate is 16%, and the central bank has set the minimum savings rate at 15.5%.
But this doesn’t work for Islamic savings accounts or Islamic banks. It only works for traditional savings accounts. This means that banks try to get customers to switch their deposits from regular accounts to Islamic accounts, where they get an average rate of 8% of the loss. Banks take advantage of the fact that customers and banks don’t have the same amount of information and use this to their advantage to push customers towards Islamic accounts without explaining or educating them about the possible opportunity loss they may have to deal with. This is a classic case of not having enough information. A normal depositor doesn’t know any better, so they are the perfect easy target for a bank’s aggressive sales campaign to lower its costs of deposits. What better way for a bank to sell itself than to say that it will follow Shariah?
When there is a lot of inflation and real incomes are falling, it is very important that depositors don’t have trouble getting the current interest rates because of a lack of information or regulation. There are many ways for citizens to get high interest rates on government securities, but not many are able to do so because they don’t have enough information or aren’t good with money. Access is also limited on purpose, since these products would cut into the business of banks, which act as a way for governments to borrow money.
Some people might say that Islamic banks can’t have a minimum savings rate because it might go against the rules of Shariah. Taking small profits from consumers who don’t know any better while banks take advantage of the lack of information may not be in line with Shariah either.
Even though a lot has been done to improve financial inclusion, the public’s trust and faith in banks keeps going down. In terms of GDP, the amount of money in circulation in the economy is close to its all-time high. There is almost Rs8 trillion in cash floating around in the economy that is not in banks.
If this kind of difference and lack of information continues, people may lose more faith in the formal banking system. If a bank doesn’t give a fair return on deposits and treats every customer with too much scepticism, then money will slowly leave the formal economy as depositors look for better returns elsewhere in the informal economy. Capital has been leaving the formal economy for a while, and this trend could speed up if banks try to get more money from depositors while the regulator looks the other way. We can either work to make society more financially open to everyone, or we can take more rents in the short term, which will hurt people’s trust in the formal financial system even more. The regulator needs to look at the big picture, because if they don’t, there won’t be much left to regulate, since more than 70% of bank assets are directly or indirectly exposed to the government. Even on the deposit side, the ratio of private deposits to public deposits has been going down over time.
The country needs a strong, growing, and inclusive financial sector, not just in words but also in practise. Financial inclusion isn’t just about taking pictures and holding PR events.