AMMAN, 27 September 2004 — After dropping to their lowest level in the first half of 2004, interest rates on local currency deposits have started to rise recently in line with the rise in the corresponding dollar rates. Equally important, after reaching their lowest level by mid-2004, the spreads between yields on bonds issued by governments of the region and those issued by the US Treasury started to edge slightly higher across the maturity profile, reflecting expectations of higher domestic inflation rates in the region compared to that of the US.
Various internal and external factors suggest that interest rates on local currency deposits, as well as, lending rates and yields on domestic bonds are likely to continue to edge higher in the months ahead. Because regional currencies are officially pegged to the US dollar, the most important factor influencing domestic interest rates are the corresponding dollar rates. Historically, there has been a spread in most countries of the region between domestic interest rates and those on the US currency in favor of the domestic rates. The spreads varied over time depending on the country’s economic fundamentals, the size of its foreign reserves, its inflation differential with the US, and markets’ assessment of the risks of devaluation of the local currency. The availability of such spreads helped preserve the attractiveness of the local currencies and provided support to their fixed dollar peg.
An improvement in the region’s economic fundamentals in the past few years made it possible for monetary authorities to steer domestic interest rates lower, closer to those on the dollar. This coincided with the rise in oil prices and the ensuing strong regional economic growth. However, there is a limit to how much interest-rate differentials could be reduced. A positive spread over US interest rates is needed to compensate holders of the local currencies for any lingering risk of devaluation (both actual and perceived) and to reflect differences in inflation rates between the US and countries of the region. The higher inflation rate in the region is due to the fact that prices of imports from Europe, UK and Japan have been on the rise reflecting the weaker Gulf currencies and the US dollar exchange rates vis à vis the euro, the sterling and the yen. The ongoing rise in construction activities together with credit expansion and excess liquidity conditions further added to domestic inflation. As a matter of fact, real interest rate on short term CDs and deposits in the region is currently negative, reflecting a loose monetary policy at a time when these economies are growing at double-digit growth rates.
Three-month Saudi riyal deposit rates reached a high of 6.9% in March 1999, while corresponding dollar rates dropped to 4.9%. Interest rates differentials between Saudi riyal and dollar deposits rose from a low of 0.35% in January 1998 to high of 2% in March 1999. The widening spreads were a reflection of heightened speculative pressure against the riyal at a time when oil prices were on the decline, dropping to their lowest average of $11.37 for Brent crude in the first quarter 1999. With the rise in oil prices during the period 2001-2004, speculative pressure on the Saudi riyal subsided and the interest rate differentials between Saudi riyal deposits and those on dollar deposits shrank to less than 0.1%. The same is, more or less, true for the other Gulf currencies. During periods where there is little or no speculation against the Gulf currencies, interest rates on local currency deposits tend to move in tandem with corresponding dollar rates. As a matter of fact, in such Gulf countries as Bahrain Qatar and UAE, interest rates on local currency deposits were equal to those on the corresponding dollar deposits and some times below them.
Yields on US treasuries and conditions in the domestic credit markets are the main factors determining interest rates on bonds issued by the local governments. The spreads between US treasuries and bonds issued by governments of the region have averaged in the past around 0.5% for shorter maturities (up to one year) and 1% for longer maturities (up to 5 years). These spreads have been on the decline recently.
Three factors determine interest rates on domestic corporate bonds. The first is the “risk free” bonds issued by the governments of the region, which provide a benchmark for pricing corporate bonds. Corporates have a higher credit risk than that of their corresponding government and should therefore pay a higher interest on their bonds compared to government bonds of the same maturity. This interest rate differential constitutes the second factor determining the price of corporate bonds. Over the past 20 years, for example, the top rated US bonds (AAA) have paid on average about 1% less interest than medium rated bonds (BBB). The third factor is the maturity of the bonds. During times where interest rates are more likely to rise than fall in the years ahead, as is the case today, the yield curve tends to be sloping upwards. This means that the same corporate borrower issuing bonds with various maturities has to pay higher interest on the longer maturities than what he is likely to pay on bonds with shorter maturities.
Coupons on corporate bonds would be higher if additional features are added to the bonds, such as a call option that gives the issuer the right to buy back the bonds after a specific period of time. A subordinated bond, whereby other creditors will be paid first in case the company goes into liquidation, will have higher coupons. On the other hand, bonds with a pledged collaterals be it real estate, cash receivables, sinking fund etc. will command lower interest rates. Any change in yields of US treasuries, an improvement or deterioration of a country’s risk assessment and any change in the credit rating of corporates issuing the bonds would have their impact on long term interest rate structure.
Maintaining a fixed dollar peg has in effect allowed interest rates on the dollar to determine domestic interest rates, even if the economic cycle of the region is not moving in tandem with that of US. This has constrained the ability of the region’s central banks to put into effect the optimal monetary policy. As a matter of fact, what is needed today is a tight monetary policy to counter balance the expansionary fiscal policy associated with higher expenditures and surplus budgets due to the surge in oil revenues. While domestic interest rates rose by 0.75% in the past four months, in line with the rise in dollar rates, monetary policy remains very accommodative, with domestic interest rates below the corresponding inflation rates. Perhaps what is needed is a much tighter policy to put the breaks on the rise in domestic demand and reduce inflationary pressures generated by the excess liquidity. The region’s Central banks should engineer a soft landing to their economies, gradually deflating the current real estate and stock market bubble before it becomes unmanageable.
—Dr. Henry T. Azzam is chief executive officer at Jordinvest.