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The
World Of Cyprus
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| ECONOMY | |
| Interest Rate Move a Prelude to Liberalization
By Sofronis Clerides
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| Last
March, the Central Bank of Cyprus announced the reduction of interest rates
by half a percentage point. The maximum rate on deposits was lowered from
7% to 6.5% effective immediately. The reduction of the lending rate from
8.5% to 8% will be effective July 17. This is only the second change in
the maximum lending rate since it was set at 9% by the Interest Law of
1944. The rate had remained fixed at that level for half a century, until
it was lowered to 8.5% in the end of 1994.
Although regulation of interest rates is going out of fashion these days, Cyprus is certainly not |
They
merely shifted objectives, aiming to set limits on the rate of interest
one could charge, rather than prohibit the practice altogether. The Cypriot
Interest Law is an example of that.
In the last few decades, complete deregulation of interest rates has gained wider acceptance. There are three main economic arguments against statutory limits on interest rates. The first has to do with savings. If the nominal rate of interest is fixed, then at times of high inflation the real interest rate (the nominal rate minus the rate of inflation) can be negative. In other words, money kept in the bank actually loses purchasing power over time. This clearly provides little incentive for people to save. Low saving implies limited availability of funds for investment, and low investment hinders the growth of the economy. This argument usually applies to countries with very high rates of inflation, and is thus not particularly relevant to Cyprus, where inflation has been largely kept in check. Indeed, the rate of savings in Cyprus compares quite favorably with that of other developed countries. The second line of criticism is concerned with the effect that interest rate regulation has on the allocation of funds in the economy. Loans are used to finance either consumption (such as car purchases) or investment (such as purchases of machinery and establishment of new businesses). With every loan comes a certain risk that the borrower will be unable to pay back the amount borrowed; this risk varies for different types of loans. Lenders would like to "penalize" risky loans by charging a higher interest rate on them. If they are unable to do so (say, by law), they might decide that the return is not worth the risk, and opt not to finance risky projects. Therefore one would expect that in an economy with a fixed interest rate, risky ventures will not be able to attract the necessary financing. This is troubling, however, as risky ventures are the ones that drive economic growth, not the relatively safe consumption loans. Furthermore, when the cost of borrowing is fixed, considerations other than credit-worthiness (contacts and personal favors, |
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in imposing limitations on the rate one can charge on a loan. The notion
of interest has existed for thousands of years. In most organized societies,
the charging of interest (or usury) was considered immoral and exploitative.
Since lending is a temporary transfer of money from someone who has a lot
of it to someone who does not, it is easy to see why that was the case.
As a consequence of this perception, laws against usury were often introduced,
and some have been traced as far back as the Babylonian code of Hammurabi
of 1800 BC.
Most major religions have held strong beliefs against usury throughout history. In addition to the exploitation argument, they also considered it unethical on theological grounds. They argued that interest is equivalent to a charge on time. But only God owns time, and it is thus immoral for mortals to put a price on it. Islamic law prohibits usury to this day. Eventually, the charging of interest became standard practice. It came to be understood that by granting a loan, one forgoes the income that could have been generated by the productive use of the money. Interest serves to compensate the lender for that loss. Usury laws did not go away, however. |
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