A senior economist says the government was forced to intervene and bring down lending rates of state sector banks expecting private sector banks to follow suit and increase lending to the real economy because the market system failed to bring down rates, despite the Central Bank’s lose monetary policy stance since the beginning of the year.

Last week the President ordered state-owned banks to slash lending rates to between eight and 12 percent to the agriculture, tourism, construction and SME sectors. He also wanted existing loans to be revised and called for more lenient credit evaluations.

"The government was forced to intervene because credit to the private sector was not growing in keeping with the Central Bank’s lose monetary policy stance, in fact it has contracted," Dr. Sirimal Abeyratne, Senior Lecturer in Economics, University of Colombo, said.

"The market failed to respond to lose monetary policy, the reduction in policy rates and decrease in yields of government securities and generate credit that the economy required. The banking sector failed to respond, or their response was poor," he told the Island Financial Review.

Dr. Abeyratne points out that although lending rates had come down slightly, the private sector was reluctant to lend to the private sector given the environment in which most businesses operate at the back drop of the global financial crisis.

When the LTTE was defeated earlier this year, foreign sentiments became more positive and foreign currency inflows began to pour in. The Central Bank purchased these dollars from the domestic banking system to boost reserves and hold the exchange rate favourable to exporters.

This created an excess rupee liquidity position in the domestic banking system.

Monetary policy was conducive for interest rates to be brought down and banks to increase their lending and the system also had enough rupees held in excess, but banks do not seem to want to lend.

"Commercial banks preferred to invest these excess funds in government securities because they gave a secure guaranteed return, so the private sector was starved off credit," Dr. Abeyratne said.

Many private commercial bank dealers said the ploy to cut rates was a short term measure in view of elections next year but the private sector welcomed this move, although confused as to who would benefit by the rate cuts.

Some dealers said the low rates could not be sustained for long unless deposit rates were brought down as well. If this happens, the public would go to state-sector banks for their loans while taking their deposits to the private sector, thus creating a two-tiered market.

Dr. Abeyratne, however, believes that private commercial banks would have to follow suit in order to stay in business but he too was unsure of the sustainability of the scheme.

"The state sector banks have little to worry about. It is the private sector banks who may face some difficulty. If there is a mismatch between deposit rates and lending rates it could severely affect their profitability and growth," he said.

Commercial banks are likely to follow suit and cut rates further but not to the same levels as state-owned banks.

"We need to seriously consider our role in the growth and development of this country. Investing in government securities will not get us anywhere," a bank CEO told the Island Financial Review.

"However, we would have to look very closely at our loan books before we do anything stupid," he said.

Dr. Abeyratne said, the government too would have to control its borrowings from the domestic sector if the economy is to feel the benefits of the rate cuts.

"If the government continues to borrow then there is no benefit."

Dr. Abeyratne points out that as credit to the private sector increases it could once again fuel inflation, along with expected increases to imports once the global economy recovers.