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Impact of Reduction in the Lending Rates

  1. KSE-100 index
  2. Lever Brothers: Strong financial performance
  3. Reduction in lending rates
  4. Consumer's behaviour towards marketing

By Dr. Talat Afza and Ali Salman
IMS, The University of Lahore
May 22 - 28, 2000


Investment is a multiple function of politico-economic stability, investment policies, infrastructure and various fiscal and monetary measures. One of the most vital indicators of these monetary measures is the mechanism of the lending rates, which determines the cost at which the banks loan out capital to meet financial needs of investors and businessmen. Lending rates, or the cost which banks and financial institutions charge for lending their money to businessmen and investors, vary from bank to bank and customer to customer.

Usually the interest rate spread or the difference between the cost of capital incurred by the bank and the cost, which it actually charges from its customers for using the money, is kept quite high in Pakistan. Experts maintain that the cost of funds incurred by the banks ranges from 6.7% for big banks to 8% for smaller institutions whereas the lending rates range from 16% to 16.8%. Enjoying, therefore, a spread of almost 10 % between cost and lending rates is exorbitantly large. The normal spread, it is argued, should range from 2.5% to 3%.

Viewpoint of State Bank

The scheduled banks in the country used to charge from 18 % to 18.25 % per annum for the loans they gave to their customers. The State Bank maintained that this extraordinarily high rate is a major reason for the ever-decreasing demand of credit and this demand will only be enhanced if the lending rates are lowered by some substantial percentage. State Bank also attributes following reasons for a logical reduction in the lending rates. These reasons are:

1. Improvement in recovery of overdue loans

2. Reduction of administrative expenses as a result of Golden Handshake Schemes

3. Additional payment by the government by 2% on its commodity operations

4. Provision of providing liquidity for export financing schemes and locally manufactured       machinery

5. Claims by the banks to have met the shortfall in bad debt provisioning

The State Bank discourages banks to invest in its securities and bonds and prefers to see money in circulation for use in private projects and it discourages by rejecting a majority of the bids offered by the banks to purchase treasury bills. A most recent example in this case is the rejection of ALL bids by the central bank against the treasury bills worth Rupees 22.7 billion in the third week of April 2000, which it received from the banks.

In a move towards encouraging the banks towards reducing their lending rates, State Bank began charity at home by cutting down its own lending rates it offers to the banks from 13% to 11%, and also the rates of return on deposits at the National Saving Centers by more than 3% i.e. from 14.5% to 11.5 %. Moreover, it has also signaled slashing down of yields on T-bills to 9% or lower thus providing enough playing field for the banks to lend at as low as 14% yet remaining profitable. The overall reduction in last one-year has been 5.5%.

Reduction in lending and return rates by the State Bank (Percentage)











Lending to banks





(Weighted average)


National Saving Certificate







Special Saving Certificates







Regular Income Certificate







Bankers' perspective

Lending rates of the banks are dependent on the discount rates offered by the State Bank and are also affected by the yields on the securities and bonds like National Saving Certificates, Defence Saving Certificate etc. Bankers claim that the lending rates have been kept high to save the banks from the commonly-prevalent trend of default on the part of the customers, many of whom have motives other than business or investment. They also put the blame on the huge administrative costs in form of large networks and on the trend of giving concessional loans to government's favoured schemes.

Banks feel it safe and secure to invest in government securities and bills instead of placing their funds in the hands of the private sector. The rates of return on treasury bills and security bonds offered by the government are lucrative enough to bend the bankers' decision in the favour of central bank's instruments. So the money flows largely from the banks to the central bank, wherein, in ideal economic conditions, it should flow towards the private sector for onward consumption in agricultural, industrial and development projects.

Bankers maintain that the constant mirroring of the businessmen as criminals and defaulters by the political governments and the media hype that has been developed, is to be blamed for low demand of credit. In addition, inconsistency in the fiscal and monetary policies, poor infrastructure and political instability have also contributed in keeping the investment rate at the lower ebbs. Another notable hurdle in extension of the credit facilities to the private sector is the absence, or the inadequacy of, expertise of manpower and of appropriate technology.

Banks, nevertheless, in response to the State Bank's reduction in the discount rates have reduced their lending rates at varying degrees.


Reduction in the lending rates by major scheduled banks


Before reduction

After reduction


National Bank

18 %

16 %

2 %

Allied Bank

18.25 %

16.8 %

1.45 %

United Bank

18.25 %

16.8 %

1.45 %

Muslim Commercial

18.25 %

16.8 %

1.45 %

Senior bankers also maintain that the average yield offered by the government on its securities and bonds is still high enough to bend the public's mind towards these official instruments instead of towards the banks. They demand notable reduction in the rates of return on National Saving Schemes. The bankers are of the view that traditionally the profit or deposits rates offered by the government throughout the world are on the lower side but "Pakistani government still offers deposit rates to the customers which are 3-4% higher than those offered by the commercial banks." This gap makes it extremely difficult to compete as the government's securities already have an unshakable advantage of the confidence and trust of the public at large.

The impact of lending rates on:


It is expected that reduction in the lending rates will have multiple effects on the economy; at one hand it will help boost the investment and hence the economic growth while, on the other hand, it will cause an increase in the inflation rate. When the lending rates are lowered, investors and businessmen are inclined to take more loans, which they can invest in their projects. This investment, then helps in triggering the economy forward by providing more employment opportunities and therefore, the national income, or GDP, increases. The reduction in the lending rates have a simultaneous effect on inflation rate, currently below 6%, since increase in extension of credit means an equal increase in the supply of money hence inflation rate is likely to increase.

Deposit or Saving Rates

Reduction in the lending rate will eventually put a pressure on the commercial banks to reduce the deposit rates to maintain their profitability. The reduction in the bank deposit rates will further decrease the already low saving rates, which is currently around 12%. Thus it will directly, and negatively, effect the savers groups, majority of whom consist of pensioners, widows and other fixed income people.


The cost at which a potential investor borrows from banks is an important component in determining the input costs of the products. The lower this cost factor, greater will be the financial leverage available with the investor and hence the profitability will also be on the higher side. This financial leverage may also be used towards lowering down of the prices of a product thereby bringing it in the access of a larger number of consumers. The reduction in the lending rates would, therefore, help in increasing the consumerism in the market.

Current situation

The extent of credit expansion is an important reflector of investment trend. Despite the reduction in the lending rates, however, the banks' credit to the private sector has declined recently. It touched its peak i.e. Rs. 773 billion in January 2000 and again fell back to Rs. 759.8 billion as reported on 25th March 2000 whereas there was an increase of 3 billion rupees in the corresponding period of the last year. This 13 billion rupees shortfall is both a cause and a symptom of sluggish economic activity that has become a characteristic of our economy since we opted for the nuclear tests in May 1998.


Investment is an attempt to risk one's resources with the hope that the revenue will exceed the costs. This attempt involves consideration of investment policies, the infrastructural facilities and the monetary and fiscal strategies. Lending rates, as we have discussed, should play a catalytic role in credit expansion and economic activity, but they are not the singular players in the arena of investment incentives. In case of Pakistan, especially, the reduction in the lending rates could not play its expected role in the expansion of credit. Moreover, it was unable to trigger the investment activity as envisaged by the monetary policy makers. As of now, the impact of reduction on employment, inflation and growth rate of GDP is not visible. It may, therefore, be concluded that if the monetary authorities want to boost up the investment, they should strongly focus on the political and economic stability, strengthening the physical infrastructure, and investor-friendly fiscal and monetary policies.

Reduction in the lending rates in addition to other factors, supplement the pro-investment activities but it remains to be seen that how far and how much effective this lone investment encouraging decision goes in playing the required supplementary role in overall economic growth of the country.

Professor and Research Associate, repectively.