COLOMBO – (EconomyNext) – Credit contracted in absolute terms in the first quarter of this year partly due to defaults in pawning or gold-backed loans, after bubbling gold prices suddenly fell in 2012. Gold prices also bubbled due to Federal Reserve excesses through its quantity easing program, another state intervention.

Sri Lanka’s central bank is trying hard to encourage pawning loans by giving a credit guarantee to increase the loan amount to 80 percent from 65 percent of gold value.

This is in sharp contrast to the activity of the Western central banks like the ECB, Bank of England and the Fed after their own credit bubble burst.

They tightened capital ratios and brought more regulations through the Frank-Dodd law at a time when lenders were already cautious, further reducing the ability of banks to give loans. After slamming the regulatory brakes very same monetary authorities printed money and e to push the banks to lend. Such contradictory moves are typical in state interventions.

Complementary Action

Our central bank on the other hand is trying to reduce the regulatory burden and encourage lending, which is its intention. So its action is complementary to the goal of boosting credit at least on this occasion.

There are calls to increase the risk weight of gold loans from zero to higher levels for capital adequacy purposes. These calls should be resisted for now. Let the banks give loans, but at lower gold value as prudence requires.

When credit growth picks up, risk ratios can be brought in if necessary.

Any move to place gold loan defaulters on credit information bureau retrospectively should also be avoided. The banks went into these loans with their eyes open and should take the consequences.

While the intention behind the credit guarantee may be good, it can create more problems in the future, by encouraging the banks to engage in less prudent behavior, if the gold price falls further as is predicted by some.

Volatility

Commodity prices have been extremely volatile after the global credit bubble burst in 2008/2009 unlike in the 1980/81 episode, because US monetary policy has also been volatile and its effects erratic.

With less easy Fed policy, many commodities and metals are also falling in price as the dollar appreciates in real terms.

The Fed is expected to stop printing new money (buy more Treasury bills) by October. But it will continue to maintain the outstanding printed money volumes by repurchasing any maturing Treasuries in its portfolio.

When the Fed ends the expansion of its balance sheet, an eventual rise in US policy rates could further reduce commodity and food prices, helping the poor and the hungry but hurting mining companies, the oil rich Middle East, Russia and Venezuela.

It is also not clear what the effect of the policy of the European Central Bank – the other main reserve currency monetary authority that affect commodity prices – will have on commodities and precious metals. It is still on an easy mode.

At the moment gold prices are holding steady in the 1200 to 1300 US dollar per ounce range. If gold prices do decline, there will be more trouble for banks in the future.

An import tax was also placed on gold to prevent prices coming down. But that has tended to make gold and jewelry less competitive than it was when compared to Dubai for example.

Such un-intended negative consequences in other sectors are also common when the state intervenes.

The import tax on gold should be removed as soon as possible so that our jewelry industry and gold sales to foreigners and to Indians can go through.

Unintended Consequences

There may also be other un-intended consequences.

The Central Bank has also placed a 15 percent rate cap on pawning loans because some banks were offering gold loans at even higher rates as general interest rates fell.

The rate ceiling can discourage some banks from engaging in promoting gold loans, in the same way as the US Frank-Dodd law and capital ratios discouraged banks from lending after the downturn.

Another danger is that private banks may anyway play safe and state banks, as well as some private banks where the state exercise more control will be less able to avoid state directions will end up with more bad loans in case the market turns negative.

All of the people will then pick up the tab through the state guarantee.

Pawning is a credit system that has evolved from the market in this country and it should be allowed to continue. Banks were trying to cash in on the gold bubble by taking a risk and they should now face the consequences.

It has to be kept in mind that gold do not grow on trees and has to be imported. Pawning was one factor that boosted gold imports during the last few years and interventionists with a Mercantilist bent should keep in mind that it contributes to the trade and current account deficit.

Questions

Authorities are perhaps mistaken in some ways regarding the importance they place on the pawning bubble.

It may be unrealistic to expect the pawning loans to bubble as it did in 2011 and 2012.

The pawning defaults indicate that the borrowers have effectively dumped their gold on banks at a profit. So they now have the money to buy the same gold in the market or keep the cash invested in their businesses without paying any interest.

The other key reason for the gold boom was that prices rocketed from around 2010. So the existing gold stock was able support more loans. Many people could borrow more with the same gold they had earlier.

That condition is unlikely to be replicated in a hurry.

This article written in August 2014 appeared in the September 2014 issue of Echelon Magazine