Consumer financing: A function of interest rate

Published on 19th Jan, Edition 3, 2015

 

Advanced economies thrive on a well-managed system of consumer financing, which affords the pleasure of luxurious facilities without owning them. In capitalistic system, this is a win-win situation for both the users and the suppliers of goods and services. The economy benefits as demand is created for goods and services; consumer markets seem bursting at the seam as buyers, backed by the strength of consumer credit, throng to bid for the goods and services offered; business benefits by creating new orders for further production of goods and services; the investors benefit by recycling their money in the process besides earning a reasonable rate of return on the money invested.

As in case of any other business, the principle of prudence plays an important role in the management of consumer credit. This is because, normally, no security cover (or an insufficient cover) is available for such type of credit. In case of credit cards, employer’s salary certificate is deemed enough to confer on the customer the right to purchase goods and services. While car financing affords a sound security cover — the vehicle can be confiscated in case of non payments – prudence has to be exercised by asking for a sufficient down payment to cover any shortfall in case of confiscation. House finance would appear to be more safe as real estate prices usually keep moving upward, but the foreclosures in case of non payments could be more costly and time-consuming. The US sub prime mortgage is the case in point when, after constructing houses in bulk numbers, artificial demand was created by offering half-desiring and in many cases undeserving purchasers mortgages at virtually no terms and conditions by completely ignoring the principle of prudence. What happened later is now history.

Consumer credit gained popularity in Pakistan in 2000s when a wave of “easy debt” was unleashed in the wake of excessive bank liquidity. Credit cards and car financing used to be a rage those days. The marketing hounds of competing banks were rampant in a middle-class society that was longing for the luxury of “spending beyond the means.” Be it a home furnishing item, an expensive dress, a motorbike or a car, will to have was all that was needed. The question of repayment was resolved by signing a few bank documents carrying harsh terms in fine print. The craving and naïve consumers were made to believe that the charge for the credit was as low as 3% per month. The uninitiated debtor hardly understood that an interest rate as high as 36% per annum – leave alone the service charges etc. – would make any Shylock mortify in shame. The result was not difficult to predict; mass-scale defaults ensued. Since car financing was safer from banks’ point of view, banks lost little or almost nothing on that account, but they lost a fortune in credit card loans. Two factors were at the root of this fiasco: overly aggressive marketing and high interest rate.

 

With the abolition of Fractional Reserve System and in the wake of Quantitative Easing following the 2007-08 global financial crisis, the stock of global money in circulation has increased manifolds. This money can’t be made to sit in bank vaults. It must circulate to keep the world economy buoyant.
Milton Friedman’s mantra “go shopping” would seem relevant in this context. World consumer markets have to be kept bustling with activity. This is what the very concept of capitalism demands. What is the ultimate cost of this crazy 24/7 shopping, is not the subject of this discourse. Unlimited, soft-term consumer credit is one way to keep the counters of shopping centers busy. We failed because our hoggish bankers tried to drink it all in one sip.

Unfortunately, our monetary policy has had been too rigid on the subject of interest rate. We kept the economy bottled up for too long a period with the highest rate in the region in an era when monetary easing was the order of the day. More unfortunately, the interest rate for consumer credit was never aligned with the ongoing central bank rate. Our banks kept charging the users of credit card at the rate of 50%, and even more, when the central bank rate used to be in single digit. This was one of the most counter-productive economic efforts on part of our banking system. In order for the consumer credit to grow, it should always be backed by a low-interest regime. In consumer economies like the United States, household and consumer credit has grown in a low-interest atmosphere. US household debt as percent of disposable income went up from 68% in 1980 to 128% in 2007. This was a stunning example of spending beyond means. US consumer credit as percent of GDP rose from 14% in Jan 1990 to 18% in Jan 2009. After the crisis, the ratio came down to 16.4% in July 2010, finally improving to 17.5% in Jan 2013.

TABLE SHOWING SUMMARIZED POSITION OF CONSUMER CREDIT IN PAKISTAN (RS. BILLION)
CONSUMER FINANCE	JUNE 2013	NOVEMBER 2013	JUNE 2014	NOVEMBER 2014
– House Building	38.969	36.412	39.264	38.955
– Transport (Car etc.)	50.487	55.083	63.680	69.222
– Credit Cards	21.795	22.258	22.770	22.399
– Consumer Durables	228	307	430	358
– Personal Loans	99.803	111.199	116.662	117.954
– Others	8.456	8.209	8.260	7.644
Total	219.738	233.468	251.066	256.532
Source: State Bank of Pakistan

Pakistan’s total consumer finance as percent of GDP is around 1%. It has, however, started to pickup with the fall in interest rate. Without taking a leaf from the flamboyant consumer economy of the US, we should strive to develop a low-interest, prudent consumer economy. Well-managed consumer finance decidedly plays an important part in the growth of a potent economy, which Pakistan definitely is. We have unnecessarily kept our economy stagnant with a primitive style of interest rate management. Our monetary policy needs to be reviewed in line with the modern economic trends.