Hit or miss? Interest rate control and other policy ideas unpacked

By Simon Cawdery, Compass Columnist

In recent weeks and months, several policy ideas have been bandied about, from establishing a body to control interest rates, to setting a new minimum wage for the islands, to formalising how import concessions are done. Simon Cawdery takes a look at a number of these policy ideas in a bid to sort out the wheat from the chaff.

1. Interest rate setting body

Economists rightly get a lot of criticism for the theoretical nature of their work. They bring immensely complex maths to ‘solve’ problems only to find that humans refuse to behave as the mathematics models suggest. One thing the economics profession is good at though is spotting logical impossibilities. 

Cayman has a tethered/fixed exchange rate. This is guaranteed by the Cayman Islands Monetary Authority owning sufficient US dollars for every CI dollar in issue. Any economic textbook will tell you, in no uncertain terms, that an economy with a fixed exchange rate cannot have its own interest rate policy. Thus, an interest rate-setting body makes no sense. It will not work since Cayman interest rates always, with a fixed exchange rate, have to be identical to those of the US.

What are we trying to solve for?

Presumably, the anxiety is that banks in Cayman charge too much for loans and mortgages and pay too little on savings and deposits. Therefore, establish this body and cap mortgage rates while simultaneously setting a minimum interest rate for savings. Rather like mythical creatures though, such a plan can only exist in fairytale land. 

Imagine a bank has $10 million in cash to lend out. Currently, they can lend it to people in mortgages at, say, 8%. The interest rate-setting body, however, says that 8% is too high and the maximum is 7%. Great news! Everyone will be able to get a mortgage at a lower rate. Except, unfortunately, they won’t. What will happen is that banks will look around and say why would we lend to people at 7% and take the default risk on mortgages? Instead, let’s lend to other banks in the US at the same or potentially better rates for less risk. 

The banks will ration lending

The result of this policy will be a rationing of lending; only the ultra-wealthy (with the best credit) will get loans while the more marginal borrowers will find their applications declined. Therefore, the policy objective of expanding lending and getting more people on the property ladder will be in tatters because fewer mortgages will be given out.

What about the ‘lucky’ depositors? Let’s say you currently earn 2% on your deposit. If the interest rate body says that this must be 3%, it seems everyone would benefit. But they won’t because banks will start to close people’s accounts. Indeed, bigger international firms will look at the unnaturally large deposit rates in Cayman and start to deposit massive quantities of cash. This will kill banks’ profit margins and generate the very real risk of their bankruptcy. Probably not the intention of the policy! 

A rate-setting body could actually cause catastrophe

The other problem is that smart people in London and New York will notice an incredible arbitrage opportunity: borrow cheaply from Cayman banks, sell Cayman dollars, buy US dollars, then lend at higher rates elsewhere and make free money. All these people selling Cayman dollars will force the Central Bank to buy them, but to buy them it will have to convert CI dollars. The end result will be the destruction of the Cayman/US dollar fixed exchange rate. Again, unlikely the intention of the policy!

The only way such a policy could work is if Cayman simultaneously introduces currency controls – stops Cayman dollars from being freely converted into US dollars. The problem is obvious – international counterparts – those very people who use Cayman because of its sensible and reliable systems of government and operations would quickly abandon Cayman, fretting, quite reasonably, that the money in their bank account would be potentially frozen and unable to be transferred for their international businesses.

It’s a poor policy idea and one that would have horrible, entirely predictable, consequences for Cayman.

What’s a possible solution?

Better would be to evaluate whether there exists collusion or anti-competitive behaviour amongst the banks. Do they scheme to limit competition? Do they secretly avoid under-cutting each other to enhance their margins? I have no idea. Has anyone ever investigated? Does Cayman have a regulatory authority that has reviewed this? 

If the banks do operate in a quasi-cartel manner, then fixing that would lower mortgage rates and lower them in a safe and prudent way. If there isn’t such collusion, then perhaps Cayman needs to think how to introduce competition into its banking sector. Statutory setting of prices that private market enterprises can charge is hardly ever a good way to run an economy. Introduce choice and competition; ask a Silicon Valley fintech to set up shop. It’s easy, after all, to earn high deposit interest in competitive markets; liberalise the banking regulations to encourage competition. Don’t do the dumbest of dumb things with known disastrous consequences!

2. Import concessions

“Show me an import concession and I will show you a bribe” – a quote that’s attributed to no one, but entirely true. An import concession is a bribe in all but name. Very few individuals get them. They only ever go to companies and generally result in already wealthy people paying less for imports than poorer people.

The argument made is that ‘without an import concession, a company wouldn’t have built the luxury condo development in Cayman’. So what? Someone else would. Ordinary people build their own homes without any import concession. Why should low- and middle-income individuals be treated worse than wealthy developers? I can’t for one moment find one sensible reason.

Let me give you an analogy. When the Dallas Cowboys built their new (and amazing) stadium, the local city council paid $325 million in funding. They provided this funding despite the NFL being one of the most profitable football leagues in the world, and the Dallas Cowboys being one of their most profitable franchises. The owner of the Dallas Cowboys said, “We won’t build a new stadium in Dallas… we may move state”. Really? Were the Dallas Cowboys going to suddenly become the Oklahoma Cowboys? What utter nonsense. That’s an explicit bribe by the local city (at the expense of local taxpayers). Explicit because they paid $325 million.

But Cayman’s government giving developers $10 million of concessions is identical. It means that all of Cayman’s population must pay more for our food, our gasoline and our electricity because of taxes, than if the government hadn’t paid $10 million to a developer. Instead of paying the developer, government could have cut gasoline tax, or import duty on essential foods… but instead they bribe, sorry… offer a concession, to a developer. It’s a bonkers policy. 

Governments all over the world do it. But that doesn’t make it sensible. I challenge anyone who is in or has been in government to publicly give me a cast-iron example of when a ‘concession’ has been properly costed, analysed and shown to deliver benefits. They may try to persuade us by using a narrow field and show the new jobs created. But what if the funds were used for improved schooling, funding an academy to teach IT skills or trade training; that, too, would have had similar positive externalities. The problem with most analysis is that it never considers the opportunity cost. So, challenge stands. Prove me wrong or let’s call a spade a spade and a concession a bribe. 

3. Minimum wage increase

This is a topic that elicits huge emotion amongst protagonists and sometimes emotion amongst economists. Intriguingly, though, the evidence is often quite nuanced and not quite what economists’ models suggest. 

The concern is that by forcing wages higher you push up costs for companies, thereby causing others to demand higher wages, further pushing up costs, impacting profit margins and increasing inflation.

Cayman’s inflation rate is broadly a function of the US and global commodity prices. Cayman is a price-taker, with little ability to influence prices (since almost all consumer items are imported). Therefore, raising Cayman’s minimum wage – which hasn’t been increased since inception – probably won’t have a noticeable negative economic impact, and almost certainly won’t be materially inflationary (compared to factors beyond Cayman’s control).

The boost to spending from low-income persons (who typically spend a high proportion of their income), as well as the benefit to their standard of living, could be economically beneficial – a large amount of the extra wages is likely to be recycled back into the economy in the same or similar shops or enterprises that they currently work in.

Those employing minimum-wage persons will argue that their costs will go up. But they can easily pass those costs on to consumers. Assume, for the sake of this article, that Cayman has 2,000 people on minimum wage and it’s increased by $2 per hour. That’s an aggregate annual cost of $9.2 million to the economy. But there are 50,000 people in Cayman earning above minimum wage, so the cost, spread amongst those others is a paltry $185 per person per year. Imagine your annual grocery bill and cleaning costs rising $185 over the year. Set against the inflationary costs already suffered, it’s relatively trivial to most consumers but really important from a poverty-alleviation perspective. 

4. Rent control

First of all, it’s helpful to understand why politicians often clamour for this. Rent control keeps rents (of potential voters) lower than the market would normally price them, thereby, in theory, keeping them affordable for the average voter who will in turn reward the politician with their vote. A virtuous political circle!

Why, though, are rents so high in the first instance? 

It’s because of supply and demand; not enough supply to cater for the number of people looking for properties. Artificially capping the pricing mechanism should immediately seem quixotic. If there is a lack of supply on the market and the “solution” is to cap rents, then why would anyone risk building new rental units if they can’t rent them at economic rates (so that they can pay their mortgages, pay their fees, etc.)? 

Obviously, they won’t! Rent controls will actually prevent the very solution (new build) that will alleviate the problem. Typically, conversations about rent controls are associated with ‘NIMBYism’ (not in my back yard) whereby development is constrained by people complaining about higher-density developments in their neighbourhood. If politicians care about high rents, then they have to be brave in the face of such protestations.

The right solution to ‘excessive’ rental rates is zoning restriction changes and encouraging of multi-family and higher-density development. This will expand supply and reduce the imbalance which is causing prices to rise. Capping rates won’t permanently solve the problem. The problem may be painful and, in the short term, incredibly difficult for those suffering from paying high rents but imposing rental controls will only worsen the situation and lead to dorm/slum-style living as multiple families share the same property, leading to other perceived problems. Better to sort out zoning and development bottlenecks.

5. Vehicle import controls

This actually makes some sense. If the policy objective is to reduce pollution, then limiting the import of cars to newer cars may work. This is because pollution is reasonably correlated to the age of a car – newer cars being more fuel efficient and therefore less polluting per mile. However, I suspect most economists would prefer a slightly different version of the policy, which would be to identify the issue (emissions per mile) and then tax that. In other words, tax cars based on their emissions per mile with perhaps a fixed minimum import cost. This would benefit the environment more broadly, since those who import Hummers (for instance) would pay a much higher import tax due to emissions than simply due to the current retail price of the car.

Economists almost always think it’s better to use a targeted measure to achieve a policy measure than a blanket ban, since you can raise more revenue (thus reducing taxes elsewhere), and more persuasively achieve your policy goal. Banning certain older cars will achieve the policy goal but probably not as efficiently as a reworked and enhanced tax system would. 

Simon Cawdery, CFA, is an investment manager and governance professional who lives and works in the Cayman Islands. He writes regularly for the Compass on business and finance matters.