Michael Klein
After 15 years of easy money, consumers are facing hefty interest rates on their debt. Since March 2022 the US Federal Reserve has hiked rates 10 consecutive times.
As Cayman banks pass on these interest rate changes to their customers, borrowing costs on island, especially mortgage payments, have risen considerably.
In some cases, to the point where, in combination with generally high inflation and cost of living increases, it causes great financial hardship.
Fears of looming foreclosures are growing.
As consumers, faced with a spike in debt servicing costs, our initial visceral reaction may be to ask why Cayman automatically adopts US interest rates at all and why local rates cannot just be lowered?
Cayman’s banks adjust interest rates in alignment with the US Federal Reserve’s rate decisions, because the exchange rate of the Cayman dollar to the US dollar is fixed.
This has helped mitigate potential imbalances in the financial system and ensured stability during all market cycles over the years.
To understand the consequences of setting lower interest rates for local banks than prevailing market rates in the United States, we first have to look at Cayman’s existing monetary system.
Cayman has a currency board, not a central bank
The Cayman Islands does not have a central bank that sets monetary policy and base rates for bank lending. Instead, it has a currency board that is part of the Cayman Islands Monetary Authority (CIMA).
A currency board is a monetary authority that ensures a fixed exchange rate with a foreign currency. Hong Kong is another well known example of a country that operates a currency board system.
CIMA issues the Cayman Islands dollar in exchange for US dollars at the fixed exchange rate to the US dollar of CI$1 = US$1.20.
It holds US dollars received in reserve in the US, thus fully backing all Cayman dollars in circulation. CIMA is therefore always able to exchange both currencies at the fixed rate.
In the first quarter of 2023, there were CI$157.8 million in circulation, and CIMA held CI$184.4 in reserve, mostly in external US dollar-denominated investments.
US economist Warren Coats, a former CIMA board member from 2003 to 2010, explained that Cayman is using the US dollar in almost the same way as a state in the United States, like Florida or Texas, would. The only difference is that rather than strictly using only US dollar notes that are printed in the US, the notes are substituted one by one for local currency. “But the monetary mechanism is the same,” he said.
CIMA does not determine how much Cayman currency to issue. Local market demand dictates that. Retail banks effectively buy Cayman dollars, in response to customer demand, and pay for it in US dollars, which are then held in reserve.
The result is that transactions, using Cayman currency, are virtually indistinguishable from transactions in the US dollar, which is also legal tender in Cayman.
For more than four decades, the advantage of the currency board regime for the Cayman Islands has been that it maintained a stable and predictable exchange rate with the currency that is economically most important to the islands.
By far most capital coming into the Cayman Islands is in US dollars, whether it is used to pay for financial services, tourism, real estate or other services and goods. Likewise, most imports to the Cayman Islands are paid for in US dollars, given that the US is Cayman’s main trading partner and goods imported from other countries are also frequently priced in US dollars.
The flipside of the currency board system is that Cayman had to give up monetary autonomy.
Cayman imports monetary policy from the US
In currency board regimes, interest rates are not set locally, but monetary policy is “imported” from the country whose currency is the counterpart of the fixed exchange rate regime.
In Cayman, local banks adjust their base lending rates in line with the US market rates. This is not stipulated by laws and regulations but rather market forces.
The Federal funds rate is the rate at which banks and credit unions lend reserve balances, held at the Fed, to other depositary institutions overnight. It sets a baseline for all kinds of lending rates to businesses and consumers.
The Federal funds rate is a key US monetary policy tool that increases or decreases the cost of borrowing and thereby encourages or discourages spending and investment in the US economy.
The inability to set one’s own interest rates can be problematic, if the two countries’ economic cycles are out of sync. For example, if Cayman was subject to an economic crisis, while the US economy is overheating, US monetary policy, which would likely entail higher interest rates, would be ill-suited to support the local economy, which would require a lower interest rate environment to stimulate borrowing and investment.
However, because of the close connection between the local and the US economy, that is rarely, if ever, the case. Even inflation in Cayman is tightly correlated to US inflation.
Thus, foregoing the ability to set interest rates independently has been a small price to pay, in exchange for a stable currency that in turn supported international trade and investment.
The problem with diverging interest rates
CIMA has regulatory power but it is not clear if it could tell banks at what interest rate to lend. In any case, Coats said, “that would be anathema to any free market economy.”
While having government step in to lower rates locally may be tempting, there are valid reasons to look elsewhere for solutions to address the high cost of living.
Firstly, setting interest rates is a crude measure that is not targeted at those households that need help the most.
Lowering interest rates across the board, even if it was possible in practice, would disproportionately benefit those, who have the largest mortgages and most sizeable loans: the wealthiest borrowers.
Demanding lower interest rates only for smaller mortgages would not fix the problem, because banks would simply stop offering them – the exact opposite of what this type of monetary policy is trying to achieve.
If local interest rates were uneconomical, banks would deploy their capital abroad and lend to borrowers in markets where interest rates are higher.
The Bankers Association confirmed this in a statement in June arguing that a departure from the current rate setting mechanism would create imbalances between the banks’ funding costs and borrowing rates.
“Such an imbalance could potentially result in banks deploying capital elsewhere and, as a consequence, access to credit locally could tighten,” the association said.
The trilemma
There are economic policy trade-offs that make it impossible for the Cayman Islands, or any other economy, to set its own interest rates and maintain a stable exchange rate without restricting the free flow of capital.
The macroeconomic theory behind this phenomenon is called the financial trilemma. It stipulates that countries must choose between the free mobility of capital, managing exchange rates and monetary autonomy. Because the three objectives are competing and mutually exclusive, at best two of the three can be achieved at any one time.
Specifically, if a country allows free capital mobility and wants monetary autonomy, it has to allow its currency to float, i.e. let the exchange rate with other currencies move freely.
If the exchange rate is fixed but the country is open to the free flow of capital across borders, it cannot set its own interest rates. This is the situation Cayman is in. It has pegged its currency to the US dollar and allows the unrestricted flow of capital in and out of Cayman.
If a country wants to have a stable exchange rate and set its own interest rates, it must restrict the free flow of capital. This is the situation Cayman would be in if it were to maintain a peg to the US dollar and set its own interest rates.
“If a bank or any financial agent in Cayman is required to charge an interest rate that is below the broader market for a specific maturity and level of risk, they will be perfectly free to do their lending elsewhere,” Coats said. “That would take currency out of Cayman with potentially unpleasant consequences.”
Capital flight would reduce the supply of Cayman dollars with negative effects for local borrowers unable to find loans at the artificially low interest rates. Consumers would face reduced imports and rising prices for imported goods.
The only option to protect the currency from such devaluation would be to restrict capital flows.
However, the free flow of capital is a basic requirement for an international financial centre and abandoning the former would mean the end of the latter.
These unpalatable alternatives to giving up monetary autonomy were already apparent in the early 1970s when the current system was adopted.
Since that time the Cayman financial services structure has worked well, the Bankers Association said. “It has proven to be robust and resilient, as reflected by Cayman having one of the strongest, most stable economies and financial services centres in the world.”
What can be done?
Coats, a former economist with the International Monetary Fund, says monetary policy decisions are simply the wrong lever to fix extreme financial hardship experienced by a group of local borrowers.
“The proper way for government to provide relief or help to a part of the population is through fiscal policy and the budget with tax-financed transfers. Not by changing the monetary system,” he said. “And in the case of currency board countries like Cayman, the capacity to do that doesn’t really exist.”
Fiscal measures could for example include properly funded government mortgage and mortgage-support schemes. The Cayman Islands Development Bank, for instance, has in the past offered below-prime mortgages to qualifying Caymanian property purchasers.
“That may be a good thing to do or not a good thing to do,” Coats said, “but it would be the appropriate way to address it through the government’s budget.”
Delinquency rates are still low
Banks have responded to rising rates by saying that they are already helping customers. The Cayman Islands Bankers Associations said banks have proactively offered fixed-rate loan options, which many customers had taken advantage of.
Banks had also continuously offered advice to customers such as strategies to pay down high-interest debts and improve financial management.
Cayman banks, the association said, always work closely with clients who are experiencing financial difficulty by exploring possible solutions and loan restructuring to provide support during challenging times. As a result, delinquency levels to date remained low and stable across the country.
Banks further agreed to a notification period of 30 days for any future interest rate increases.
