Let’s Discuss Interest Rates

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OUTSIDE THE BOX By Alex Otti  alex.otti@thisdaylive.com

Interest rate is a very important subject in economics. Its origin dates back to the medieval times and it is almost as old as money and exchange. Economic history has it that in the olden days, merchants would keep gold, which is today represented by money, with goldsmiths who would charge the owner of the gold for safe keeping. This was started in England several centuries ago.

As time went on, the goldsmiths stopped charging merchants and instead started paying to keep gold in safe custody for them. This transformation became necessary because goldsmiths realised that they didn’t just have to lock up the gold in their safes but gave same out as loans to those who required them to do business from whom they charged fees. These fees, they shared with owners of the gold. That marked the advent of modern banking.

In a loan situation, interest is the difference between money borrowed and money paid back in relation to the time the money was kept by the borrower. It is usually calculated in percentages over a period of time, usually one year or fractions thereof. If for instance, I borrowed N100 from you and one year after, I paid back N110, the additional N10 paid is the interest and the rate would be10% per annum.

In strict terms, interests are justified for two main reasons. One, because of what economists refer to as the “time value of money”, the N100 I borrowed from you would not buy what it could have bought a year ago when you lent it to me. So, it is important to cushion the effect of inflation. Second, it is expected that the N100 I borrowed from you should have been profitably used to make additional money over and above the original loan amount. It is therefore, only fair that you get some part of the profit I made not only to compensate you for parting with your money for that period of time, but also for you to share in the prosperity created by combining your money with my effort to bake a bigger cake.

In modern times, however, interest rates have been used in more ways than described above. They are used to influence the direction of the economy as a major tool of monetary policy. They are also used to encourage or discourage savings, investments and consumption. They are used in foreign exchange management as well as inflation. They also influence borrowing and the stock market trading activities. We shall examine these and more in turn. The whole idea of this intervention is to help our understanding of the concept of interest rates as a tool in managing economic desiderata in the nation while at the same time deepening debate of this important subject as we struggle to stabilize our challenged economy.

The relationship between interest rates and savings is a direct or linear one. Under normal circumstances, when interest rates go up, savings would go up. Because of the relationship between savings and consumption, when savings go up, consumption would reduce. This is simple because in economics, income is either saved or consumed. The incentive to save is discouraged when interest rates are low. The reverse is also correct such that when interest rates are high, people would rather save than spend.

Interest rates affect borrowing by individuals and firms. If interest rates are high, the tendency is for businesses to stay away from loans. When loans are cheap, the incentive to borrow is higher because businesses would be able to return the loan, the interest and keep reasonable margins for themselves. This fundamental principle also affects the bond and stock market, be they public or corporate. With low interest rates, investment in bonds and stocks would increase. However, in a high interest rate regime, investments in bonds and stocks would reduce. The only exception is where the change in interest rates is outweighed by the rate of change of the price of bonds. For instance, if interest rate increase is lower than the rate of change in stock prices such that healthy margins still exist, then it would still be profitable for the investor to borrow and invest in the bond, again subject to other alternative options open to him.

Interest rates have a very interesting effect on inflation. This is because inflation erodes the purchasing power of the populace. It is defined as the rise in the general price level of goods and services over a period of time. Strictly speaking, an inflation rate of 10% means that the worth of N100 in your hands over the same period of measurement is N90. So, to adjust for inflation, economists talk of real value as distinct from nominal value. While the former refers to inflation-adjusted value, the latter speaks to the absolute unadjusted value.

In the example we gave about my borrowing N100 from you, the N10 would mean a nominal interest rate of 10%. If within the year, inflation rate was 3%, (and note that this is for purposes of this discussion as we all know where inflation rate is today), then the real interest rate would be 10% minus 3% which would be 7%. In reality therefore, if interest rate is set anywhere less than 3%, we will be dealing with negative real interest rate. Assuming that we are dealing with a rational and well informed lender, he would not lend the money to me at any rate less than 3% as he would be losing money. You will, however, notice that some information may not be at the disposal of the lender at the time of making the lending decision. At best, he would make projections, if he is very savvy.

This is a major problem with fixing interest rates while looking at inflation figures. Another major issue has to do with investment or savings options available to the individual. Banks would tell you that majority of savers are not interest rate-sensitive. This is because of a whole lot of factors, ranging from leaving balances in accounts for transactions through comfort /habit to switching costs and loyalty. It is therefore understandable if savers and investors do not withdraw their money after National Bureau of Statistics had published that inflation rate had gone up to 18.3% by the end of October 2016. Meanwhile, they are getting much less than that from their savings in their banks. If you decide to tweak your rates to adjust to the inflation rate, you may not get commensurate reaction from that action.

This is, however, not true of borrowers particularly businesses as the impact of an upward adjustment in rates is immediately felt in the bottom-line. Besides, an immediate and commensurate adjustment in the prices of the products may be met with resistance by the consumers as they also reel from the negative effects of inflation. Typically, businesses react to adverse changes in interest rates in ways that further hurt the economy. They start with cutting costs and the first casualties are usually labour and over heads, which will in turn lead to reduction in output and capacity utilisation and in extreme cases, shutdowns and closures. I’m confident we are very familiar with these in the recent times.

These actions lead to worsening unemployment, reduction in consumption, reduction in government revenue as unemployed people and closed companies would be taken out of the tax net and finally, more social tension and crime. Meanwhile, whatever the closed companies were producing would be replaced by alternatives mostly imported. This is true given that the cost structure of most firms in the same industry are similar. As this is done, more pressure is put on the scarce foreign exchange and the production plants abroad are kept open and active with more jobs being created as a result of increased demand.

On another note, a high interest rate regime, engenders poor loan quality in the banking industry. This is because borrowers are brought under pressure and many end up defaulting. Usually, banks are wary of lending under this regime for fear of creating bad loans. Besides, the banks are able to invest their loanable funds in government securities and bonds which today attract interest rates in the region of 18% pa and above. If government pays over 18% for risk free instruments, most banks would see no incentive in lending to businesses at higher rates, given the risk associated with such loans with a possibility of total default and eventual write-off of both principal and interest.

The last point I want to address is the foreign exchange market. Theoretically, a high interest rate regime would discourage foreign exchange speculation. This sounds logical because if interest rates are low, people will borrow from the banks and launch speculative attacks on the dollar for profit in due course when exchange rates would have deteriorated further against the local currency. When the value of the local currency becomes weaker, they would open their vaults and release the stockpiled foreign currency and make super profit after paying the low interest charged by the bank.

This argument is only sound in theory as there are a lot of other variables that determine how speculators behave. The first major factor is not interest rate. It is the behaviour of exchange rate and their sense of where those rates are going to be in the future. So, the issue is not interest rate, but the foreign exchange management policy. I had argued in the past that if in the minds of speculators, the degree of depreciation of the foreign currency will more than compensate for the high interest rates, they will continue to borrow to stockpile dollar, no matter where you take interest rates to. Again, funding for speculative attacks is not limited to loans from banks. It could be from disposal of assets including investment in the stock market, savings and other sources. So, keeping interest rates high in a bid to protect the naira is very unlikely to serve the purpose intended.

Given that we are aware that we do not have all the foreign exchange we require, it would be wise to stop the attempt at fixing the rates and holding them at predetermined levels. Doing that is the greatest incentive to speculators. Yes, floating the currency may lead to temporary increase in exchange rates, but it will also lead to more inflow of foreign currency into the market and ultimately, exchange rates will come down and settle at more realistic levels than where they were in a controlled environment. The CBN will reserve its right to intervene from time to time by selling or buying dollars in the market to help stabilize exchange rates. The market will be seen as more transparent and speculation will give way to confidence.

Before I conclude, I must mention the role of the regulatory authorities, in this case, the CBN in determining the direction of interest rates. This role is played by other reserve banks in virtually all the countries of the world. The Monetary Policy Committee of the CBN meets every other month to set the benchmark rates called monetary policy rate (MPR). This is the rate CBN lends to commercial banks upon which market rates are based. In the last couple of months, our MPR has been set at 14%. Interestingly, a global comparison of reserve rates is published periodically by the US Federal Reserve and recent data can be found in www.tradingeconomics.com.

Amongst other revelations, most underdeveloped countries are amongst the countries with highest policy rates. Ghana came first with a policy rate of 25.5%; followed by Argentina, 24.75%; Malawi, 24%; Mozambique, 23.25%. Nigeria is 18th with our policy rate of 14%. As you approach the lower end, countries like Austria, Belgium, Luxembourg, Spain, and France show up with policy rates of 0%. Yes 0% interest rates. Japan, Sweden, Denmark, and Switzerland have negative policy rates of -0.10%, -0.50%, -0.65%, and -0.75% respectively. Note that USA and UK have policy rates of 0.75% and 0.25% respectively. Could this have anything to do with the management of these economies or is it sheer coincidence? Well, ladies and gentlemen, as I wish you a prosperous 2017, I will make one request: Let the discussion continue.