Let The Rates Tumble
“There is no difference where aims are concerned, between a terrorist with a gun and bombs in his hand and a terrorist who has dollars, euros and interest rates” Recep Tayyip Erdogan
The ordinary person on the street may not appreciate the importance of interest rates to day to day existence, or even their implication to the peace and security of a country. The following account of what happened in Turkey not too long ago, may help bring this matter into sharper focus. Mr. Recep Tayyip Erdogan, 64, a one time footballer, became President of Turkey in 2014, having served as Prime Minister from 2003 to 2014. He has invested massively in infrastructure, providing roads, airports and high speed train network, in the country. An attempt by the military to topple his government in 2016, failed and he responded with a very big stick, purging the military, clamping down on opposition and throwing so many people in jail. Not long ago, Erdogan reshuffled his cabinet, appointing his son in law as Economic Minister (sounds familiar, right?). The market responded with strong disapproval leading to a massive loss in the value of the local currency, Lira and the stock market. Mr. Erdogan in that famous quote above insists that an armed terrorist has the same intention with a foreign funds provider who must collect his principal with interest, irrespective of what happens to the borrower. He must have been referring to foreign lenders here and the jury is still out on whether he was right or wrong . Nevertheless, our intervention today is not necessarily on debt, but on interest rates on the local currency.
In a previous piece in this column, we had defined interest rates as the difference between money borrowed and money paid back in relation to the time the money was kept by the borrower. It is calculated in percentages over a period of time, usually one year or fractions thereof. In economics, there are various justifications for applying interest on funds. The first one is because of a concept known as the “time value of money”. Because money is what money can buy, what money can buy today, in most cases, is not what the same amount of money can buy tomorrow. Another term for this is “inflation”. In layman’s language, inflation defines the situation where what money can buy tomorrow is less than what that same amount of money could buy yesterday. To cushion the effect of inflation on the lender, interest rates are applied which ensures that the lender is not worse off than he was when he made the lending decision. Again, there is an inherent risk associated with lending. The risk is that the money may not be paid back either wholly or partially, for all sorts of reasons. To compensate for that risk, the lender will usually apply an interest charge to the funds being borrowed. The more the perceived risk, the higher the interest rate and vice versa. Closely related to risk is return. It is expected that the loan should have been efficiently deployed to make additional money over and above the loan amount, all things being equal. It is therefore, appropriate that the lender gets some part of the return not only to compensate him for parting with his money, but also to share in the prosperity created by the economic activity generated by the loan.
Beyond the simplistic uses of interest rates as highlighted above, there are more fundamental macroeconomic uses. Interest rates are central to influencing the direction of the economy as a major tool of monetary policy. They are also used to encourage or discourage savings, investments and consumption. Inflation management and foreign exchange management have a lot to do with interest rates. They influence borrowing and lending decisions as well as the stock market trading activities. The Central Bank, also known as the Reserve Bank in some countries, is the body that has the responsibility to manipulate or adjust interest rates to control money supply and set the direction of the economy along desired lines as highlighted above. The major challenge with this role is that the dependencies and variables in the economy can be likened to juggling balls in the air. Sometimes, in a bid to catch one of the balls, another one or two may slip through and drop. The major outcomes that most Central Banks grapple with are inflation, foreign exchange management, savings, consumption, lending and investment. Depending on the outcome the Central Bank wants to achieve, it would tinker with interest rates accordingly.
Theoretically, if the Central Bank wants to encourage Savings and Investment, it would increase interest rates. If it wants to reduce savings, it would reduce interest rates. When savings go up, consumption is reduced. If the Central Bank wants to encourage lending, it will reduce interest rates. If it increases interest rates then lending will reduce and vice versa. The more complex situation would be when the Central Bank wants to reduce inflation and at the same time increase spending. Reducing interest would increase spending but it will also push inflation up in the short run. This is the dilemma that a lot of Central Banks face. So some trade offs must be done at this stage. The Central bank must determine what its priority is. It must be willing to tolerate one set of outcomes over and above others.
It is on this basis that we want to once again look at interest rates in Nigeria. Exactly two years ago in July 2016, the Monetary Policy Committee (MPC) of the Central Bank Of Nigeria (CBN) moved the Monetary Policy Rate (MPR) up, from 12% to 14%. The MPR is the benchmark rate for the market, and the rate at which the CBN would lend to banks if they were to borrow from it. It is theoretically (and traditionally) the lowest rate that exists in the market. Virtually every other rate takes a cue from this rate. The CBN has continued to maintain the MPR at 14% in the last two years. One may then ask, why did the CBN keep the MPR at these high levels for such a length of time? Simply put, it wanted to discourage speculative attacks on the Naira and stop the exchange rate from spiraling out of control. Understandably, exchange rates had gone beyond the N500 per dollar mark at the parallel market on the back of dwindling oil prices and slow down in the growth of the economy and subsequently, recession. The second argument was that lower interest rates would worsen the inflationary situation and lead to even deeper economic crisis.
On the issue of foreign exchange rate management, we have always held the view that the greater problem lies in the attempt to fix rates and hold them “by fire, by force” at artificial predetermined levels. The argument of maintaining high interest rates to discourage borrowing for speculative attacks on the Naira is palpably flawed. We had contended that if in the minds of speculators, the rate of depreciation of the Naira will more than compensate for the high interest rates, they will continue to borrow to stockpile foreign currency, no matter where you take interest rates to. Besides, funding for foreign exchange speculation does not necessarily have to come from bank loans. It could be from disposal of assets including investment in the stock market, and savings. It therefore implies that keeping interest rates high in a bid to protect the naira may just be counter productive. Since 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 foreign exchange speculators. While we acknowledge that floating the currency may lead to temporary increase in exchange rates, we must also agree that it could lead to more inflow of foreign currency into the market and ultimately, exchange rates could come down and settle at more realistic levels than where they were in a controlled environment. Yet, another advantage is that exports will be encouraged as exporters will earn more from their foreign exchange while imports will be discouraged as they become more expensive locally. Finally, the government which today is the largest supplier of foreign exchange in the Nigerian market will earn more naira for its dollar and would be able to do more locally, both in terms of paying local debt and reducing its local currency borrowing. This, to my mind, is the only path to a more transparent market which would ensure that speculation gives way to long term stability and confidence.
Today, with MPR at 14%, there is no incentive for real players in the economy to borrow. There is hardly any legitimate business that can borrow at rates indexed to the MPR (and in some cases, borrowers are made to pay MPR x 2 which is 28% per annum) and return a profit. On the part of investors, rather than take risks in other markets, it makes more sense to keep the money in the bank or buy government instruments at rates hovering around MPR and go to bed, knowing fully well that their investment is risk free. To the commercial banks, there is no reason to extend facilities to business enterprises and individuals in the productive sectors of the economy. Why would they do that when there are government instruments that are risk free and which generate returns that are very close to the Monetary policy rates? Of course the banks know that when interest rates are very high, the chances of booking bad loans also become high. This is because the possibility of business failures is enhanced. Meanwhile, the high cost of administering the loan would still be factored in.
Again, on account of massive government borrowing, the local (private sector) borrowers are crowded out of the market. To the extent that there are appropriately priced government instruments available, as alternatives, lenders would naturally go for those instruments. With the MPR at 14%, pricing of such treasury bills and treasury certificates should be indexed to the reserve rate. At the end of the day, the private sector is the loser which ultimately translates to a collective loss for the entire economy. From a macroeconomic point of view, whenever the economy is experiencing a decline or slow growth, the solution is to stimulate such an economy. Stimulation of the economy can happen in different ways, but its effect is always to put more money into the economy. The policy that would get the economy out of the woods should therefore be an expansionary one. Anything that is done to tighten money supply would simply not work. High interest rate is not an expansionary policy. Like we had explained, when interest rates are high, savings increase and consumption is reduced. This is fatalistic for the economy as reduction in consumption means reduction in output of goods and services as such are geared towards consumption. Reduction in output leads to reduction in labour and other factors of production and ultimately results in lay-offs and shutdowns. When these happen, taxes are also affected and government revenue would go down and the only way the government could fund its consumption is by further borrowing, thus piling further pressure on interest rates.
The same effect would be noticed if the discussion is approached from the side of businesses. High interest rates discourage businesses from borrowing as their margins would be eroded by such loans. The converse is also true when rates go down. So to encourage businesses to borrow and increase economic activities that would generate employment and improve GDP, interest rates must be reasonably low. Keeping them high would keep businesses away from borrowing and deny the economy the needed growth.
Interest rates also 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. With low interest rates, investment in the stock market would increase. However, in a high interest rate regime, investments in the stock market 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 stock, again subject to other alternative options open to him.
Except if someone can demonstrate to us that the above analysis is wrong, we are persuaded that the way to go is to let interest rates tumble now in order to stimulate this economy and begin to experience reasonable growth. Yes, we have got out of recession and the economy has started growing again, but the quantum of growth which by the way has been declining in the last three quarters, is still minuscule at an average rate of about 2% per quarter. Dissecting the numbers would also show that the major driver is crude oil with the recovery in price. I will conclude with this witty quote by George Washington thus “the worry is the interest rate paid by those who borrow trouble”