Why BOZ should reintroduce interest rate capping

However, with an expansionary monetary policy, interest rates started to ease - though at a slow transmission pace to the economy. Below is term structure of Kwacha interest rates that show a decline or rather a downward shift in the yield curve from treasury bills elevated at (19% -21%) and bonds above 25% as at 31 December 2016 to treasury bills now paying (9% - 17%) and bonds within a 17%-19% bracket.

See graph below:

The graph below also shows the monetary policy easing versus widening of credit spreads between 828bps to 1,916bps manifesting in rising average lending rates to 29.4% a trend inversely related to a decline in benchmark lending rates. The market is still stressed and this is the reason NPLs have swelled to breach the prudential limit of 10%.

One would expect that with the benchmark lending rate decreasing, the average lending rates would correlate positively but this has not been the case. What we observe in a 20 commercial bank industry is more of an inverse proportional relationship between average lending rates and the monetary policy rate. (Lending rate = Monetary Policy Rate plus credit spread reflecting level of risk of client). Ideally with more liquidity in the system our analysts expected to see a corresponding rise in interest income line especially from loans and advances but interestingly, these lines declined by between 8.5% to 23% breakdown being SBZ- 22.9%, BBZ-19.5%, SCB – 8.51% and ZCB – 5.2%. See histogram below for trend.

Where did the liquidity go?

A look at the securities income line for most banks in the industry show a general rise in securities revenue from investments in government securities. Suffice to say the commercial banks appetite for government debt rose significantly due to the structure of the Kwacha yield curve.

See histogram below:

According to the quarterly financial statements published in the press, Zanaco had the highest securities income of ZMW405million (121% increase from ZMW183million) followed by Standard Chartered with ZMW399million (50% increase from ZMW265million). Stanbic earned ZMW357million (191% rise from zmw123million) and Barclays ZMW345million (181% increase from ZMW123million). Clearly the FY2017 reports show a ( YoY) increase in the interest income line from investment in bills and bonds by significant quantum.

We can make inference and conclude that the excess liquidity from relaxation of statutory reserves were locked up in government securities to earn commercial banks interest income in two ways; the split for whose financial classification which we don’t have a breakdown for. However, this income was booked on the banking and trading book lines.

Some commercial banks could have taken a view on compression of the yield curve in Q4: 2016 and then lengthened duration on trading and banking books for mark to market purposes in what we call interest rate trading. Interest rate trading involves taking positions in discount instrument to leverage of pricing of the yield curve for trading income purposes. When this happens on the banking book the income goes to an equity reserve account. We call it an equity reserve account because capital amounts are locked up in government security as part of prudential requirements which then appreciate or depreciate depending on direction of yield rates on government securities. The easiest way to make money on duration is buying assets when interest rates are highest in anticipation that they will fall the existing positions will then be marked to market with gains posted to income statements. Most treasury departments with good interest rate traders make their money easily this route. Clearly the Zambian yield curve compressed in the one-year period proving opportunity for most players.

“Attractiveness of the Kwacha yield curve is the sole causer of crowding out effect as banks face lesser risk locking their liquidity in risk free assets that lending at a time when average lending rates and defaults rates are fairly high in the industry.”

Business Times Lead Analyst

Other players could have locked in paper on their banking books when the curve was elevated this then allowed the commercial banks earn interest income. What makes it difficult to analyze is the split between trading and banking classification which most commercial banks mix in one bucket dubbed interest income.

Market Note

We have used (4) banks as a representative sample to generalize results to the entire 20 bank industry as these account for over 60% both in profitability and bank balances held with the bank of Zambia.

What stands out in this analysis of the big for banks is that, in the year 2017 the loan and advances line slowed marginally ( YoY) giving an opportunity for securities income line to significantly to rise in an era of expansionary monetary policy. This was embarked on in a move where the Ministry of Finance wanted to stimulate private sector growth which halved in 2016 to 3.22% compared to 6.7% in good years. Tightening monetary policy in December 2015 was a move aimed at aligning fiscal dislocation with monetary policy. Relaxation of monetary policy by slashing the policy rate and easing the statutory reserve ratio was to signal the intimacy between fiscal and monetary policy after the currency slide had been curbed, inflation was arrested to single digit and government was working towards fiscal consolidation as prescribed by the authorities. Commercial banks still grappled with expensive cost of deposits which made it difficult to lend at expected lower rates at a time when default rates were high in the industry breaching the 10% prudential limit at 12.4%. With excess liquidity after the SRR was relaxed, banks immediate opportunity was to invest in government securities which is vivid in the financial statements for FY2017 depicting the performance of the commercial banking industry. What makes it even worse is that in the 2016 budget the Minister of Finance pronounced that government would finance more of its needs with domestic debt as opposed to contracting international foreign denominated debt. Last year December the Bank of Zambia announced an increase in auction size of bonds by 65% to ZMW1.65billion. The signal this move has sent to the market is that there’s a rise in government appetite for debt to fund most of its needs especially that IMF talks stalled. This move could further force yields higher and make it very attractive for banks to lock in liquidity and further crowd out the market at the expense of domestic lending. If this happens then Zambia’s growth will be at risk.

“The Zambian yield curve compressed an average of 795bps on the short end – treasury bills and 626bps on the long end – bonds. Those that took long positions in government paper in carry trades made their money.” Business Times Lead Analyst