A few months ago, I explained how inflation
was a natural occurrence of our modern economies, just as our own inflation
started to skyrocket. The time has come once again to revisit that topic, as our
inflation woes have only worsened, and our economic situation has become more
precarious as well. With our GDP growth turning negative in the second quarter,
and our government expecting overall growth to slow to 2.5%, it is time to examine
our options.
Inflation can be defined, inter alia, as
the rate as which money loses value. If the inflation rate is at 5%, for
example, that means N$ 100 of goods this year, will cost N$ 105 next year. It
means your money will lose 5% of its value every year – a frightening prospect!
If you thus want to save, you need to to get a return, or interest rate on your
savings, of at least 5% just to break even. This means that the interest rate
as quoted by the banks, are simply what is known as a nominal interest rate.
The real interest rate is the nominal interest rate minus the inflation rate.
To build capital you thus need a positive
(above zero) real interest rate. This is also true for investment in a
business. When investing in a business, you expect a return – a return on
investment. But similar to interest rates, this needs to be adjusted for
inflation as well, to get the real return on investment. For a business this
return is generally reflected in its profits after tax.
But businesses need capital, and this is
generally procured either via direct investment in a business (also known as
equity investment) or via debt, or loans. Since equity investors get partial
control of a business depending on their investment, and share in the profits,
it is generally the most expensive, since the business owner will have to give
up a certain percentage of her profits. Businesses therefore tend to approach
banks for loans.
Where do banks get the money to advance
loans? Why, they get it from you! The depositor who is saving money at the
bank! In order to pay you your interest, they in turn give loans at a higher
interest rate to businesses and individuals than what they pay you, and use the
difference to cover their expenses. Obviously they cannot lend it ALL out –
after all, when you want your money, you’ll not be happy if told that it is in
the hands of XYZ corporation that has not repaid its loan yet.
Generally, however, a lot of money gets
saved each day, a lot of loans are repaid each day, and a certain percentage of
savings are untouched. So the bank aims to keep a certain percentage of capital
in reserve, to pay out should money be withdrawn. Per Bank of Namibia
regulations, they need to keep at least a minimum percentage, but they are free
to keep more. Unfortunately, they don’t earn any interest on funds in reserve,
so they generally keep close to it.
So what happens when a bank experiences an
imbalance, and needs more cash to keeps its reserve intact? They lend from the
central bank, as I’ve explained in a previous Theory of Interest. These funds,
however, are not for free. They borrow from the Bank of Namibia at the Repo
Rate. Thus, the repo rate is the anchor, the benchmark, by which banks set
their interest rates.
If the repo rate is lowered, then banks
have some breathing room. They can advance loans at lower rates – and those who
have to repay them, businesses and individuals, have a lower repayment amount.
For individuals, this means more money to spend at the various businesses in
the economy, enhancing their profits. For businesses, this means their real rate
of return goes up, as their profits increase due to lower interest costs. Thus,
as the interest rates goes down, the economy is stimulated. Growth increases.
Conversely, when the repo rate goes up, the
opposite happens. Loans need to have higher rates – meaning businesses have
lower profits, and individuals have less to spend. With higher rates,
businesses need to have higher real rates of return to be able to qualify for
loans, while their current loans decrease their profits and rates of return. Economic
growth thus slows.
Central banks, however, are not in charge
of economic growth – they are in charge of monetary stability. In other words,
they need to keep inflation in check. As I’ve previously covered, inflation
occurs when economic spending (creating new money by issuing debt) outpaces
economic growth. And so, the natural reaction when faced with increasing
inflation is for the central bank to increase interest rates, so as to reduce
spending (or reducing the money in circulation).
It is thus clear that the Bank of Namibia
is in a bit of a bind. With our economic growth currently slowing due to
external factors, the last thing our economy needs is the additional pressure
an interest rate increase would put on it. But our inflation keeps slipping upwards.
Our Repo Rate is currently at 7%, with inflation at 7.3%. This presents an
additional problem for inflation targeting, as the banks can effectively
utilize their facilities at the reserve bank to borrow at less than inflation –
effectively making money in a real sense every time they borrow, since the
money they pay back has lost 7.3% of its value, while they only had to pay back
7%.
The Bank of Namibia’s next Monetary Policy
Committee meeting will be on the 7th of December, and we should be
monitoring their repo rate decision with all the attention it deserves. Will
they take the view that our current inflation is simply lagging behind their
previous rate increases, and will drop soon – and thus keep the repo rate as
is? If they are wrong, inflation could spiral out of control. Will they take
action to keep the repo rate above inflation, and put more pressure on the
economy? If they do, will that put a damper on our potential economic recovery
next year? We’ll know on the 7th of December – and then we’ll have
an idea of what 2017 could have in store for us.
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