Out of interest - JSE MAGAZINE

Out of interest

SA will not remain unaffected by the global experimentation with rates

Out of interest

The world is entering an era of ultra-low and even negative interest rates and, in the process, the basic principles of investment are being upended. What does this mean for SA investors? Does it even matter? After all, inflation is sitting at 4.5% officially and in September the SA Reserve Bank held its key lending rate steady at 6.5%, which means that the prime lending rate for consumers hovers around 10%.

SA’s relatively high nominal interest rate also means that cash assets are yielding returns above inflation, which is good for investors and savers. So at first glance the rest of the world’s experiment with negative rates is not our problem. That said, ours is a small open economy that needs to sell goods and services to the rest of the world. If the rest of the world is not growing, our economy will suffer. And there are reasons to be concerned that the negative interest rate policy will backfire. Negative interest rates popped up first in countries where the savings rate was exceptionally high, higher than the rate of capital formation. First it was Japan, then Denmark, Hungary, Norway, Sweden and Switzerland followed suit.

In September the European Central Bank joined in and cut its interest rate by 10 basis points to a record low of -0.5% and also ordered a new round of quantitative easing ($20 billion in bond purchases and other financial assets) in November. The theory is that if you make it costly for banks to hold their excess reserves with central banks, they will instead lend it out to companies and consumers, and in the process stimulate economic growth.

This is not the case in the US, where negative interest rates have never been a serious possibility. The Fed did lower rates to 2.25% in July, the first cut since 16 December 2008, and followed this with another quarter of a point cut on 18 September. At the time, Fed chairman Jerome Powell said that a weakening US economy could require a ‘more extensive sequence’ of rate cuts. But, he added: ‘I don’t think we’d be looking at using negative rates. I just don’t think those will be at the top of our list.’

The negative rates environment will benefit anyone who holds debt or uses debt as leverage, including countries, companies and bond holders, since the cost of servicing that debt has dropped. On the flip side, low and negative interest rates are bad for savers, particularly pensioners and retirees who are trying to generate enough income from their assets to meet their liabilities through lower volatility bonds. They are forced to invest in increasingly risky assets that are more volatile to achieve their goals.

New research from the University of Bath suggests that lower rates are also bad for banks and banking profitability. ‘If bank margins are compressed due to low long-term yields, and if there is limited loan growth, then bank profits will fall accordingly,’ says Ru Xie of the university’s School of Management. ‘The decline in profits can erode bank capital bases and hitherto further limit credit growth, thus stifling any positive impact on domestic demand from negative interest rate policy monetary transmission effects.’

Banks are vital cogs in a modern economy. So if something is bad for banks, by extension, it has the potential to harm the real economy that relies on banks to provide the financial infrastructure so the economy can function. ‘In the long run, negative rates ruin the financial system,’ Deutsche Bank CEO Christian Sewing said recently, according to Bloomberg.

Aside from the impact on the financial system, negative interest rates have another consequence: they distort the pricing of risk. Risk is priced via the cost of capital. If capital is invested in a risky enterprise, investors demand a larger return to compensate them for that (SA and other emerging-market bonds being a case in point). The cost of capital for the risky enterprise is higher. The reverse also applies – if capital is invested in a low-risk activity, the return for the investor and the cost of capital is also lower – it’s one of the most elemental factors in economic decision-making. But if some central banks push interest rates below zero, then pricing risk becomes more difficult.

The bottom line is that no one really knows how this will end up since we’ve never seen it before, and there is very little research to suggest it is working. It may be that far from stimulating demand, the actions of these central banks will fuel more uncertainty, which decreases economic activity and growth. This doesn’t bode well.

By Sasha Planting
Image: Hanlie Huisamen