On interest rates

A lot of lamentations have been expressed about the high lending rates with figures pointing straight at financial intermediaries especially the lending institutions. Some voices are even advocating that we should retrieve ‘Control levers' to tame interest rates just like what Kenya did.  

For example, on page 10 of the New Vision of March 29, 2018, there was a shouting header: Minister tells SACCOS to lower interest rate.

And recently, Prof Nuwagaba laboured to explain the intricacies between Interest rates, Inflation and exchange rates (New Vision, March 26, 2018) but with no clear implementable policy prescriptions since it is after-all, an impossible trilemma. A similar situation arises in the case of the supply, demand and price (interest rate) of funds. Controlling one will automatically distort the remaining two, more so if they are at the mercies of free market forces.

It is a fact. Interest rates play an important role in an economy. Just as police traffic directs the flow of a city's traffic through a congested intersecting streets, interest rates channel the flow of funds from savers to borrowers. Interest rates are the signals that affect the channeling of funds to demanders or borrowers from suppliers or savers. Usually, this happens through a financial intermediaries such as banks, mutual funds and insurance companies.

A balance is struck between the demand for funds by borrowers and the supply of funds from savers by an ever-adjusting level of interest rates. Changes in the quantity of funds available to finance the spending plans of borrowers as well as changes in borrowers' demands for funds alter interest rates which, in turn, affect the levels of consumer and business spending and the level of prices.

The million dollar question: Is there really a magic formula for achieving the "right" level of interest rates for an economy, if such a level actually exists. To answer this question, we first need to unpack the behavior and interest of the key players in financial markets - the borrowers, savers and financial intermediaries - in order to understand how the interest rate levels are actually determined in practice.

The borrowers

Most of us are borrowers. We take on debt in various forms for a variety of reasons. Consumers, for example, borrow for short periods of time when they use credit cards instead of cash to make purchases. Households also borrow for periods of up to thirty years when financing purchases of houses. Business firms often incur debt when acquiring equipment or when modernizing or building factories. And, of course, governments borrow to cover the excess of their expenditures over their income from the collection of domestic revenues mainly taxes and other fees.

The savers

Typically, we save when the level of our income exceeds expenditures. Motivated to save by a variety of economic and non-economic factors, consumers hold their savings in traditional forms such as savings deposits at banks or thrift institutions and pension or retirement plans. Businesses and firms also save when they retain the profits remaining after business-related expenses, taxes and dividend payments to shareholders have been deducted from gross revenue.

Business retained earnings are often placed temporarily in bank deposits or used to purchase short-term securities until the funds are needed to finance expenditures such as the acquisition of new equipment. Unlike consumers, however, businesses generally borrow more than the amount they save.

Finally, governments may save if their cash receipts from taxes and fees usually exceed their expenditures. In most cases, governments net borrowers of funds in financial markets, with budget deficits being the rule rather than the exception.

The financial intermediaries

Financial intermediaries basically are dealers in financial claims or debt - their own and that of others. Their business is to transmit the flows of funds from those who have more funds to invest to those with a shortage who must pay for their use. Intermediation is a two-step process.

First, an intermediary, say a bank, obtains funds from savers in the form of deposits. In exchange, the bank issues a financial claim representing its obligation to repay the deposited funds or to transfer them to others at the depositor's request. Second, the bank uses the acquired funds to purchase the financial claims of others. Examples of these claims include loans to consumers and businesses, and government securities.

Intermediation provides savers with an outlet for their funds while simultaneously providing funds to borrowers to finance their spending plans. Dealing in debt and funds generally involves both the payment and receipt of interest. If the interest an intermediary earns on the funds it lends to borrowers is greater than what it has to pay to acquire funds from savers, a profit is earned for its intermediation. If, on the other hand, there is a negative spread or difference between what an intermediary receives from its borrowers and what it has to pay to attract funds from savers, the intermediary loses money.

Financial intermediaries generally obtain their funds from savers. However, they use funds to meet the borrowing needs of different sectors of the economy. While most intermediaries use a portion of their funds to lend to the government sector by purchasing government securities and bonds, some are more specialized in their lending. Thrift institutions, for example, use their funds primarily to acquire financial obligations of consumers, namely home mortgages and automobile loans. Pension funds and insurance companies, on the other hand, use much of their acquired funds to extend credit to business firms by purchasing corporate stocks and bonds.

Interest rates determination

Since interest rates and time are closely related, the expression that "time is money" is helpful in understanding the financial demand supply linkage and, in turn, the determination of interest rates. Assume there are only two individuals. Each earns income and pays taxes. One individual decides to spend less than his/her after-tax or disposable income, while the other would like to spend more than his disposable income. The second individual can accomplish his spending objective only if he can find a source of financing, either from his own resources or from those of others. Let's assume that the necessary financing takes the form of a loan directly from the first individual.

Normally, such a loan would be made only if the lender is reasonably assured of two things: one, that the amount borrowed, or the principal, will be repaid at the end of an agreed-upon period of time; and two, that the total amount the borrower promises to repay is greater than the principal, thereby compensating the lender for giving up the use of her money for an amount of time.

Even if there were little or no risk of the principal not being repaid, the lender would still require something in return from the borrower if she's to be coaxed into foregoing the use of some of her disposable income for current spending. While making the loan reduces her spending now, the receipt of interest from the borrower would enable her to increase her spending later on. A lender's requirement to be compensated, and a borrower's agreement to make that compensation, whenever money and financial claims change hands for a period of time, is what interest and interest rates are basically all about.

Risks and uncertainties

Both borrowing and lending typically involve a degree of risk and uncertainty which are reflected in the level of interest rates as well as in the tempo of activities in financial markets. Not being repaid, receiving only partial payment or receiving payment whose purchasing power has diminished are some examples of the risk and uncertainty surrounding financial activities. Since a borrower repays the principal and interest in money, inflation over the course of the loan will make the amount the lender receives worth less in terms of the goods and services money can buy.

Lenders typically estimate an expected rate of inflation and try to protect themselves against money's loss in value by requiring a premium related to that expectation. This premium, of course, is in addition to what lenders normally require as compensation for making loans.

The greater the inflationary expectations in the financial markets, the greater the premium borrowers would have to pay if they hope to obtain funding. Borrowers and lenders typically formulate their expectations of future inflation on the basis of their experience with past and present rates of inflation; other factors such as the outlook for fuel prices or monetary policy may also play a role.

A rise in prices and expectations of worsening inflation tend to drive up the general level of interest rates, while a slowing of inflation and an improvement in the inflationary outlook generally lead to a lower level of interest rates. Interest rates are also affected by the likelihood a borrower may fail to repay some or even all of a loan's principal and interest. This possibility of default may be related to a change in the financial health or condition of the borrower brought about by normal as well as unexpected swings in the overall level of economic activity.

A recession, or slowdown in economic activities, for example, could depress the earnings of a business, impairing its ability to repay its borrowings. While lenders aren't able to accurately predict the chances any single borrower may default on a financial obligation because of an economic slowdown, they are able to assess the overall creditworthiness of borrowers. In fact, private credit rating agencies provide a wealth of information on the credit histories and current financial health of borrowers.

Borrowers with a relatively unblemished repayment history and reasonably good prospects of future earnings from which borrowings will be repaid are given high credit ratings. Others with histories of repayment difficulties or who are borrowing for more speculative ventures are characterized as less creditworthy. While lenders are generally cautious in providing funds to those who are higher credit risks, some are willing to take the extra gamble if an interest premium is received in compensation.

In addition to their concern with the effects of inflation, lenders also want to know how taxes affect their interest earnings. Taxes, like inflation, reduce the value of income whether received as wages, profit or interest.

Conclusion

There are, indeed, a host of factors that feed into determining the general level of interest rates.

Interest rates change in response to the expectations borrowers and lenders have about the future level of prices. Changes in the foreign exchange rates or in interest rates abroad and, of course, the closely watched monetary policy actions taken by the Central Bank, all have a pronounced impact on the level of interest rates.

The level of interest rates affects and is affected by the overall condition of the economy. The supply of funds from savers represents the amount available to finance spending by borrowers. If the supply exceeds the demand for funds, interest rates will generally fall. But, if borrowers' demand for credit exceeds the available supply, interest rates will tend to rise. Changes in the quantity of funds and the rise and fall of interest rates, in turn, affect the condition of the economy. Likewise, changes in the economy, in turn, influence the activities in financial markets, namely the amount of funds demanded and supplied and the level of interest rates. It is a complex demand-supply equation and more so in a liberalized market regime.

In my view, before apportioning blame or failures in achieving the ‘right' interest rate we first need to listen from the three key players (savers, borrowers and intermediaries) and make the verdict.

The writer works with the National Planning Authority