Martin Owiny
14 October 2007
column
Interest rates play an important part in a market economy. They reward savers for capital, while they help allocate resources to borrowers.
Banks and other financial institutions play an important intermediary role in pooling together the funds from individuals and companies, and then allocating these funds to individuals and firms wishing to borrow.
Writers often talk about "the interest rate", but a glance at a financial newspaper would confirm - there are a bewildering number of rates in modern financial systems. As a borrower, there is "prime rate", the interest rate a bank charges low risk borrowers.
A wealthy individual may get a small mortgage on his/her expensive house at "prime minus 1%". The rate charged on more risky credit card debt may be prime plus 5%.
Interest rates differ in relation to: Term or maturity - the length of time before the loan needs to be paid off; Risk - investors need to be paid a higher premium in lending funds to more speculative activities; Liquidity - the more liquid a bond is, the lower the interest rate; and Administrative costs - the higher these costs are, the more the interest rate charged.
Economists distinguish real versus nominal interest rates. The nominal interest rate measures the yield in our currency per year per invested. The real interest rate is corrected for inflation: hence a nominal 10% return is, at a time of 8% inflation, a real return of 2%.
Savers generally get a rate of interest below that at which banks lend money. This margin, along with their other charges, is what banks use to generate their revenue. When tax on interest and inflation is taken into account, in many instances, the return to investors is negative. In other words, in constant price terms, the original stake, plus the post-tax interest, is worth less than the original stake.
Interest rates come in a host of guises. The shorter the period, the lower interest rates generally are. This is because lenders need to be compensated for locking up their funds for longer periods.
Why do interest rates in a particular country go up or down? There are several reasons for this: official policy (i.e. monetary policy); economic factors; global events.
Monetary policy
The setter of monetary policy is usually a country's central bank. Central Banks may try to maintain positive real interest rates. What this means is that the raft of rates is above that of inflation.
Positive rates are in the context of attempting to get inflation low, and to keep it there. More active interest rate policy is no longer thought to be able to encourage growth. In fact, more stable, and lower, real and nominal interest rates - which is thought to be more kind to investment and thus economic growth. The most important tool for influencing the raft of interest rates in the economy is the repo rate, that is the rate at which the central bank lends money too.
Assuming inflationary pressures are on the rise - or are expected to rise - then the monetary authorities are likely to push up interest rates. Monetary policy is considered to work with a lag of around 18 months on the real economy. If government spending is rising rapidly, the central bank is likely to raise rates.
Economic factors
Many economic factors influence interest rates. Inflation has an effect on nominal rates. If a country has a low savings rate, then interest rates are likely to be higher. If investment spending rises - for example because of new mining ventures - then interest rates will rise. If government revenues rise faster than spending, then rates are likely to decline, on the other hand. If consumers become fearful about job security, this should boost savings - and lead to lower interest rates.
What does this mean for you? Both borrowers and lenders would like to be able to predict which way rates are likely to go. This is because with fixed period rates, one can lock in a benefit in relation to the floating rates. Say the mortgage rate is currently 15%, with banks offering a fixed two - year option at 16%. If the home-owner feels that rates may go up 2% within six months, it may be worth fixing the rate now. (In economic theory, there is also a premium to be paid for certainty: i.e. fixed rates should be higher than the current floating rates).
Lenders, on the other hand, should in such circumstances keep their funds liquid - i.e. concentrate on the shorter end of the curve. This is so that when rates do rise, once they perceive rates to be near their peak, they can lock in savings at the highest rate for the longest possible time. Both savers and borrowers have an incentive to have interest rates less volatile. More stable rates allow people to make more rational economic decisions. Savers can plan how much needs to be saved for retirement planning; home buyers can more reasonably plan what house they can afford.
To those paying them, interest rates are painful, and should be lower. To those receiving interest income, the rates are often perceived to be too low, and a rise would be in order. What the economy requires, for sound, sustained growth, would be relatively stable rates, that are positive in real terms - but not exorbitantly so.
Monetary authorities have to keep an eye on exchange rates, government spending and taxation policies, and the growth potential of an economy - and crucially the expected path of inflation - in steering interest rates. It is often a thankless task, since the ordinary person in the street often finds it difficult to understand the full rationale for decisions. But an appropriate interest rate policy is crucial for a country's long-term economic health.
(*) Mr Owiny is general manager, Stanbic Investment Uganda Ltd, and chairman, Investment Management Association of Uganda
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