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Friday, December 1, 2006
Blunt instrument

Monetary policy has so far clouted consumers with three interest rate hikes, up 0,5 percentage basis points each time: 8th June, 3rd August and 13th October this year.

The reason given for the increase in the ‘Repo’ rate (see footnote) is that strong household consumption expenditure, supported by higher asset prices and increased credit extension to the private sector remains one of the primary risk factors that threaten higher inflation, and may cause a worsening trade deficit.
There are various assumptions here, including that a trade deficit is bad for the economy — I don’t think the Americans will agree with us there; talking of which it took that country 17 interest rate hikes to start cooling credit demand there. But the negative side to this, as one commentator observed, was that, “The US economy appears to be losing momentum.”
So is monetary policy in South Africa intent on doing the same thing? And if so, is it a good idea? What would happen if the interest rate policy – to increase Reserve Bank Repo rate in order to make borrowing more expensive – were ‘successful’; that is, achieved its aims of reducing consumer spending?
Under this scenario, people will spend less, if only because their bond repayments have increased in line with the 1,5% overall rate increase. There is also the fear factor of more to come. Following the US example, the economy will ‘lose momentum’, and with less spending the retail sector will make less profits, and share prices (and dividends) will fall. Investors, and especially savers in retirement, could lose out.
Because the shops need less goods, there might be less imports (good for the rand?), but there will also be less demande for locally manufactured goods and that will tend to increase unemployment. I hope that those who lose their jobs will not have loans on credit cards or retail shopping cards to repay (unlikely).
Closing the door after the horse has bolted (by increasing rates on loans already taken out) changes the price of an existing debt. It is rather like coming and knocking on your door and saying, ‘Oh, by the way, that lounge suite you bought last year has gone up in price; you owe us more money.’
Screwing around with interest rates like this is, in my view, immoral. By all means increase the price of new loans, but for existing debt it doesn’t seem fair, and doesn’t make sense. Such moves will create distressed loans.

Reduced economic activity hampers the ability of individuals to service their existing debt. Higher debt repayments will put borrowers under increasing pressure; some may even resort to borrowing more to cover the shortfall in monthly budgets.
Will this lead to higher bank repossessions? Higher rates will also make existing houses less affordable. These two factors will affect the supply/demand balance of housing.
For example, a property worth R1,5m when the bond rate is 9,5% is only worth R1,4m when the rate is 11,5%. This is because the arbitrating factor in the value of a property is the monthly cost of the repayment, not the asset value. If house prices fall in real terms, equity values will be squeezed and banks may see their security value narrowing. This could add to further pressure on bond debt. Those nearing the end of their working life, who wish to trade down to a smaller more secure duplex, or move to the coast or to a retirement village, may have to reduce the selling price of their home. So much for their savings.
If bank lending comes under pressure, the sector will make fewer profits, exacerbated by increased bad debts. Banks will join the retail sector in lower share values and lower dividends.
A bleak scenario; not that this will necessarily happen — but it does question the received opinion that higher interest rates are good for an economy.
In addition, we have not begun to talk about the effects of higher interest rates on capital expenditure and plans to expand manufacturing capacity.
As it is a lack of sufficient local production arises from a lack of capital investment; partly caused by restrictive immigration policies, a shortage of skills, and a loss of skills to overseas. One reason we need high levels of imports to support growth. It’s a bit of a mess.
Higher interest rates are supposed (eventually) to reduce debt; the process of doing this in theory means consumers would spend less. However, this also assumes the debt is ‘elastic’, that is to say fairly easy to repay by a change in spending habits.
Instead, it would be fair to suggest that a great deal of the debt is inelastic; incurred by the need to purchase essentials.
It is almost impossible to change spending habits when it comes to food, transport, education, security and healthcare. Significantly, the last four in particular are supposed to be government’s job to sort out – which it isn’t doing (see box). It is precisely because these cost centres are vital that their prices are going up faster than the rate of inflation. The annual agricultural and producer food price has gone up 23% for example; school fees are rising by between 10% and 17% for 2007. The major private hospitals are raising prices by between 7,9% and 16,9%.
Nor can people buy less fuel, otherwise, how will they get to work? Petrol has risen a net 50 cents approximately since January this year. It is around R5,75 now (let’s not forget it was R3,73 this time in 2003, just three years ago, an overall 53% increase. Haven’t consumers been clouted enough?
By the same token they cannot cut down on health care since no-one has yet developed immortality. One is left with the question, how much debt sitting in access bonds arose from healthcare, security and education costs? If you need an alarm system to protect your home and family, do you have a choice? Have people ‘paid’ their school fees, or were they funded from loans carried forward from, say, 2003, 2004 and so on? I am sure plenty of alarm systems, electric fencing installations and insurance costs are spread through using the homeowner’s access bond.

Non-durable and semi-durable goods are discretionary. But to what extent would reduced spending on furniture and DVD players cut down the rate of inflation? Electronic goods, at least, come down in price every year. What people can cut down on – and do – is giving to the church and other charities; or no longer employing a weekend gardener, for instance. Neither is beneficial to the economy.
And what about the private sector monopolies? Price increases for steel from Mittal, timber from Sappi/Mondi and cement and concrete from the likes of Lafarge are all exceeding the rate of inflation. The building sector needs all these materials; they have no choice but to buy from monopolies. Higher interest rates simply make matters worse. Where there is no or little choice, increasing interest rates will have no beneficial effect.
In some respects monetary policy and its focus on inflation via interest rate manipulation is dealing with the symptoms, not the causes of our economic imbalances. Perhaps now is the time to look at a list of causes instead that need addressing (see box). By Nigel Benetton


Repo rate. The repo rate is derived from a repurchase agreement where securities owned by a retail bank (the first party) are sold to a central bank (the second party) at one price and then repurchased by the first party after a short period of time at a slightly higher price (the second party is essentially providing the first party with a loan). This price is the repurchase or ‘repo’ rate.
This is one of the credit management tools used by the Reserve Bank to regulate liquidity, or ‘customer spending’. The retail banks borrow money from the Reserve Bank to cover their daily shortfalls. The Reserve Bank only makes a certain amount of money available and this determines the repo rate. In the past it was usually determined by supply and demand, factors over-ridden by current monetary policy.
Prime rate. The prime bank lending rate is “the rate charged to a bank’s best customers” and is used as a benchmark for other lending rates. It is in turn linked to the Reserve Bank ‘Repo’ rate. On 15th April 2005 we saw the lowest prime rate for many years, but at 10,5% it was still in ‘double digit’ territory. The last time we enjoyed single digit prime rate was 16th August 1979 and through to early 1981. Prior to that 31st May 1974 was the last day of sustainable single digit prime interest rates.

Copyright © Insurance Times and Investments® Vol:19.6 1st December, 2006
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