Johan Rossouw
THE outcome of the bi-monthly meetings of the Monetary Policy Committee of the South African Reserve Bank (SARB) pertaining to adjustments to the repurchase (repo) rate is closely watched by financial market participants and widely publicised by the media.
However, ordinary South Africans often are unclear as to what the adjustment of the repo rate means for them.
To shed more light on this, it is important to better understand the South African interest rate mechanism.
In order to facilitate and maximise sustained economic growth and job creation, the appropriate growth-optimising policies need to be in place. The SARB is responsible for so-called monetary policy, which includes interest rate policy.
The ultimate monetary policy goal is to protect the value of the rand by keeping inflation (the rate at which prices for consumer goods and services rise on a sustained basis) low and steady, because if South Africa’s inflation rate is allowed to escalate materially beyond those of our trading partners, market mechanisms would tend to push the rand weaker, which would, on balance, be harmful to our economy. High inflation would generally also be bad for consumers’ ability to afford whatever they need and, ultimately, for citizens’ wealth.
The National Treasury, in consultation with the SARB, sets the inflation target. The SARB then independently makes monetary policy to achieve this target (the current inflation target is a range of 3 to 6 percent).
A key instrument to guide economic activity is the adjustment of the repo rate. The repo rate is the rate the SARB charges commercial banks for purposes of borrowing from the SARB (currently 3.5 percent) and is therefore the reference interest rate for purposes of the interest rate that commercial banks charge their clients. Consequently, the repo rate and the adjustment thereof is the interest rate mechanism the SARB uses to effect changes in interest rates throughout the financial system.
As could be expected, commercial banks add a mark-up to the repo rate for purposes of on-lending to consumers. The reference interest rate generally charged by commercial banks to their “best” clients is referred to as their “prime” interest rate – generally called the “prime rate”. The prevailing prime rate of most commercial banks is 7 percent. Any adjustment in the repo rate tends to be passed on by commercial banks by an equivalent adjustment in the interest rate they charge clients in a particular category.
It is important to note that it does not necessarily mean all consumers/ borrowers will pay the equivalent of the prevailing prime rate on debt. Since commercial banks are competing with each other, the prime rate is only a reference interest rate (and may even differ among institutions), and each bank has its own assessment of client risk and the interest rate applicable to different categories of clients and individuals. In fact, some low-risk clients may be charged an interest rate below the prime rate (“prime less” interest rates), while higher-risk clients may be charged more than the prime rate (“prime plus” interest rates).
Clients who fall in the higher-risk so-called “unsecured” category could be charged substantially higher interest rates. These clients will typically borrow from credit providers other than the commercial banks, such as micro lenders and retailers.
Even though other risk-related charges may proportionately be much more substantial in the make-up of the eventual interest rate charged to clients in the “unsecured” category, an adjustment of the repo rate should ultimately also have an impact on the maximum allowed interest rate charged to this category of clients, because the National Credit Act allows for a certain mark-up rate on top of the prevailing repo rate as the maximum allowed interest rate for different categories of debt.
Apart from the direct impact a repo rate adjustment may have on the interest charged on debt and the return on cash investments, there is a significant indirect impact on consumers.
The SARB summarises the impact of a typical scenario where the MPC raises the repo rate as follows:
“First, it will increase costs for borrowers with floating interest rate debt (such as the interest rate on home loans). It will also promote saving and discourage borrowing. Together, these effects weaken demand, reducing price pressures in the economy. (This is often called the savings and investment channel.)
“Second, a higher interest rate will tend to strengthen the rand’s exchange rate by improving returns on randbased investments. In turn, a stronger rand reduces the price of imported goods. (This is the exchange rate channel.)
“Third, by raising rates, the central bank signals a commitment to reduce inflation. Price and wage setters will factor this expected reduction into their wage and price decisions. (This is the inflation expectations channel.)
“Fourth, higher interest rates will affect asset markets by, for example, moderating house prices. This can reduce the wealth of asset owners and cause them to reduce their purchases, slowing the economy. (This is known as the wealth channel.)”
Johan Rossouw is the group economist at Vunani
*The views expressed here are not necessarily those of IOL or of title sites
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