1. Interest rates determined by market forces
The interest rate is a very important price that plays a vital role in establishing and maintaining equilibrium in the market for loanable funds. Like all other prices, the interest rate is determined by forces of demand and supply. If the demand for loanable funds tend to exceed the supply of loanable funds, the interest rate will tend to rise, and vice versa, when demand is less than supply, the interest rate will tend to decline.
Changes in interest rates emit important signals to the borrowers (demand side) and lenders (supply side) operating in the market for loanable funds. Obviously, an increase in interest rates indicates a shortage of funds, caused by increasing demand or a decline in the supply of funds. An increase in interest rates therefore brings a clear message to borrowers: reduce your demand for loans. At the same time, the higher rates entice potential savers to consume less, that is, to save more and thus make more loanable funds available at the better return.
In a market-oriented economy as we have in South Africa, efficient financial markets are essential instruments for the effective functioning of the interest rate mechanism. Interest rates must be flexible and must react in a sensitive way to changes in the underlying market forces. Excessive government intervention in the financial markets will reduce the effectiveness of the price mechanism, and can easily lead to permanent distortions in the flow of funds in the financial markets. Such distortions can lead to chronic shortages of funds, and also to the maldistribution of the available production resources of the economy. In the longer term, unrealistic interest rates, be they too low or too high, will lead to economic growth below the real potential of the economy.
In the real world, there are many different interest rates, associated with the maturity of underlying loan agreements, the liquidity or marketability of the financial instruments used, and the risks involved in different kinds of loans. The inter-relationship between different interest rates may also change from time to time, for example the term structure of interest rates. Changes in these interrelationships also often carry important messages. In South Africa, for example, recently the slope of the yield curve for different maturities flattened out, indicating a decline in inflation expectations.
The main sources of supply of loanable funds in an open economy are domestic saving and net inflows of capital from the rest of the world. The demand comes mainly from government to finance both current and capital expenditure, from businesses to finance investment in fixed assets, inventories and other trade assets, and from consumers to finance both durable and non-durable consumer expenditure. A net outflow of capital to the rest of the world, as South Africa experienced from 1985 to 1993, reduces the amount of funds available for domestic application.
In a country such as South Africa, where gross domestic saving over the past decade declined from about 25 per cent to 17 per cent of gross domestic product; where the deficit on the government's budget now absorbs private saving to an amount equal to about 6 per cent of gross domestic product (against a more normal 3 per cent of gross domestic product); where new fixed investment is growing at a rate of about 10 per cent per annum and real inventory accumulation amounted to R11,0 billion over the past eighteen months, and where private consumption expenditure is growing at a steady 3½ per cent per annum, interest rates must and will be high. Were it not for the net capital inflow of about R20 billion since the middle of 1994, the level of interest rates would have been much higher in South Africa at this stage. In other words, the economy would have been less buoyant.
2. The Reserve Bank and interest rates
There is a widely-held misconception that the Reserve Bank can wilfully fix interest rates at whatever level will be best for the economy. It is true that the Reserve Bank can influence the level of interest rates through exercising a very special power that has been conferred on it by Government, and that is the power to create money. The Bank can, it is true, add to the supply of loanable funds by creating more money.
But the creation of more money through the use or abuse of the printing press has an important side-effect: it disturbs the established relationship between the amount of money and the volume of goods and services produced in the economy. Any excessive creation of money will lead, sometimes with long time lags, to inflation, and the process of the erosion of the value of money will eventually destroy the total economy. One of the more important elements of any programme for the cure of inflation, once it has reached a high level, is extremely high interest rates -- not only in nominal terms, but also in real terms. Efforts by the Reserve Bank to maintain interest rates at an artificially low level will therefore in time become counter-productive and force even higher interest rates, and a painful adjustment back to equilibrium.
The Reserve Bank has been tasked by Government with the responsibility to protect the value of the currency. The Bank must, in other words, refrain from creating an excessive amount of money. In the modern sophisticated financial systems, money is created mainly by the private banking system on the basis of reserve money supplied by the central bank. The Reserve Bank therefore has a vested interest in the money creating activities of the banking sector, that is, in the amount of credit extended by banking institutions to their clients.
The Reserve Bank has a number of operational instruments that it can use to influence the ability of banking institutions to create more money. The Bank can also through its monetary policy measures influence the demand for money emanating from the private sector. None of the available instruments can, however, preserve the fundamentals of a market economy and, at the same time, secure low interest rates in an adverse financial environment. Indeed, efforts to ward off inflation and to keep interest rates low at the same time in such conditions, will make monetary policy impotent, and will lead to an escalation in financial instability, both in the domestic financial and in the foreign exchange markets.
In a situation of a rising demand for funds, not matched by a simultaneous increase in the supply of funds, the Reserve Bank has no further options -- either we accept a higher level of interest rates as determined by market forces, or we create more money and fuel inflation. It is true that high interest rates are bad for economic growth; that they will discourage new investment; that they will restrict the expansion in the economy. But this is what they are intended to do: to depress the economy back to a growth rate that is affordable in terms of the real production capacity or performance of the economy. High interest rates are not the cause of a restricted economic growth rate; they are the symptoms of a country's efforts to grow beyond its means.
The question is not whether high interest rates are bad for the economy -- this we all agree on. The question is what can be done to bring interest rates down to a lower level. The answer is certainly not for the creation of more money by the central bank. The Reserve Bank controls only one interest rate, and that is the Bank rate, representing the rate at which the Reserve Bank is prepared to create money for banking institutions. It will be foolish of the Reserve Bank to reduce this rate in an environment where bank credit extension to the private sector is growing at a rate of 19 per cent per annum; where the money supply is rising at a rate of 16 per cent per annum, and where the total production of goods and services is increasing at a rate of only 3½ per cent per annum.
The route to lower interest rates lies in the restructuring of the basic fundamentals of the economy -- can we increase the supply of loanable funds through an increase in domestic saving? Can we increase production and raise total income to generate more saving? Can we reduce Government expenditure, the deficit on the budget and the demand for funds emanating from regional and local governments? Can we reduce private consumption and thus release a greater share of current production for real investment? Can we attract more long-term foreign investment for participation in the real economic development process of the country? Can we do all this and maintain overall financial stability, with low inflation and equilibrium in the overall balance of payments? If the answer is yes to all these questions, we shall have low interest rates in support of sustainable long-term economic development. If the answer is no, we shall have high interest rates, also in real terms, and economic growth below our real potential. It will be futile to blame the Reserve Bank for the high interest rates in our country.
The main task of the Reserve Bank so often is to do nothing. The Bank must in most situations remain neutral and allow market forces to determine the level of interest rates and, for that matter, the level of the exchange rate. The Bank's role of lender of last resort to assist banking institutions with short-term, temporary and reversible liquidity shortages must in the medium and longer term have a neutral effect on the money supply, and the accommodation made available to the banks at the discount window of the Reserve Bank must at all times be made available only at market- related interest rates.
3. Prospects for the near future
Over the past eighteen months, most interest rates in South Africa rose to relatively high levels. The yield on long-term government stock, for example, rose from 11,7 per cent in January 1994 to almost 17 per cent in June 1995, before declining again to the present level of about 15 per cent. The interest rate on 91-day Treasury bills likewise rose from 10,1 per cent early in 1994 to over 14 per cent in June and July this year, before declining slightly to 13,7 per cent last week. Measured against the current level of the rate of inflation, the real rates of interest in South Africa are extremely high at this stage.
Interest rates rose against the background of the relatively low level of domestic saving, a large deficit on the budget of general government and a strong rising demand for credit to finance the growing private sector expenditure on both capital and consumer goods. The present level of interest rates would have been higher were it not for the large net inflow of capital from the rest of the world, which amounted to about R20 billion over the past fifteen months and which was partly monetised by the Reserve Bank.
There is, as always in the present situation, a false perception that the Reserve Bank is responsible for the high level of interest rates. This is, of course, nonsense. Over the past year, the Bank indeed leaned against the wind quite heavily and added to the supply of funds by facilitating an increase in the total M3 money supply of no less than R50 billion from the end of 1993 to the end of June 1995. The Bank indeed ran the risk of refuelling inflation in the process and was at one stage quite rightly criticised amongst others by the International Monetary Fund, for having allowed a too expansionary monetary policy in 1994.
Against the background of the large net inflows of capital, the Bank had to choose either to let the exchange rate appreciate, or to absorb some of the capital inflows in its foreign reserves. By buying up some of the surplus foreign exchange from the market, the Bank increased its foreign assets by more than R10 billion, but in the process supported an increase in the money supply at a rate of more than 15 per cent over the past year. If anything, Reserve Bank intervention helped to keep interest rates artificially low during this period and avoided a rise in particularly short-term rates to an even higher level.
The high level of interest rates in South Africa at this stage reflects underlying demand and supply conditions in the market place, and has not been created by any malevolent Reserve Bank whims, as some people seem to believe. The future trend in interest rates will depend on changes in these underlying demand and supply conditions, and not so much on Reserve Bank policies. In the current situation, Reserve Bank policy should be to remain neutral, and to allow market forces to establish equilibrium in the financial markets in the interest of sustainable economic growth in the medium and longer-term.
In this scenario, the prospects for lower interest rates over the next year will depend to an important extent on:-
the size of the public sector borrowing requirement as determined mainly by the size of the deficit on the budget;
the demand for credit, and particularly bank credit, to finance investment and consumer expenditure;
the possibility of increasing the propensity to save, or to reduce the high level of consumption relative to the disposable income of the private sector;
the magnitude and composition of net capital inflows and indeed also developments in the current account of the balance of payments. It is in the end only the surplus or the deficit in the overall balance of payments that can lead to changes in the money supply, and also in the exchange rate of the rand;
trends in the rate of inflation which will influence not only nominal interest rates, but also the level of real interest rates. (The higher the rate of inflation, or the expected rate of inflation is, the higher will be the inflation premium built into the total interest rate); and
trends in inflation, interest rates and exchange rates in the rest of the world.
The Reserve Bank will be reluctant to yield to the pressures to use its powers of creating more money to reduce interest rates artificially to an unrealistically low level. Such a policy will only bounce back on us with a vengeance in the form of higher inflation and serious balance of payments problems in future, and a more painful process eventually to restore financial stability.
A high level of interest rates is after all a reflection of deficiencies in the structure of the macro economy, and not a cause of the deficiencies. It is part of the disciplines of the market economy that function automatically as a timeous signal of the futile efforts of a country to live beyond its means. Either the means must be increased, or the demands must be subdued. By refuting this important adjustment process of the financial markets, we expressly and openly reject the disciplines of the market economy.