The low interest rate, falling credit paradox
Brian Benza | Friday May 27, 2016 10:17
For the second time this year, consumer inflation breached the lower end of the Bank of Botswana’s (BoB) 3-6 percent medium term objective in April. While the slow down in the rate at which general prices are increasing might be an indication of sluggish economic activity, some analysts argue it provides the BoB with room to further cut interest rates to boost productive lending. Although, such a move carries a risk of capital flight with some investors likely to start looking outside the borders for higher interest rates.
Botswana’s consumer inflation slowed to 2.8 percent year-on-year in April from three percent in March, according to Statistics Botswana.
This was the sixth time inflation has been below three percent since January last year, a development that has given room for the prevailing low interest rate regime, the lowest in decades, in nominal terms.
The transport component, which forms the second largest component of the inflation basket at 18.98 percent, has benefited inflation on the downside due to several reductions in oil prices since 2014. Additionally, Botswana’s import bill comprises just over 60 percent goods and services from South Africa. Thus inflation continues to benefit from limited imported inflation due to the foreign exchange inflation pass-through, which remains minimal due to a weaker rand.
Additionally, the low wage and employment growth rates could be causing weak household consumption and thus resulting in lower demand-pull inflation pressures through to 2017.
Analysts say this could be because of lower growth in employment and wages, which translates to weaker household purchasing power and ultimately weaker demand for goods and services. A weaker credit extension level at eight percent also implies consumption induced by borrowing is limited there being less activity from the demand side.
Both consumption by households and spending by government has grown at a declining rate and that could also explain why inflation will be lower. As a net importer of oil, the effect of the supply side cannot be discounted as lower oil prices have contributed significantly to falling inflation.
Although the downside risks outweigh risks to the upward, FNBB research manager, Moatlhodi Sebabole believes pressures to inflation are likely to come from cost increases on the supply-side of the economy due to potential water and electricity tariff increases; additional levies on alcohol; drought-induced increase in food prices; and a prospective inflation spillover from South Africa. But the record low inflation and interest rates levels have failed to spur credit growth.
Despite interest rates reaching a three-decade low in 2015, banks’ credit growth slumped to a 10-year low last year on the back of tight liquidity while banks have also become very cautious in making new loans due to concerns about the volatility of the deposit base and the ability of customers to repay.
But is there further room to cut interest rates and will it be enough to encourage further lending by banks? Analysts believe there is still further scope for more interest rate cuts, although it could come at a cost.
The bank rate currently sits at six percent.
According to Sebabole, the benign inflation outlook, sub-trend growth, a current account surplus and real interest rate differentials with Botswana’s trading partners that remain within historical ranges, suggest that the central bank still has room to cut rates over the next few months by either 25 basis points or 50 basis points.
Textbook economics as dictated by what is called Taylor’s rule, which measures the bank rate by real GDP output gap and inflation deviation from the inflation objective, indicates that there is room for BoB to cut rates by 25 basis points in the next few months.
Alternatively, Sebabole says if one looks at the real effective exchange rate, which considers competitiveness of Botswana’s exports, the room for BoB to cut rates extend to 50 basis points as that will not put the balance of payments under undue influence.
“So, mathematically there is room for the central bank to cut rates further, however, other factors of financial stability make it less likely that further rate cuts will be effected.
“This is primarily because rates in other markets like South Africa, Namibia, Mozambique, Zambia and even the U.S have been going up and are expected to increase further in the near term. “This poses a risk of flight if investors prefer to chase higher rates as further rate cuts will result in lower money market rates and thus even pose a risk to capital flight in the fixed income market. Thus any rate change ought to balance the financial and price stability effects,” said the economist. With the economy expected to recover this year from 2015’s negative growth, other experts believe the BoB will need to look at how long the current low inflation trends will last at the next MPC meeting.
“Low inflation is a signal of sluggish domestic demand and subdued economic growth. If the central bank believes that the current low inflation environment is not transitory, but more permanent in nature, then it does have room to further decrease interest rates,” said an investment analyst at Afena Capital, Kwabena Antwi.
BoB data also shows that the uptake of loans by businesses has considerably slowed down when compared to households, suggesting that a further cut in the bank rate might not be that useful as the level of interest rates have not been the main determining factor in credit growth.
The challenges of slower credit growth have also resulted in lower profits for banks.
In the first nine months of 2015, the post-tax rate of profit for the banking sector as a whole was only 12.5 percent (annualised), sharply down from 18.6 percent in 2014 and half of the 25.7 percent earned in 2013.
“Almost all of the profit was made by the three largest banks, meaning that some of the medium-sized and small banks were probably making losses. “There is a danger that such a sharp fall in profitability could lead to instability in the banking system, which would have widespread costs. And as a general indicator of deteriorating business conditions, it is of major concern.
“Furthermore, there is a fiscal impact through reduced tax revenue, given that the banks are amongst the largest taxpayers in the economy, after Debswana,” stated the analyst.
Whatever decision the MPC takes at their next meeting, it is clear that analysts are agreed either decision has its own pros and cons. The chances of an interest rate driven uptick in credit growth is unlikely in this current economic environment where businesses face weaker demand prospects and households’ purchasing power has been eroded.