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Rate hike has merits, but will hurt economy

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The Monetary policy committee (MPC) of the Reserve Bank raised the repo rate yesterday by 50 basis points to 6.75 percent. The repo rate goes on to determine the prime rate – now at 10.25 percent – and impacts all interest rates across the economy, including what you pay on your debt and earn on your investments.

The Reserve Bank’s purpose is to control prices in the economy and by implication that also means to try rein in any drastic rand depreciation. Given this mandate, the bank is obliged to raise interest rates when inflation is forecast to escape the target band of 3 percent to 6 percent. But is raising interest rates at a time of low growth a good thing?

The mechanics of a rise in interest rates dictate that the cost of borrowing will increase and, therefore, people and businesses will spend less. This brings down the demand for goods and services and drops the pressure on inflation.

Higher interest rates also attract greater foreign inflows into portfolio investments that pay an interest earning, such as bonds and other debt instruments. When money flows into South Africa the rand strengthens, or at least weakens at a slower rate. A stronger rand further helps to slow inflation as import costs will not rise as much as they otherwise would.

But this year there is another reason that the Reserve Bank will want to see interest rates rise and it’s purely political. The bank is technically independent from the government and while it is in constant conversation with the Treasury, the government cannot tell it what to do or how to run its policies. The reputation of the Reserve Bank and investors’ reactions to its policies depend entirely on how believable this independence is.

The government would like to see interest rates come down – it would make borrowing cheaper, increase money supply into the economy, boost spending and increase economic growth and job creation. After the finance minister fiasco the bank is worried that – even if keeping interest rates constant is prudent policy for the time being – foreign investors will see it as confirmation that it has lost its independence and is now playing second fiddle to President Jacob Zuma’s short-termism.

A sudden outflow of portfolio investment would cause another dive in the rand and release more inflationary pressure.

Trying to steer international money movements doesn’t come without a cost. Even if you’re one of the lucky few who can borrow at prime, you’re paying more than 10 percent of your debt per year just in interest payments. Most people pay a lot more. Take inflation out of the equation and South Africans are paying more than 5 percent on their loans in real terms. If your loan is intended for business investment, that loan would have to increase your business earnings by more than 5 percent a year in real terms just to make it a worthwhile decision.

Such a large increase in earnings is not likely in today’s economic climate and a rise in interest rates will continue to choke off business investment and job creation.

In addition, if interest rates rise, those who already owe money at market-related rates will have to use more of their disposable income to pay interest, leaving less money for consumption and investments that support other businesses.

Raising interest rates this month has its merits but it’s not worth it. Interest rates are a useful tool to tweak South Africa’s competitive advantage when the markets are calm. But a hike of 50 basis points – a large jump for a single meeting – will do little to change the behaviour of portfolio investors while they’re dealing with US interest rate rises, European quantitative easing, Chinese currency volatility and South African political uncertainty.

Higher interest rates will stifle growth, increase unemployment and turn away direct investors.

Higher inflation and a weaker rand are bitter pills to swallow, but policy must get back to the economy’s basic need – helping idle hands to produce value. THE BUSINESS REPORT


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