Financial PlanningInvestment

Savings, interest rates and government’s new growth path proposal

The new growth path recently announced by government states that employment creation is the main priority of economic policy. The need to increase jobs cannot be overstated. High unemployment means unacceptable rates of poverty and inequality, and greater social instability. Unemployment was high in times of robust economic growth and has been even higher following the global economic and financial crisis. Compared to other emerging economies South Africa has a significantly higher unemployment rate.

Figure 1: Unemployment rate in selected emerging economies


Source: World Bank

The policy challenge and proposal

According to the 2010 Medium Term Budget Policy Statement (MTBPS), in order to reduce employment significantly, South Africa needs to attain a growth rate of 7 per cent for a period of ten years. This would enable South Africa to generate approximately 5,5 million jobs. The ultimate effect of this would be a meaningful decline in poverty and inequality.

Higher savings and lower real interest rates have been identified as part of the policy mix that can stimulate the required growth in South Africa. Higher savings makes more resources available – through financial intermediaries – for companies to undertake investment opportunities, while lower interest rates make it more affordable for them to do so. The focus placed on savings and interest rates is not surprising following the Industrial Policy Action Plan (IPAP) released by the Government earlier this year, stating that South Africa’s cost of capital is high relative to its trading partners, and that the financial industry is not adequately aggregating savings and channelling them towards productive investments. One needs to be cautious with Government’s assessment because it includes both developed and emerging markets. When one compares South Africa against only other emerging markets, real interest rates are actually competitive.

Figure 2: Real interest rates in selected emerging economies


Source: World Bank

The interplay between savings, interest rates and employment

It is instructive to consider savings and interest rates together, given the close relationship that economic theory suggests they have. Interestingly, while the desired effect of higher savings and lower interest rates described above plays itself out among companies, the relationship between these two variables is also critical to the household sector. Furthermore, the resources that will be channelled to companies by financial intermediaries are saved by households. It is necessary to examine how interest rates and savings relate to both households and companies in order to get a holistic view of how these policy variables can contribute towards the new growth path.

The theory around interest rates and savings was developed with the assumption that banks are the primary financial intermediary between households and companies. Households are motivated to save by the interest rate offered by these institutions. The proposal of lower interest rates poses an immediate challenge to attaining higher growth because low real interest rates will discourage savings by households through the banking system. Simply put, individuals will save less if they get a lower real return. In a well-developed financial system, such as the one in South Africa, individuals will substitute savings through banks with other financial assets such as equities and bonds. However, this does affect the ability of most companies to access external finance. Only a limited number of large companies are listed on the Johannesburg Stock Exchange or issue bonds.

Fortunately, the story among households doesn’t end there. Lower interest rates also mean that individuals have more income because they are paying less to service their debts. This additional income could either be saved with banks and passed on to companies, or spent on goods and services. When households are able to spend more, companies will increase investment and hire more workers. Thus, through higher savings or greater spending, households have a positive impact on the economy when interest rates are lowered.

The theoretical arguments suggest that the overall impact of lowering interest rates on savings is ambiguous. On the one hand, it discourages saving because households receive a lower return while on the other hand it encourages saving because it increases household income. One has to consider the context to which these arguments are being applied. Compared to other emerging markets, South Africa’s savings culture is poor. In a consumption-based culture, such as the one in South Africa, lower interest rates may do more to stimulate spending than to affect saving behaviour. If that is the case, growth remains consumer driven, rather than saving and investment driven. To attain a more sustainable growth path requires continued efforts to instil a culture of saving across the country.

Figure 3: Gross domestic saving (% of GDP) in selected emerging economies


Source: World Bank

Even if the pool of savings by households does not increase, lower real interest rates means that companies can borrow from the existing pool more cheaply. Certain projects that were unprofitable at higher interest rates could become profitable at lower rates. As a result, companies undertake new investments and hire additional labour, which reduces unemployment. However, given that real interest rates in South Africa are already competitive compared to other emerging markets, it is unclear that lowering them further will stimulate further lending by banks. The issue could have more to do with a lack of viable businesses for banks to finance than prohibitive borrowing costs.

The need for new companies

South Africa’s high rate of unemployment requires that new companies are established. It will not be enough for existing companies to hire more workers, although this is also important. New companies require affordable external finance in order to undertake several business-related activities including establishing premises, purchasing equipment, implementing marketing strategies and addressing cash flow requirements. The benefits from lower interest rates for these new companies are likely to exceed the benefits to existing companies. The case for lower real interest rates should be considered with the development of such companies in mind.

The IPAP states that, because of the low level of credit allocation by the private sector to productive sectors of the economy, the State must play an important role in providing finance to these sectors. The IPAP calls for concessional credit that can be channelled through Development Finance Institutions (DFIs) such as the Industrial Development Corporation (IDC). The Brazilian example is cited whereby the national worker’s compensation fund is one such source of concessional credit. If South Africa is going to take this route, then one needs to ask whether a policy to reduce real interest rates is necessary. It might be more critical to focus on providing new companies with non-financial support that will enhance workforce quality, business management and market access. Improving the quality of these companies through such means will make them more sustainable in the long run, allowing them to access funds through market channels.

Trade-offs cannot be avoided

As with all policy options, the proposal for lower real interest rates is not without trade-offs. One particular negative effect of such an environment is the decline in interest income earned by pensioners. This means they would have to access their capital at a higher rate than previously envisaged or reduce their standard of living. These are unpleasant prospects, especially when one considers that people are living longer after retiring than in the past. Government must remain alert to such effects arising from policy decisions and take appropriate steps where necessary to address them. Ideally, economic policies must be supported by social protection initiatives that will ensure the negative effects of these policies are minimised.

Another trade-off that policymakers may have to consider is between inflation and job creation. If lowering real interest rates is going to have a meaningful impact on employment, higher inflation in the future is a possibility. Low inflation protects purchasing power and creates a stable environment for economic decisions, including the decision to undertake long-term saving. These benefits of low inflation should not be under-estimated. However, the extremely high unemployment rate currently facing South Africa may justify the pursuit of this trade-off at a level not seen in the past.

Concluding comments

I have attempted to assess how the relationship between interest rates and savings can contribute to the new growth path. Lower interest rates will be beneficial to companies that need to borrow from banks. This will allow these companies to undertake investment and hire more workers, leading to a reduction in unemployment. The challenge with this course of action is that lower interest rates could worsen an already poor savings environment. However, given that how much people earn is the primary determinant of how much they can save, it may be worthwhile in the long term to risk this negative effect on saving in order to have more people employed. Coupled with education to foster a better savings culture, this course of action may ultimately allow South Africa to save more.

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