Gift Kasika

The relationship between the interest rate, savings and investments is important in determining and predicting a country’s economic growth potential and the capacity to finance its own investments.

The interest rate is defined as the amount charged on financial assets, or alternatively a yield on financial assets for a specific timeframe expressed in percentage terms. There is a wide variety of interest rates on the market as there are a variety of different financial assets with different maturity periods, issuers, risk of the financial asset, tax on the financial asset returns, the liquidity of the underlying financial asset, and so forth.

In the face of all the above differing financial assets, their interest rates tend to react in more or less similar fashion in response to a monetary policy or any other disturbance on the financial system. Considering their general treads and similarities in their reactions, the analysis of an interest rate can be captured on a single representative financial asset as interest rates have more in common than they differ. Amongst other financial assets, the most representative is the interest rate on a treasury bill. Treasury bills are short-term government securities with maturity of less than a year, denominated in a timeframe of three months, six months and a maximum of one-year maturities from the date of issuing. Being issued by the government, treasury bills are considered risk-free as the government often honors their obligations with the backing of the central bank, provided they are denominated in a local currency which the central bank has the mandate to print, like the Namibia dollar.

The risk-free nature of the Treasury bill is an important quality which makes them theoretically interesting in analysing the attractiveness to market participants, and it’s therefore an ideal representative of all other interest rates on the financial market.

Besides that, the interest rate for a short-term debit bill serves as a benchmark for other interest rates because they are mainly sold by commercial banks to their central bank when they are in need of cash. As such, it’s the rate at which the central bank provides cash to the banking sector through open market operations and at the discount window.

This interest rate is commonly referred to as the Bank Rate or the repurchase rate (repo rate) in short. Banks add a mark-up of a certain percentage on the repo rate as a charge to their customers. The bank’s rate to their customers is referred to as the Prime Lending Rate. It’s the rate at which commercial banks provide credit to the non-bank public, as well as to other banks in need of cash reserves.

All in all, other interest rates tend to move in the direction of the repo rate. An interest rate of a longer term revolves around the expectations of the yield on short-term interest rates plus a risk premium. The general direction/movement of an interest rate is captured by the structure of the interest rate. The structure of the interest yield curve is used to predict the effect of a disturbance and crises to the general interest rate. The repo rate is one of the policy tools on which central banks exert their influence on the banking sector and the financial system as a whole in order to achieve their monetary policy objective, and therefore influence the macroeconomic state of affairs. Other policy tools under the full control of central banks is the level of cash supply. Being the monopoly issuer of cash, the central bank has the mandate to manipulate the level of liquidity in the financial system to the desired target level.  The interest rate as a policy tool works through its influence on the supply and demand of loanable funds from commercial banks to the non-bank public. When the interest rate is high, borrowers are discouraged from borrowing, depending on expected returns on their potential investment since they will have to repay the bank the principal debt plus the interest rate, while on the other hand, a lower interest rate stimulates more borrowing on the side of the non-bank public.

Commercial banks’ capacity to extend credit to the non-bank public is constrained by the amount of back-up cash reserves in their possession because deposit holders have the mandate to convert their deposits into cash at any point in time, and banks therefore have to be in a position to meet their clients’ demands. By manipulating the supply of cash, the central bank indirectly influences the capacity of banks to extend credit to their customers.

The interest rate is determined by the scarcity of cash reserves rather than the scarcity of money/loanable funds. The relevance of the availability of loanable funds applies to the non-bank public than to commercial banks since the central bank is readily available to provide cash to banks in need at the prevailing interest rate.

Being a yield on investments, the interest rate is one of the defining incentives that determines the level of savings and investments. Savings are the income that has not been spend, or alternatively deferred future consumption. On the other hand, investments are the purchase of goods for future consumption, or purchasing of financial assets in the hope to generate a positive return in the future.