Un-complicating macroeconomic anecdotes

Tue, 13 Jun 2017 13:49:40 +0000

By Kelvin Chungu

But we know that each time there is a policy pronouncement that there will be someone   who is either smiling or unhappy. But to gain the pulse of the resulting national sentiments, one has to visit the watering well.  And you can decipher the rise or decline in the temperature of the economy just in time.

It is as though with each policy shift, there is a tormentor or a motivator close by watching your every move. The effect is almost as though you are dealing with a witchdoctor, keenly playing the game of monopoly, and with a pulse on the economy of every corporate and individuals hemmed at them.

The recent liquidity crunch was one point in question. It was as expected a point of discussion because the Kwacha had almost become a godly sort after property. If you were a foreigner and overheard the general discussions in Zambia at the time, you could almost come to a conclusion that the Kwacha was playing tricks on many people. Here today, and fast to leave your wallets. The complaints were unanimous then, but for now, the smiles are back.

So let’s dwell on the monetary policy, money supply and the effect on the lending rate, just to appreciate it all.

Monetary policy and money supply

The Monetary Policy Committee (MPC) of the Central Bank proposes and implements monetary policies, which are often times described as the Central Bank actions that influences or targets some measure of the money stock in an economy. To do that, the MPC monitors the level of money circulating in the economy and then puts in measures to influence it. Up or down. The most common measures of money supply in Zambia are narrow money and broad money supply, with broad money having a diverse range of iterations from M1 to M4 in other jurisdictions, depending on the liquidity of the money.

Narrow money measures the currency in circulation less currency holdings by commercial banks and the Kwacha demand deposits with commercial banks. Broad money supply includes the narrow money, the Kwacha time and saving deposit and forex money deposit.

The Central Bank monitors the money stock and makes a decision about how to influence its direction. The decisions around the money supply depends on the Central Bank’s own prescribed target economic outcomes and rate adjustments are made depending on the observation of deviations from the target outcome.

The output of monitoring the money supply is to be able to answer a key question around what the developments in money and credit growth suggests for the inflation outlook. The growth or decline in broad money growth is part of instruments our well educative peers use to gauge the pulse of the economy. This is because it has been well established that there is a relationship between growth in broad money and inflation over a long run. Although a thorough assessment of the reasons of money growth or lack thereof is required to predict the economic outlook.

When we read the policy statement, it sounds very complicated, but it is important to understand that at its basic, it is about money, which is like an appliance transmitting monetary policy to economic activities and inevitably inflation.

To achieve the target monetary policy goals, the central bank will typically set short-term interest rate, while permitting for the supply of narrow money to expand or contract, as necessary with the goal of enabling the needs of the economic participants to be met at a specific rate.

Another important participant is the banking sector, who are also principal creator of money and therefore influence the level of money supply in the economy.

The banks operate by receiving deposits and then in turn lending part of that money to other economic participants. As part of the banking process, whenever banks lend money, they also create deposit for those who have borrowed the money. Each of those deposits created goes to add to the broad money supply, which typifies the link between the growth of money and credit. Therefore the growth in the supply of broad money is impacted by cost of interest rates and the general performance of the banking system.

What does this mean?

Whenever there is an increase in the supply of money, the money demand factors such as spending and rates of return must also change, for the economic participants to be willing to hold more money being supplied. Conversely when the demand for money by economic participants increase, there is need to make certain changes to encourage the banking sector to increase the money supply by lending more to the private economic participants.

Why is important to understand this? Basically, any transaction between the banking sector and the other economic private sector participants involves either the creation or destruction of banking sector deposits and will therefore broadly affect the supply of broad money.

The reduction in the supply of broad money constrains liquidity which then impacts the growth of the economy and consequently leads to a contracted economy.

In the case of Zambia, since January 2016, the level of aggregate broad money growth has been very low at 2.3%. This broad money growth was driven by the growth in Kwacha time saving and demand deposit which grew by about 23% offset by a decline in forex deposit by about 20% in the same period. This means that there was no significant new deposit created, other than just a switch from forex to Kwacha deposit over this past period. The effect is evident, there was a reduction in inflation, but at the expense of GDP growth.

Effect on lending rate

Having regard to the above discussion, it becomes relevant to understand that broad money growth is often present in a growing economy, but there are constrains in the growth of this money supply.

These constraints or risk are part of what the banking sector considers before it can acquiesce to increase the money supply in response to an increase in the demand for money. As noted above, the starting point is the setting of policy rate to target the inflation position in response to the central bank’s inferences from money supply. This policy rate is then expect to influence the level of ultimate lending by commercial banks to households and companies, however the policy rate adjustments in Zambia does not seem to reflect the ultimate lending rate for a number of reasons, some of these are;

Firstly, in terms of banking structure with few limited players, there will always be low customer bargaining power leading to higher than usual lending rates offered by commercial banks.

Secondly, the lack of information about the credit worthiness of the potential borrowers increases the tendency by commercial banks to offer higher rates.

Thirdly, the general location of lending department in Zambia, tend to be divorced from day to day banking activities which leads to obscuring of information about the rates offered by competing banks and as such leads to higher than usual lending rates due to lack of information.

Fourthly, the policy rate which the central bank uses to influence the level of money supply tends to be short term, while the lending rates reflect long term mechanisms, which means there is also a premium on pricing the maturity risk.

Fifth, banks obtain funds from a number of sources including short to medium-term deposits and the interbank market which have different maturities and risk characteristics. For instance, during the recent liquidity constrained period, when the central bank tightened its monetary policy, there was a lot of competition among banks for deposits, which resulted in rising rates on time deposits impacting on the cost of funds. It is therefore necessary to understand that in the short term, when we compare lending rates with policy rates, it can be misleading because policy rates do not reflect the effective cost of funding of banks, which is more associated with the liabilities that banks use to acquire funds.

Finally, there is the risk of loss due to the incapacity or reluctance of economic participant to meet its contractual commitments. This is a huge risk in Zambia estimated at 10% actualized aggregate non-performance risk. This risk tends to lead to commercial banks to overprice its loans and in turn constraining the creation of credit and ultimately deposit.

In conclusion, monetary policy works to control the symptoms, however the structure of our economy is imperfect and results in the discord between the policy rates and ultimate lending rates. Notwithstanding the above, the effect of Monetarism has been interesting to observe in Zambia, in terms of its stabilization role. The past two years have been particularly more educational on this and perhaps a fodder for those academic economists that are looking for a topic to explore.

About the Author

Kelvin Chungu is an Associate Director in the Assurance, Advisory and Business Development Service lines and can be contacted on 0976-377484.