THE PAIN INFLICTED BY HIGHER INTEREST RATES
The South African consumer, and consumers worldwide have had a tough time recently. High global oil prices and a weakening Rand have resulted in higher interest rates, and all three factors have placed a lot of inflationary pressure on the consumer, who is finding that they have less, and less money left over in their bank account towards month end. The South African Reserve Bank uses inflation targeting as their monetary policy, adjusting interest rates where they feel it is necessary to either tighten or loosen the economy. With South Africa deeply in a rate hiking cycle we look at the impact of higher interest rates in this month’s Financial View.
We should probably start this article by saying that the inflation that we are currently experiencing in South Africa is not caused by internal factors. The inflation is being directly driven by external factors such as the war in Ukraine, shortages are driving up food and energy prices. Our South African Reserve Bank is one of the best in the world and the Governor of the Reserve Bank, Mr Lesetja Kganyago, has been quite open in his philosophy of dealing with inflation as soon as you see it. This contrasts the rhetoric of some of the other central bankers, including many in the developed world, who say that inflation was going to be transitory, and that inflation would “sort itself out”. This has not been the case and now central banks around the world are trying to get inflation under control, no matter the damage caused to their respective economies.
Our Reserve Bank uses short term interest to control inflation and attempt to keep it within a target band of 3% to 6%. When inflation is forecast to be below this range it allows them to drop the Repo rate and encourage spending. When inflation is expected to be high, they tighten the economy by hiking the Repo rate, and discourage spending.
The above graph reflects the Repo rate in red and the recorded Consumer Price Index (CPI) from when South Africa implemented inflation targeting as a policy. One can see that as inflation in blue climbs then the Reserve Bank moves the Repo rate up. This continues until such time as the trajectory of inflation turns negative and then the Repo rate is reduced.
As one can see on the right of the graph the Repo rate has been hiked very aggressively recently and we are almost at similar interest rate levels that were in place before the Covid crash with the Repo rate almost doubling from 3.5%pa to 6.25%pa in less than 12 months.
The impact of increased interest rates
Higher interest rates do benefit the investor and the pensioners who are getting a better return on all positive cash balances. However, most South Africans have an element of debt, and the higher interest rate means that the premium on the repayment of any debt increases.
Consider the following examples. In South Africa our prime overdraft rate is 3.5% higher than the Repo rate. Anyone buying a house in 2021 for R1m would have had monthly repayments of R7 753. If someone had to buy a house now for R1m the monthly repayment would have increased to R9 485. A massive 22% increase in the monthly obligation to the bank. (examples assume a 20 year mortgage loan)
The extra funds required to settle mortgage obligations means less funds left for other expenses, ranging from food and school fees to discretionary spending on things such as holidays and entertainment.
The real danger of higher interest rates
As we demonstrated in the previous section higher interest rates mean greater commitments to settling long term debt, however the real danger is in short term debt such as credit cards. The reason for this is that credit card rates and the interest rates on store accounts can be set way above the Repo rate. They can be as high as 14% above the Repo rate per legislation – a massive 20.25% at the current rate.
A lot of the credit card providers in South Africa give 55 days to settle the transaction, this is interest free, after this period they start charging interest and they charge the higher interest rate. Remember these banks and other providers do not issue the credit card as a favour, they issue the credit card as a way to increase the profits of the bank. The more you spend on your card, the more you pay away to the bank.
TransUnion release a quarterly overview of consumer credit trends in South Africa, and they published the following high-level table indicating the year-on-year change in originations. This shows the increase/decrease in number of new accounts for the past year compared to the comparative period one year earlier.
What this is clearly showing is that South Africans have been taking on a lot more short-term debt. Significantly more accounts were opened for credit cards, clothing accounts and store accounts. Reading the whole TransUnion report paints a pretty scary picture of the scenario the South African consumer finds themselves in currently.
The report also includes the average balance per account. Consider how indebted the average South African is:
- Average credit card account balance – R21.2k
- Average clothing account balance – R2.2k
- Average retail revolving account balance – R6.2k
- Average retail instalment account balance – R8.1k
According to TransUnion the average South African has almost R40k owing for short-term debt, often at high interest rates.
The danger is that it is expected that the Reserve Bank is going to have to implement further interest rate hikes in an attempt to bring inflation in line with the targeted range. What is already expensive is going to get even a lot more expensive.
In an environment where interest rates are hiked it is very critical to limit expensive credit. Sometimes this means that we need to wear slightly older clothing or continue to drive our older vehicles. Wherever you feel that you can delay spending in this environment will ultimately benefit you. As you can guess when interest rates are high the biggest beneficiaries are the advancers of credit. We think this would be a good time to buy the banks’ shares and not use their products.
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