South African Reserve Bank Interest Rate Cut

Written by Morningstar Investment Management

On Thursday the 19th of March, the governor of the South African Reserve Bank (SARB), Lesetja Kganyago, announced a reduction in South Africa’s repo rate by 1% from a level of 6.25% to 5.25%. The repo rate is the interest rate at which the central bank lends to other commercial banks. This significant move from the central bank followed the cut of 0.25% towards the beginning of 2020 and is the first time that the bank has reduced interest rates at consecutive meetings since 2011. The latest move from the central bank is largely unprecedented, with the bank generally being relatively conservative in following its primary monetary policy objective of price stability and the secondary objective of balanced and sustainable growth.

Why did the SARB make such a significant reduction in the repo rate?

The spread of the coronavirus (or Covid-19) is expected to have a significant effect on the global economy in the short term. Governments sudden and drastic measures implemented since 15 April in a bid to contain the virus in South Africa have halted the economy. Consumers will need to come to terms with limited freedom of movement and most businesses are likely to come under severe pressure. Global central banks have been fast to react to the concerns by providing support in the form of lower interest rates and in some cases fiscal stimulus in order to cushion the impact of this demand shock. The most significant of the moves is probably in the United States, where the US Federal Reserve has cut interest rates significantly and agreed to purchase $700 billion of Treasury bonds and mortgage-backed securities.

The SARB is the latest central bank to act in an attempt to cushion the impact on consumers or businesses who have debt by reducing interest rates and thereby reducing the cost of debt. They highlighted the fact that inflation in South Africa is currently well contained at close to the midpoint of the target range of 4.5% and is expected to remain at this level for the foreseeable future. Lower oil prices are also expected to have a deflationary impact, given the fact that South Africa is a net importer of oil.

What tools do governments and central banks have to stimulate an economy?

Governments and central banks generally have two policy tools at their disposal in the event of concerns around economic and financial stability. The first is the use of monetary policy, whereby central banks can lower interest rates in an attempt to stimulate the economy by alleviating the pressure on consumers, companies and even the government by reducing the cost of borrowing. The second is using fiscal policy, whereby policy makers can inject stimulus or purchase bonds or other securities in order to stimulate the economy. An extreme example of this was the “quantitative easing” followed by major economies around the globe in response to the Global Financial Crisis in 2008.

What does the interest rate cut mean for South African citizens?

The interest rate cut is positive for those South Africans that are currently in debt. Home loans, car loans and credit card interest rates are, in most cases, tied to the prime commercial lending rate. With the reduction in the repo rate from 6.25% to 5.25%, the prime lending rate has reduced from 9.75% to 8.75%. This means that South Africans will pay less interest on their loans, which should provide them with more money in their pockets to spend on other items.

The table below illustrates the monthly and annual saving for home loans of different amounts, assuming an interest rate equal to the prime lending rate and a payment term of 20 years:

As an example, someone with an initial home loan of R2million will save R15,553 in payments over a year due to the reduction in the prime commercial lending rate (assuming the rate remains at this level).

On the opposite end of the spectrum, savers will not welcome the reduction in interest rates as they are likely to see a reduction in the rates offered by banks and other institutions on fixed deposits and other savings products.

Should we be concerned by the drastic measures taken by global policymakers? What do they know that we don’t?

While central banks do not have access to a crystal ball, they do have access to a wealth of information regarding the state of the economy and the functioning of markets. They also have many intelligent individuals that can analyse this information and make the correct policy response.

There is very little that central banks can do, however, if the virus spreads, the impact of the restrictions placed on society will mean a prolonged period that people can’t work, travel, shop, and so on, which can have a severe impact on the economy and household wealth. What they can do is attempt to limit the contagion or secondary effects by:

  • Allowing households and businesses to access credit, and
  • Keeping markets functioning by providing liquidity to all market participants, keeping borrowing costs low, and trying to prevent the financial stress from becoming a systemic problem, as we saw in the global financial crisis in 2008/09.

Will your portfolio positioning change, given the interest rate cut?

At Morningstar Investment Management, we do not proclaim to know how markets will move today, tomorrow, next week or even in a year. What we do know is that we are quite confident that in 10 years from now, the coronavirus will be a distant memory with very little long-lasting impact on the economy. In the short term, however, we aim to diversify portfolios between different asset classes and geographies, keep costs low and seek underpriced assets. Given the recent market moves, we have taken the opportunity to rebalance a few portfolios, which involves buying equities which have become steadily cheaper and selling bonds and cash which provide more protection in the event of a market sell-off. In some portfolios, we are increasing our equity exposure slightly and moving duration slightly longer to take advantage of the price dislocations in the market.

In conclusion

We live in uncertain times. No individual, business, government or central bank is 100% sure how long the issues with the spread of the coronavirus will take to dissipate or the exact effect that it is likely to have on the global economy in the short term. What we can control as investors is our behaviour in circumstances such as these. While there may be an urge to do something or make changes given the recent market moves, we would encourage investors to take a long-term view and keep perspective of their horizon. During these times we have an opportunity to do what others can’t or won’t – to see opportunity amid the madness and sow the seeds for future investment success.