October 21, 2004

By David Butler

It is broadly held that we have reached the bottom of the interest rate cycle. While we may see some minor changes from the current level, one must believe that any substantial changes can only be up.

But just how quickly can we expect rates to move from their current levels, and once this phase of the interest rate cycle commences, where can we expect rates to peak? Are we going to see an inexorable rise from these record lows?

We must first look at the rand. With rates as low as they are, and, consequentially, buoyant consumer spending, South Africa is running a significant current account deficit. Over the medium term this deficit would normally create pressure on the rand to weaken.

But with foreign interest in South Africa as significant as it is - whether it is foreigners investing in the financial sector or investing into South Africa as a commodity play - this spending is being more than matched by capital inflows.

For this reason, the pressure exerted from the shorter-term current account deficit is being more than matched by longer-term and (traditionally) more stable capital inflows.

For an example of this, just look at the US current account deficit. It is running at over $50 billion (R315 billion) a month, and rather than this bringing a collapse in the currency, the dollar is remaining relatively stable against most of the major currencies.

This is not to say that it could not collapse, but in the medium term this has not been the case. Hence, even with significantly increased consumer spending and importing, there is much room for this flow to be offset by capital investment.

Even in the event of a weakening rand, this will not immediately necessitate a rate hike.

Beyond the acute inflationary driver of the rand, we must look at other macro factors, specifically inflation expectations.

The SA Reserve Bank has done a remarkable job of containing and then reducing the level of inflation in the economy.

If inflation and inflationary expectations can be sustained within the 3 percent to 6 percent mandate of the Reserve Bank for a period of time, say for a further two years, then I would argue that inflation expectations of old would have fundamentally changed.

Already we are seeing these lower inflation expectations manifesting themselves in the escalation clauses in rental and lease agreements. Ten percent escalation clauses, commonplace only two or three years ago, have now been replaced by escalation clauses of 7 percent to 8 percent.

Finally, and perhaps most significantly, a substantial influence on the interest rate level, or more accurately on the change in interest rates required in the event of an inflationary period occurring, is the level of debt that has been built up by the consumer base.

With the consumer base more heavily indebted than it was only a couple of years ago, any increase in rates will have a far greater effect on the pocket of the consumer than it would have had before this build-up of debt.

Overall, we may be at the bottom of the interest rate cycle in South Africa. But international interest rates, particularly those in the US, do not seem set to go up any time soon.

Eventually interest rates will rise, yet how far is the big question. With consumers more heavily indebted then ever, less of an interest rate rise will be required than in the past to achieve a slowing down of spending.

Furthermore, inflation expectations will have fundamentally changed by this time. And finally, there is no external pressure requiring a rate hike.

The days of prime at 20 percent plus are long gone. A peak in interest rates of only 3 percentage points above current rates is what I would expect.