Staggering Inflation Negative Real Interest Rates, Adversely Affect People’s Ability to Save

Ethiopia hopes to increase private saving from 16.6Pct to 18.7Pct of gross domestic product (GDP) by 2020. This task, however, may prove cumbersome, given that real interest rates in the country have been below zero for years, which doesn’t bode well for people looking to put their money in banks. Even the World Bank has hinted at the adverse effects of this reality on Ethiopia’s development prospects. EBR’s Bantayehu Demlie spoke with banking sector experts, customers and academicians to learn more about this complex issue and offers this report.

Increasing the role of domestic resource mobilisation in financing development goals has become a top agenda item for Ethiopia. It’s an objective shared by a number of countries: The consensus document of the Third International Conference on Financing for Development, which was held in July 2015 and dubbed ‘the Addis Ababa Action Agenda’ (AAAA), emphasised the need for developing nations to mobilise domestic sources to finance increasing development projects.
In line with the AAAA, the second phase of Ethiopia’s five-year Growth and Transformation Plan (GTPII), which started this fiscal year, aims to increase domestic savings and investment. In fact, the Plan acknowledges the centrality of resource mobilisation, stating that unless the expected investment is financed by domestic sources, the sustainability of the country’s rapid economic growth will be at risk.
According to the GTP II, domestic resources will finance at least two-thirds of the overall investments that will be implemented during the period. The Plan also aims to lift the gross domestic saving (private and government saving) to 29.6Pct of GDP from the current 22.5Pct.
At this juncture, the real challenge is increasing the private saving rate, which constitutes the larger portion of gross domestic savings. Currently, private saving stands at 16.6Pct of the GDP and the government plans to increase this to 18.7Pct by the end of 2019/20.
This challenge arises due to the nature of saving in Ethiopia, where the real interest rate (the deposit interest rate minus the inflation rate), has been below zero for many years, which discourages individuals from saving. Currently, both the minimum and maximum deposit interest rates remained unchanged at 5Pct and 5.75Pct, respectively, according to the 2014/15 annual report by the National Bank of Ethiopia (NBE).
With the average interest rate on savings deposit staying at 5.38Pct and given a surge in the overall inflation rate to 10.4Pct at the end of 2014/15, the maximum real interest rate currently stands at -4.65Pct, far from the return that is expected by depositors.
In economics, the real interest rate is defined as the rate of interest an investor expects to receive after allowing for inflation. Simply put, it’s the amount an individual who lends money for repayment expects to be compensated for the time value of their assets or not having the use of that money while it is lent. Additionally, depositors expect to be compensated for the risks of having less purchasing power (due to the expected rise in the inflation rate) when their deposits are withdrawn.
Development experts have long known that a positive real interest rate, saving rate and economic growth are directly related. This positive correlation has generally been interpreted as supporting standard growth models in which higher saving rates result in a higher economic growth rates.
In Ethiopia people aren’t necessarily concerned with interest rates when deciding to save, according to some insiders. “The driving motive for saving is not interest rates but accessibility of financial services,” argues Ephrem Mekuria, Communications Manager at the state-owned Commercial Bank of Ethiopia (CBE).
Ephrem bases his argument on a study conducted by the Bank regarding its recently concluded five-year strategic plan. “We found that the majority of the Ethiopian public is not sensitive to interest rates,” he told EBR. “Only a certain section of the society may be sensitive. Interest rates may play key roles on saving mainly in developed societies, but not in our case. As a result, we do not consider interest rates as part of our competitive field.”
The interviews conducted by EBR with the Bank’s customers support Ephrem’s argument. On Thursday, March 3, 2016, Mustofa Lalo, 20, was in queue to deposit cash at the Addis Ababa University Sidist Kilo Campus branch of the CBE. “I have never thought about the interest rate when I come to deposit money. It is too insignificant to think about,” he told EBR, surprised that he was questioned about the Bank’s interest rates. “I deposit money to save for my future plans and because I may spend it if I keep it with me.”
Mesay Tassew, 25, another customer that EBR approached agreed with Mustofa on the insignificance of the current deposit rate to stimulate saving among the general populace. “The rate does not seem to take into account the morale of the economically disadvantaged majority. It does not push them to save beyond [using their revenues for] daily consumption,” she told EBR.
Economists also argue that while there is a general positive relationship between saving and interest rates in developed countries, it may not necessarily be the case for developing nations. “This is because interest rates are not the only factor that explain saving behaviour,” explains Kahsay Birhane, a PhD candidate and lecturer of economics at Wollo University, who served as National Account Expert at the former Ministry of Finance and Economic Development. “People tend to save when they have a permanent income, when they’re older and when their relative income is higher compared to others,” he said.
Despite this, the World Bank’s February 2016 report entitled “Ethiopia’s Great Run: The Growth Acceleration and How to Pace It” reveals that low interest rates have led to a substantial decline of domestic credit measured as percentage of GDP. The figure fell from 35.7Pct in 2004 to 28.6Pct in 2014, according to the report.
Another harmful impact of a negative real interest rate is that it creates artificial income inequality and widens the benefit differential. It makes depositors collect money with reduced purchasing power over time. This could be aggravated by several other factors. One such factor is an inefficient financial sector. The absence of a formal legal framework for the informal financial sector, such as equb, a communal saving scheme, makes the sector risky. Still, people resort to these saving mechanisms despite this reality.
The financial sector is also criticised for being “biased towards borrowers,” according to Kahsay. It benefits borrowers at the expense of depositors. The other factor contributing to why people are less interested to save is the rapid urbanisation and rural-to-urban migration. “Urbanisation is generally inversely related to saving. This is because the [value] of production by people migrating to cities is not much beyond consumption compared to rural households,” he argues.
Experts stress that an optimal interest rate helps to remedy the above costs and the perception that depositors are generally insensitive about interest rate shouldn’t be a reason to ignore its importance. They also stress that the fact that depositors are not fully aware of the impact of interest rates does not mean that they would not like to have higher interest rates. “The insensitivity may arise from realising that they have little or no control on negotiating a deposit interest rate, which is pre-determined by the NBE. This also implies that much has to be done on financial literacy,” says Kahsay.
However, the experience of Zemen Bank, which is the only commercial bank to pay above the minimum interest rate in Ethiopia, presents a compelling case against the “interest rate insensitivity” argument. Currently, the Bank pays rate of up to 6Pct, while the minimum national rate stands at 5Pct.
Some banks, such as the CBE and Zemen, calculate interest on a daily basis, while others calculate the interest on either the customer’s monthly minimum or average balance. Thus, if the customer has a balance of ETB1 million for the whole month except for one day when he or she withdrew ETB999,000, leaving in his account balance at ETB1,000, in banks where interest is calculated monthly, the depositor will only get interest for the one thousand or the monthly average balance.
“This means we pay interest for every single amount of money that our customers deposit,” says Ojeuna Mekconenn, Zemen Bank’s Marketing Manager. “Our way of calculating interest is particularly beneficial for big businesses, which deposit and withdraw money frequently.”
Ojeuna argues that better interest packages reflect the Bank’s broader customer-friendly policies. “We offer better rates because we believe in providing exceptional service and exceptional value to our customers. We believe in making the customer the focal point of our activities, starting from the design of our bank to the delivery of service on the ground,” he explains.
In spite of the potential benefits of increased interest rates to the overall savings rate, EBR’s interviews with relevant government officials reveal that a recent plan to raise the interest rate is unlikely. Anonymous sources confirmed that the central bank does not have any such plan because if the rate is increased, the cost of investment might be high.
Teklewold Atnafu, Governor of the central bank, mentioned this in his remarks in the Bank’s 2014/15 annual report. Rather he said efforts will be made to improve the real interest rate by containing inflation around the single-digit band.
Habitamu Asifaw, Perspective Plan and Monitoring Expert at the National Planning Commission, a government body entrusted to oversee the compilation and implementation of the GTP I and II, agrees, saying the plan should be to keep the inflation rate at a single digit.
However, this may prove to be a cumbersome task, considering that the overall inflation rate has been unpredictable in the past. From 2006 to 2016, the average inflation rate was 17.81Pct, peaking to an all-time high of 64.20Pct in July 2008 and falling to -4.10Pct in September 2009, according to Trading Economics, a leading fiscal analysis website.
Prime Minister Hailemariam Desalegn, in his March 2016 half-year performance report to the Parliament, said that the overall inflation is expected to increase due to the drought the country is experiencing currently.
However, Habitamu says the increased inflation rate will be mitigated in due time. “The inflation rate is increasing because of the shortage of supply of food items as a result of the current drought. In normal times, inflation comes from the demand side [boom]. This type of inflation will be remedied through enhancing productivity expected from the coming rainy seasons,” he argues.
Additionally, Habitamu says existing and new saving schemes will be used to boost domestic saving. These include new schemes such as housing (condominium) savings and health insurance savings, as well as existing methods such as institutionalising workers’ cooperative union savings, aggressive bank branch expansion, and significantly decreasing government expenditures by ensuring that projects are completed in a timely manner. “This way, the government expects to encourage investment and raise the rate of investment from 39.3Pct to 41.3Pct of the GDP by 2019/20,” he asserts.
In line with the government’s strategies, the CBE says it is undertaking different activities to encourage a culture of saving. Firstly, it has been heavily working on awareness raising and bringing attitudinal changes among citizens. According to Ephrem, Ethiopian culture encourages consumption over saving.
The Bank is also enhancing the accessibility of banking services. One way is aggressive branch expansion. CBE’s branches increased from 200 five years ago to 1024 at the end of March 2016. At the close of last fiscal year, CBE had 963 branches. On average, the Bank has been opening 150 new branches annually since 2010. The expansion is expected to tighten during the Bank’s next five-year strategic plan as well. “Of the expected expansion of bank branches from 2,868 at the start of the GTP II period to 5,736 after five years, CBE and the Development Bank of Ethiopia are expected take up the largest share,” according to Habitamu.
The other activity used by CBE to enhance accessibility is through mobility. “We have been utilising ‘van-based mobile banking service’, through which we reach out to areas where we are unable to open fixed branches. We are physically available on market days and other public gatherings and conduct basic banking services,” Ephrem told EBR.
In addition to these, the CBE introduced various services, including interest-free saving and account services targeting women and students. These same strategies will further be utilised during their new five-year strategic plan and technology-based services will be used more widely, according to Ephrem. “Our strategic focus is to expand the customer base. A bank with a broad customer base is a healthy and reliable bank.” The figure for CBE account holders increased from 2 million five years ago to 12 million currently.
Like the CBE, Zemen identifies services rather than interest rates as important competitive areas. “It is difficult to establish a correlation between the interest amount we pay and the behaviour of our customers. But certainly we know we have many customers who choose us for the better interest rate we pay. In fact, we compete not by the interest rate but mainly on the services we provide,” Ojeuna told EBR.
Initially established as a one-branch-only bank, Zemen remains agile in providing innovative banking services. “We were the first bank to open from 8AM to 7PM … and offer door-step banking. This is what we call [providing innovative] service to our customers. Zemen now has banking centres in Hawassa, Adama, Dire Dawa, Mekelle, Bahir Dar, Gondar, Humera, and a kiosk in Zeway. In Addis Ababa, in addition to its head office in Kazanchis on Joseph Tito Street, it has centres in Bole, CMC, and is opening soon on Churchill Avenue and Bisrate-Gabriel.
Despite the government’s approach towards boosting domestic saving, experts doubt whether Ethiopia’s minimum interest rate of 5Pct is optimal. “To be conclusive it needs research, but comparing it with the sub-Saharan African average and looking at its gap with the prevailing lending rate, Ethiopia’s deposit interest rate needs revision,” argues Kahsay.
The average sub-Saharan African interest rate in 2015 was 7.91Pct, according to data from the Investment Frontier, a website that provides research and information for investors. The average inflation rate for the same period was 5.25Pct, thus giving a regional real interest rate of 2.66Pct.
The World Bank’s report also demonstrates that ensuring a positive real interest rate is crucial in mobilising domestic savings. This is because through a gradual increase in the deposit interest rate, households and firms will find it more attractive to use formal deposit accounts for their informal savings. The expected result would therefore be an increase in deposits.
Others recommend that the government should leave the determination of interest rates to market forces as it did with lending rates. Admassu Bezabeh and Asayehgn Desta, researchers at the Dominican University of California, published a study entitled “Banking Sector Reform in Ethiopia” in the International Journal of Business and Commerce in April 2014. In it, they argue “allowing market forces to determine interest rate … is critical for the efficient mobili[s]ation of savings and allocation of deposits to profitable enterprises.”
They further argue that higher levels of savings did not accompany the 2010 marginal increase of the interest rate from 4Pct to 5Pct. This is because the increase was below the level that can allow financial institutions to mobilise deposits and extend credit to support the growth of businesses and the economy at large, according to the researchers. This, in turn, requires higher interest rates above the inflation rate to make saving a profitable endeavour. In fact as the central bank requires banks to increase deposits by at least 30Pct annually, a positive real interest rate could help them meet such regulatory requirements. EBR