Artificially low interest rates fueling inflation

Interest is a fee paid on borrowed capital. The most common form in which these assets are lent is money, but other assets may be lent to the borrower, such as shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. In all cases the interest is calculated upon the value of the assets in the same manner as upon money. According to this Interest can also be viewed as "rent on money".Generally speaking, a higher real interest rate reduces the broad money supply. The "real interest rate" is the nominal interest rate minus the inflation rate. Zimbabwe continues to have negative real interest rates. These rates discourage investment and production but aid undesirable levels of speculation and in turn aid and abet inflation.

According to the quantity theory of money, increases in the money supply lead to inflation as explained in my first article published by Newzimbabwe.com. This means that interest rates can affect inflation .

Interest is compensation to the lender for foregoing other useful investments that could have been made with the loaned money. Instead of the lender using the assets directly, they are advanced to the borrower. The borrower then enjoys the benefit of the use of the assets ahead of the effort required to obtain them, while the lender enjoys the benefit of the fee paid by the borrower for the privilege. The amount lent, or the value of the assets lent, is called the principal. This principal value is held by the borrower on credit. Interest is therefore the price of credit, not the price of money as it is commonly - and mistakenly - believed to be. The percentage of the principal that is paid as a fee (the interest), over a certain period of time, is called the interest rate.

Loans, bonds, and shares have some of the characteristics of money and are included in the broad money supply. And any increase on these assets which is not matched by production feeds into the inflation spiral. The returns on loans, bonds and shares whilst having different names they are equivalent to interest and these returns can be inflationary if not matched by an equivalent quantity on the supply side.



Zimbabwe’s interest rate outlook, as already noted, continues controlled and directed towards a low interest rates policy through subsidised credit facilities designed to support the productive sectors of the economy. These facilities whose rates are as low as 25%include the Agricultural Mechanisation Program (AMP), the Agricultural Sector Productivity Enhancement Facility (ASPEF) and the Basic Commodities Supply-Side Intervention Facility (BACOSSI). The Government, as the biggest borrower on the financial markets, will be negatively affected if the Treasury bill rate was to be increased. As a result, the one year Treasury bill rate has been held constant at 340% since January 2007.

These facilities mortgage the nation’s future due to their nature of being loss making without any mechanism to compensate for the direct loss arising out of their implementation. As noted earlier the lending body borrows money at the treasury bill rate of 340% ,then lends through facilities such as BACOSSI,ASPEF,AMP at a rate of 25%.This direct loss could be recovered through taxation assuming the borrower pays tax . Unsound interest rate policy leads to rapid money supply expansion.

There is need to make interest rates market determined and let private sector play a leading role. This could be done through commercial banks and other privately owned financial institutions. Artificially controlled interest rates work in the same ways as any other price control. They normally achieve the opposite effect(opposite the desired outcome).

These facilities while implemented with good intentions end up fueling inflation. This is mainly because of loop holes and other factors which encourage speculative behaviour at the expense of long term investment. Facilities such as these work if accompanied by a stable macro-economic environment which allows for long term planning. There is need for predictable policies and consistant application of the rule of law which builds investor confidence to invest with a longer term view.

The Zimbabwe economic environment, as it stands now is not of short-term speculative participants. The speculative behaviour is both understandable and rational given the current operating environment.


Speculation, in finance, involves the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividends or interest. Speculation or agiotage represents one of four market roles in financial markets, distinct from hedging, long- or short-term investing, and arbitrage.
Overall, the participation of speculators in financial markets tends to be accompanied by significant increase in short-term market volatility. This is not necessarily a bad thing, as heightened level of volatility implies that the market will be able to correct perceived mispricings more rapidly and in a more drastic manner. Speculation aids a more efficient price discovery process. Speculative purchasing can also create inflationary pressure, causing particular prices to increase above their true value (real value - adjusted for inflation) simply because the speculative purchasing artificially increases the demand. Speculative selling can also have the opposite effect, causing prices to artificially decrease below their true value in a similar fashion

There are markets for investments which include the money market, bond market, as well as retail financial institutions like banks, which set interest rates. Each specific debt takes into account the following factors in determining its interest rate:
Opportunity cost: This encompasses any other use to which the money could be put, including lending to others, investing elsewhere, holding cash (for safety, for example), and simply spending the funds.
Inflation: Since the lender is deferring his consumption, he will at a bare minimum, want to recover enough to pay the increased cost of goods due to inflation. Many governments issue 'real-return' or 'inflation indexed' bonds. The principal amount and the interest payments are continually increased by the rate of inflations. In Zimbabwe’s case there is an imbalance mainly due to negative interest rates. Its understandable that the Government being the biggest borrower has tries to maintain low interest rates (negative real interest).The logic being to access cheaper credit, but this has allowed other borrowers to borrow at the same or similar rate and such funds have led to rapid money supply expansion reportedly at or 17,000%.

Default: There is always the risk the borrower will become bankrupt, abscond or otherwise default on the loan. The risk premium attempts to measure the integrity of the borrower, the risk of his enterprise succeeding and the security of any collateral pledged. For example, loans to developing countries have higher risk premiums than those to the US government due to the difference in creditworthiness. An operating line of credit to a business will have a higher rate than a mortgage.
Creditworthiness of businesses is measured by bond rating services and individual's credit scores by credit bureaus. The risks of an individual debt may have a large standard deviation of possibilities. The lender may want to cover his maximum risk. But lenders with portfolios of debt can lower the risk premium to cover just the most probable outcome.
Deferred consumption: Charging interest equal only to inflation will leave the lender with the same purchasing power, but he would prefer his own consumption NOW rather than later. There will be an interest premium of the delay. He may not want to consume, but instead would invest in another product. The possible return he could realize in competing investments will determine what interest he charges.
Length of time: Time has two effects shorter terms have less risk of default and inflation because the near future is easier to predict. Broadly speaking, if interest rates increase, then investment decreases due to the higher cost of borrowing under normal circumstances.
Interest rates are and should generally should be determined by the market, but government intervention - usually by a central bank- may strongly influence short-term interest rates, and is used as the main tool of monetary policy. The central bank offers to buy or sell money at the desired rate and, due to their control of certain tools (such as, in many countries, the ability to print money which is the case in Zimbabwe) they are able to influence overall market interest rates. And if they do not properly use such tools hyper-inflation can easily be the result.
Investment can change rapidly to changes in interest rates, affecting national income, and changes in output affect unemployment. Positive real interest rates encourage savings which would hopefully be invested to increase production. Increased production will help to meet demand and bring about demand and supply equilibrium. This will result in stable prices.

Gilbert Muponda is a Zimbabwe-born entrepreneur, living in exile .He can be contacted at gilbert@gilbertmuponda.com