Learn about the Real Interest Rate

Money is that thing you get when you sell the fruits of your labour. Depending on what you do you either make a lot of it, or too little of it. Although to most, like me, it always seems to be too little. When you make that money you typically spend it on stuff, like food, or accommodation, or toothpicks, depending on what floats your boat.

However, every once in a while you find yourself with too much money. Not too much in the sense that you don’t know what to do with it, but too much in the sense that you only need it later. For simplicity, lets say in  a years time.

Now let say you have a  friend who wants that money now. Maybe she wants the money to do this small business with guaranteed returns or she expects to get money from somewhere else in a years time. She says, “Hey Tope, can you loan me this N1000? I’ll pay you back in a years time”. How do you decide if you should loan the money to your friend?

First, she has to at least pay back the money at the end. And maybe she will. But then you think to yourself, this N1000 in a years time might not really be the same. Right now this N1000 can buy me 5 mudus of garri. But in a years time it might only be able to buy me 4 mudus. After all you can’t eat money. Its what money can buy that you can eat. So if the price of 5 mudus rises between now and next year, she has to pay you at least the difference in the price of 5 mudus. If she doesn’t then you are actually losing by giving her the money.

Congratulations Tope, you are now an economist.

The phrase “you can’t eat money” is really important in understanding monetary policy. Money itself doesn’t really matter. In fact in most cases it is pretty useless. It is what money can buy that really counts.

So in terms of what money can buy, Topes friend has to pay at least enough interest for Tope to still be able to buy 5 mudus of garri. If Tope’s friend does that, then the real interest rate is actually 0%. Because in terms of the real value of stuff, Tope loaned out 5 mudus of garri and got 5 mudus of garri back at the end of it. And Tope eats garri.

In general terms we call a change in the price of stuff inflation. So if the price of garri increases by 20% between now and next year, then Tope’s friend has to pay back at least 20% for the loan to make sense. Given that inflation is 20% then the real interest rate is actually 0%. Tope is loaning out the money for free in real terms.

Which brings us to the point of this article. Inflation in Nigeria is somewhere around 9.6%. Which means in real terms, interest rates have to be at least 9.6%. If it is lower then everyone who gives out loans would lose money in real terms. And most people are not in the business of losing money.

Once you start to think of things in real terms then the interest rates banks charge starts to make a little sense. The Nigerian government, probably the most risk free borrower, gets long term naira loans at somewhere about 10%, or about 1% in real terms. Not so bad is it. Prime borrowers get loans somewhere about 18-19% which in real terms is about 9-10%. Again not so bad is it? For comparison the prime interest rate in real terms in Brazil is 22%, 5% in China, 5% in India, 3% in Germany and 11% in Ghana. Nigeria is not that strange after all.

Of course once you start to account for risk then it should be higher that the 18-19% or the 8-9% in real terms. Risk has a price and lets be honest, most Nigeria borrowers are very risky.

What happens if you use government to force banks to give out loans at “near 0%” when inflation is clocking 10%? Everybody behaves like smart Tope and chooses to eat their garri instead. Yes i’m referring to you Gov El-Rufai.

Take home assignment. Why do most rich Nigerians, including the VP, choose to save money in US dollars? Hints: A naira savings account will pay you about 5%. Inflation in US dollars is about 0-1%.

NB: In reality no one can predict the future and you actually have to guess what inflation will be in the future. Throws in some complications but the moral of the story is still the same.

 

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2 thoughts on “Learn about the Real Interest Rate

  1. This is really simple but very enlightening. Thanks for the efforts, Nonso. I learned very useful things reading ng this.

  2. Please correct me if I am wrong Sir but isn’t inflation akin to simple interest while interest rates charged by our banks are compounded? Perhaps even compounded monthly?? That converts the whole effort of the entrepreneur into a loan servicing scheme. I truly believe that without such an oppressive interest rate (point taken on risky loans) and the whole array of hops and skips that the banks require loan applicants to perform, our economy can be restarted faster with long lasting benefits for all. Finally, thanks for the interesting article!

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