To tame inflation, many African central banks have in recent years raised interest rates aggressively so that policy rates (a central bank’s benchmark rate) are now generally higher than in other parts of the globe. Yet inflation remains stubbornly high on the continent.
Policy rates are designed to influence inflation through lending rates, but this relationship is sometimes challenged by what lies along the path from one to the other. The smoother the path between the policy rate and the rates at which households and businesses ultimately borrow, the greater the ability of monetary authorities to influence the availability of capital in the economy, and ultimately inflation. The effectiveness of monetary policy therefore depends not only on the policy rate but on the architecture through which that rate is transmitted to the economy.
Five layers
Monetary policy discussions often focus on the policy rate, but no matter how considered that rate is, it is only effective if the transmission plumbing works. A functioning interest rate system usually consists of five layers that must flow in sequence.
The first layer is the policy rate; the second is the interbank overnight market rate that the policy rate targets; the third, the money market in which there are the standing facilities, repos and treasury bills; the fourth layer is the yield curve; and the fifth, the lending and deposit rates received by households and businesses.
The policy rate is therefore only the starting point, and how its effect travels through the financial system matters.
Many interbank markets are fragmented, with little activity
Just as a lighthouse signals to ships where the port is, the policy rate signals where the central bank wants interest rates to be. The architecture then determines whether or not the signal reaches its destination quickly and clearly.
Put another way, the policy rate is like the engine of a car while the rate architecture is the transmission. No matter how powerful its engine, a car will not move effectively if the transmission is faulty. Without good transmission, monetary policy becomes less effective, market rates get disconnected, liquidity management becomes costly, and inflation expectations harder to anchor.
Missing infrastructure
While the central banks of most African countries have policy rates to signal policy, far fewer have complete interest rate architectures for transmission. Many have fragmented interbank markets with limited activity and low transaction volumes. Some lack credible overnight benchmark rates and have shallow repo markets, resulting in inefficient use of collateral for financing.
Also, while a number of African financial markets have some rate architecture, their yield curves are incomplete, with the result that beyond the very short maturities price discovery becomes a problem. This may in turn lead to illiquid markets where some institutions or segments of the market may be flush with liquidity while others are perpetually short. For many monetary authorities on the continent, the challenge is therefore not setting policy rates but transmitting them.
The change we need
To position our financial markets as tools to help control inflation and drive growth and economic development, African governments must make certain changes.
We must strengthen our overnight markets to efficiently trade and allocate capital. To do this, we need to develop credible benchmark rates and create and deepen repo markets, which will improve our liquidity management frameworks. We also need to encourage active secondary market trading of capital by promoting transparency and data availability.
Africa must create its own path to financial market development
In embarking on this change journey, however, we must be conscious of where we have come from and where we presently are. We cannot just copy the advanced world, because our markets are different from theirs. We have smaller transaction volumes, different liquidity structures, a greater role for government securities and higher banking sector concentration. This is why we must create our own path to financial market development, while using the advanced markets as benchmarks.
In this development, a sequenced approach is best because the architecture must be built from the foundation upward – markets cannot sustainably develop from the top down. A good sequence for this journey would be:
- Liquidity management framework
- Active overnight market
- Overnight benchmark rate
- Repo market development
- Yield curve strengthening
- Derivatives market development.
Economists, finance professionals, and accountants all have roles to play in building a market architecture that supports the continent’s development aspirations and enables monetary policy to permeate the economy.
For a long time, the focus of financial sector reform in Africa has been on institutions – banks, regulators, exchanges and central banks. The next phase may need to focus on infrastructure because ultimately, economic growth depends not only on the availability of capital but on the systems that determine how that capital is priced, allocated and moved through the economy.
Explainer
An overnight benchmark rate provides a common reference point for market participants, anchoring money markets, supporting derivatives markets and aiding policy transmission. To be trusted, it must have clear, transparent and credible calculation methodologies. South Africa’s Zaronia, Egypt’s Conia, Kenya’s Kesonia and Nigeria’s newly launched NOFR have been adopted to be just that, replacing systems based on quotes or expert judgment.
A credible yield curve is a transmission must-have, as governments can price debt off it, corporates raise capital, investors allocate assets and banks price loans. Many African yield curves are really issuance curves, reflecting scarcity and buy-and-hold behaviour. Some also have fragmented curves, with different government-backed instruments trading at different levels, leading to confusion in pricing financial products.
